Stable Coins: Everything You Need To Know

The crypto market is very volatile. Factors like viral news can put speculators in a frenzy. They’ll move in and out of trades swiftly. The results can expand or wipe out substantial crypto market value.

For example, last November’s dip made Bitcoin lose US$600 billion in market value. The whole crypto market lost above US$1 trillion in value.

Stable coins are designed as safeguards against such volatility. It ensures your money is safe to maximize your investment in lucrative crypto assets. That’s where USD Coin, Tether, Terra Luna, and other stable coins come in.

But, the collapse of the stable coin TerraUSD (UST) and its sister Luna raises more questions than answers. The stablecoin fell almost to zero, wiping off over US$45 billion. Some people lost all their money, and others committed suicide.

However, Tether, another stablecoin, still maintains a US$1 value while TerraUSD (now trading as Terra Luna Classic) is almost at US$0. If it is confusing that one stable coin can destabilize while another remains unshaken, then this blog will help you understand everything.

What are Stable Coins?

Stablecoins are cryptocurrencies designed to withstand market volatility by pegging them to fiat money or exchange commodities. For example, if it can be pegged to a fiat currency like the US dollar or commodities like gold or diamond.

In that case, a single crypto unit will equal a single unit of the US dollar (US$1). An example is the USD Coin, and Tether pegged to the US dollar.

What Is the Purpose of A Stable Coin?

A stable coin is designed to have a fixed value over time. As a result, it allows you to trade, lend or borrow other digital assets with minimal risk exposure as an investor. It protects you from price volatility associated with other cryptocurrencies like Bitcoin.

That makes them practical and a better store of value and medium of exchange across digital asset trading platforms like Coinbase. It also bridges the gaps between physically exchanged commodities and fiat currencies with digital assets.

For example, with the constant decline of the US dollar as a world reserve, other stable coins like CNHC pegged on offshore Chinese Yuan (CNH) have become a favorite for exporters and importers.

So, how do they work to achieve stability to protect against market volatility?

How Do Stable Coins Work?

Stablecoin is the answer to mounting pressure to drive broader adoption of cryptocurrencies by reducing their price volatility. As stated earlier, stable coins are pegged to fiat currency or commodity as collateral.

For price stability, stable coins must maintain a certain amount of collateral (reserve assets). Recent advances have led to algorithmic formulas as collateral. TerraUSD (UST) is an example of an algorithmic stablecoin. Algorithmic stable coins achieve stability by controlling the supply of crypto tokens.

However, you need to learn about the various stable coin types to understand how each works.

Types of Stable Coins

Stable coin taxonomy depends on its underlying collateral structure. Let’s explore the major types of stable coins:

Fiat-Backed Stable Coins

They are the most common stable coins backed 1:1 by fiat currency. The central issuer or financial institution keeps the collateral reserves equal to the tokens in the market. So, if the collateral reserve is $100 million, only 100 million tokens (worth $1 each) of the stable coin will be circulated.

Fiat-backed stable coins are also off-chain assets because they do not use other cryptocurrencies as collateral reserves. Examples of fiat-backed stable coins include:

• Tether (USDT)
• Paxos Standard (PAX)

Tether has recently come under sharp criticism for the lack of transparency in its audit book. And the outcry has been growing louder after it temporarily dropped from $1 to $0.95 in May. But, it quickly gained the 1:1 value emphasizing that liquid assets back it.

Crypto-Backed Stable Coins

Also known as on-chain stable coins, they use other cryptocurrencies, like Ethereum, as a collateral reserve. It operates similarly to fiat-backed stable coins.

A certain amount of the crypto is a “security pledge” to cover volatile market events. So, it will not be 1:1 as a fiat currency collateral reserve because it is not enough to hold a peg. Most collateral can be twofold or more to maintain a peg.

For example, if it is pegged to a US dollar, the amount locked up would be about $2 for every $1 stable coin. In short, crypto-backed stable coins are over-collateralized to achieve stability against price fluctuations.

The over-collateralization is necessary because even the collateral cryptocurrency asset like Ethereum is volatile.

DAI is one of the crypto-backed stable coins using Ethereum as collateral. Smart contracts are an incredible feature that DAI and most crypto-backed stable coins use to maintain stability.

Smart contracts are programs based on blockchain that act or run when certain predetermined conditions are met. You do not need a central issuer or middleman like in fiat-backed stable coins. Smart contracts handle everything-a necessary foundation in decentralized finance (DeFi).

So, if the Ethereum (ETH) price drops but maintains a set threshold, the excess collateral helps DAI maintain price stability. However, if it dips below the set threshold, the smart contract will collect the collateral and clear the debt position.

