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A Detailed Overview on Stablecoins

Cointime Staff· 6 min read

On 9 May 2022, a stablecoin TerraUSD (UST) found on the Terra blockchain, had crashed. This incident was infamous for causing the combined loss of about US$60 billion in UST and LUNA, Terra’s native and sister cryptocurrency. Naturally, the crash would have made newcomers and veterans of the crypto community to question the validity and security of stablecoins. This type of coin is named as “stable”, after all.

So, what are stablecoins and are they still safe investments today?

Stablecoin 101

Stablecoins are a type of digital asset created as a “stabler alternative” to other more volatile cryptocurrencies. They can also be used to regulate the stability of value and market cap of their native cryptocurrency counterparts.

As such, stablecoins are pegged* to other collaterals like:

  1. Fiat (USD, EUR, GBP, etc). Usually $1.00 USD
  2. Algorithms — AKA “Algorithmic Stablecoins”
  3. A mix of Algorithms and Other Cryptocurrencies — “AKA Hybrid Stablecoins”

*Pegging: The practice of attaching a crypto currency’s price to the price of its target asset.

Stablecoins help crypto users in a few ways:

  • It provides users with a means to exchange their more volatile cryptocurrency investments with stabler alternatives while sparing them minimal exchange fees when converting cryptocurrencies into fiat or other cryptocurrencies in Centralized Exchange platforms (CEX) or cross-chain bridges.
  • It helps users store and then reinvest their assets into other projects when they feel that it is the right time to do so by mitigating their investments’ volatility when exchanging volatile assets to stablecoins.
  • It gives crypto users a means to access projects found in Decentralized Finance (DeFi) applications and conduct activities like flash loans, allowing them to lend or borrow cryptocurrencies of equal measure.
  • It offers the avenue for payments should products or services require the maintaining or dependence of a usually US$1 price base.

i. Stablecoins

Most stablecoins familiar to the crypto community (Think USDT and USDC) are pegged 1:1 with the US dollar directly. This means that a single stablecoin is theoretically priced the equivalent of $1.00 USD regardless of what happens in the project. Stablecoins that are backed directly by the US dollar are usually placed under strict government regulation. Also, many stablecoin issuers or blockchain platforms claim that they hold an equivalent value pool of fiat with the stablecoins in circulation, giving crypto users the assurance that the amount of stablecoins that they hold can be easily cashed out into fiat without the projects folding.

There are also over-collateral stablecoins that are backed by other cryptocurrencies. DAI, a stablecoin created by MakerDAO, is one such stablecoin backed by a combination of Ethereum, Wrapped Bitcoin, USDC, and other crypto assets. This combination of pegging aims to maintain DAI’s price to the equivalence of US$1.

ii. Algorithmic Stablecoins

Some stablecoins depend on algorithms (or smart contracts) created to maintain a price peg of the usual US$1. These contracts regulate the supply and price of the stablecoins in conjunction with their native sister counterparts.

For example, the computer code for TerraUSD (UST) helps keep its price to US$1 by regulating its sister LUNA token. For every creation or burning of UST, the equivalent value of LUNA is created or burned respectively. This works vice versa too.

iii. Hybrid Stablecoins

Stablecoins like FRAX attempt to maintain a US$1 price by pegging them with a mix of fiat or other cryptocurrencies in tandem with algorithms. FRAX’s US$1 value is maintained through a collateralization of USDCs and its own code.

For Projects: A Design Perspective; Pros and Cons

In general, there are no pros and cons for projects to adopt the creation of stablecoins and maintain the volatility of their native cryptocurrency projects.

However, it is important for projects to understand the risks involved through the ways they introduce stablecoins in their projects.

No three different types of collaterals chosen will be completely safe. All of them can bring some levels of risk to projects looking to adopt stablecoins as part of their business strategy. Choosing the adoption of over-collateral stablecoins or hybrid stablecoins places your stablecoin project and its value under the dependence and whims of centralized entities and the value of fiat currencies. Meanwhile, algorithms may not have the room to account for the human sentimental aspect of financial decision making — Much like how, in the sense of over-simplification, the price of UST and LUNA had dropped drastically due to the mass selling of both by its users, causing the crash.

Much like other crypto projects, stablecoins are also not spared by common security vulnerabilities. There is no universal way to implement a stablecoin in its code. Thus, every stablecoin project will have its own security overlaps and possible unseen problems.

For Users: Are Stablecoins Safe Investments?

In general, stablecoins are safe investments. Their values are naturally stable based on their fiat currencies and have many specific uses.

“A good practice is to check whether a stablecoin can be firmly pegged to the fiat currency it is designed to be pegged to. For over-collateralized stablecoins, users should check if the implementation [of the peg] in its smart contracts ensure that the stablecoin is backed by sufficient collaterals projects claim they possess. This means that the implementation [or code] has a liquidation mechanism to sell said collaterals in their pool and maintain the peg when the collaterals’ value decreases.

If the peg is backed by fiat currencies, users should check if the assets or cash are found in good custody of one or multiple financial institutions well-governed by governments.”

— Tan Yuefei,Fairyproof CEO

However, users are not spared from hackers or scammers when they interact with stablecoins. Many hackers would still use stablecoins to maintain the value of their exploits, hence, users would still be vulnerable to having their stablecoin possessions stolen from their wallets.

Conclusion: A Fairyproof Perspective

Regardless, are stablecoins necessary in the crypto space? Yes.

When ETH had reached its All-Time-High (ATH) to around US$5, 000, many ETH holders wished to exchange their earnings to something less volatile and stable while avoiding high off-chain transaction costs or keeping from strict regulations from governments. Swapping their earnings to other stablecoins allows them to achieve those things.

“Over-collateralized stablecoins are generally straightforward and easy to understand. The challenge comes in discerning if an algorithmic stablecoin is sound and will work.

Many people have tested and attempted to deliver pure, algorithmic stablecoin protocols. So far, most of them have not succeeded, while some have caused dire consequences to the crypto space — Like UST. No doubt, the idea of a pure algorithmic stablecoin is attractive to many crypto geeks — New algorithmic stablecoins protocols are still proposed and emerging today. Although these innovations are great and should be respected, most of them will need to endure great challenges before they can be proven to work.

So, for users, be weary with pure algorithmic stablecoins.”

— Tan Yuefei,Fairyproof CEO

On top of that, users must also be vigilant of the integrity of the stablecoins they invest in. Make sure that: the stablecoins can be secured by sufficient collaterals, they are not rugpulls, and that the projects are secure in terms of their code.

In summary, it does not hurt to read more before making financial decisions.

So, where do you start in your journey for more crypto knowledge?

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