DAI uses two mechanisms to maintain stability:

• Smart contracts automatically stabilize DAI’s value if its price starts to fluctuate.
• MakerDAO, a decentralized autonomous organization (DAO), regulates it by changing specific parameters of the smart contracts to ensure stability.

Algorithmic Stable Coins

Algorithmic stable coins do not rely on crypto or fiat currency as collateral. They depend on specialized and complex algorithms alongside smart contracts to regulate token market supply.

An example of an algorithmic stablecoin is TerraUSD (UST).

The algorithmic system will reduce token supply if the price falls below the fiat currency it tracks. TerraUSD stablecoin tracks the US dollar to peg it at US$1.

Supply volume is done through the “burning of tokens,” where tokens are sent to the “eater’s” address (black hole). It will reduce the volume of tokens in circulation. With reduced supply, the demand increases, pushing the price of the stable coin to the fiat’s value.

In March 2022, TerraUSD (UST) gained a 75% price value after burning about 29 million tokens. But the overwhelming negative market sentiment sent it to almost zero 2 months later. In short, burning tokens is practical, but it is not applicable in all cases.

If the stablecoin price goes above the fiat currency it tracks, more tokens will be issued to push down the value of stablecoin. With more supply than demand, the price will automatically go down to match the fiat currency.

Algorithmic stable coins can easily collapse to market volatility. The collapse of TerraUSD is calling for more scrutiny on algorithmic stable coins and overall federal regulation of stable coins to protect investors.

Commodity-Backed Stable Coins

Unlike fiat, crypto, or algorithmic-backed stable coins, having a commodity-backed stable coin gives you fractional ownership of a physical asset. It can be oil, real estate, or precious metals like gold.

Gold is arguably the most collateralized. Paxos Gold (PAXG) and Tether Gold (XAUT) are examples of commodity-backed stable coins. But it is worth noting that even gold and oil react to market forces. So, they may experience price fluctuation and potential value loss.

Commodity-backed stable coins enable investments in hard-to-reach places. For example, getting a gold bar and a secure storage facility be a challenge in most areas. The best part is exchanging stable coins like PAXG for cash or gold is easy.

But not all commodity-backed stable coins have the same luxury. However, you can redeem gold-backed stable coins for gold. It is unclear if you can do the same with SwissRealCoin to get a real estate property or a barrel of oil from Venezuela’s Petro coin.

Which Is the Most Stable Coin?

That said, the most stable coin must have liquid assets as collateral backing. Fiat and commodity-backed stable coins are the most stable coin at the time of writing. Tether is the most stable coin on Coinbase and Binance. USD Coin and DAI are very stable too.

However, even the most stable coins like Tether (USDT) can experience weak price fluctuation during the market dip. Even commodities like gold and oil fluctuate from time to time. But, they can quickly gain ground due to liquid assets backing their value positions.

Are Stable Coins A Good Investment?

Although stable coins do not generate much when you trade them like Bitcoin or Ethereum, they are better for long-term staking. They do not fluctuate much, so they are not lucrative as volatile Bitcoin or Ethereum.

Holding them longer also has risks, yet they yield better returns if you stake them in some DeFi platforms. Borrowing and lending platforms are the best as they offer better interest rates.

You will receive interest equal to the amount of time you locked your stable coin in the platform. You can get an annual percentage yield (APY) of 7–12% for your stable coins.

Here are some of the DeFi platforms offering high yield rates for your stable coins:

• Aqru offers 7% APY
• Crypto.com offers 10% APY for stable coins.
• Nexo offers up to 12% APY for your stable coins.
• Binance offers 14.8% APY for your stable coins.
• BlockFi issues 8% for assets upto $20,000

Each platform has different terms and conditions that may change from time to time. So, better check it before locking your stable coins.

It is worth noting that Anchor Protocol, which supports TerraUSD (UST), offered 20% APY. But, the collapse of TerraUSD has affected the platform too.

As a rule of thumb in investment, only commit a percentage you are willing to lose. Do not tie your whole life savings to a single asset.

Conclusion

Stable coins offer the stability needed to handle volatile crypto markets. But, they can also face price fluctuation, especially if enough liquid collateral assets do not back them. Tether, USD Coin, and DAI are some of the most stable coins.

Stable coins are a good investment if you stake in DeFi platforms. DeFi platforms like Binance, Nexo, and Crypto.com offer a high yield rate (10%-14%) for your stable coins. They borrow and loan out your coins for other financial services on the platforms. As a result, part of the interest is given to you for the period you loaned the stable coins.

But, the crypto market, even stable coins, faces considerable price fluctuations. Because they are not regulated to protect your investments, only commit what you are willing to lose.

Author Bio

Benjamin is a technical writer with a bias in SaaS, blockchain, and FinTech. Feel free to hit me up for in-depth and easy-to-read articles to drive awareness and new leads for your brand. (benranker3@gmail.com)