Stablecoins are a type of cryptocurrency that has a fixed price due to pegging to the price of another asset. Stablecoins are an integral part of the cryptocurrency world; however, they also have drawbacks and reasons to doubt their reliability. In this article, we discuss the main types of stablecoins and their advantages and disadvantages.
Stablecoins act as the main currency for making payments because their exchange rate is stable and transactions are fast. Almost every crypto investor resorted to using stablecoins — cryptocurrencies linked to an asset, usually the US dollar.
Importance of stablecoins in the cryptocurrency ecosystem
Regarding the use of stablecoins, it should be understood that they are not independent carriers of value and act only as media and instruments of exchange and preservation of capital.
The main application of stablecoins is trading on cryptocurrency exchanges. The absolute majority of cryptocurrencies on well-known exchanges are traded specifically to stablecoins, such as USDT, USDC, BUSD, and DAI. Stablecoins also make it easy to estimate and track the size of a portfolio, for example, $1000 instead of 0.033742 BTC. Because of this property, they are especially in demand for decentralized exchange (DEX), where there is no binding to fiat structures.
Stablecoins also make it easy, fast, and inexpensive to withdraw and move capital between cryptocurrency exchanges. Before the advent of stablecoins, traders had to withdraw funds through third-party exchangers and tightly regulated fiat exits (fiat gateways), which entailed many commissions, low speeds, and the possibility of losing actual or potential earnings due to waiting, downloads, or network errors. The speed and ease of moving stablecoins also provide great opportunities for arbitrage trading.
Four Types of Stablecoins
There are different types of stablecoins, each with its own mechanism for supporting price stability. Some are backed by the stock of the underlying asset, with a bank account holding an equivalent amount of US dollars for each stablecoin in circulation. Others rely on algorithms and smart contracts to regulate the supply and demand of stablecoins and ensure the stability of their value. There are four main categories of stablecoins based on collateral:
- Backed by real fiat currencies, such stablecoins have reserves denominated in fiat currencies, such as dollars, euros, or pounds. The advantage of such stablecoins is their increased reliability, but there is a need for trust between users and third parties responsible for managing the reserves. An example of such a stablecoin is USDT and USDC.
- Cryptocurrency-backed: The price of such stablecoins is linked to the values of other cryptocurrencies. For example, the DAI stablecoin is pegged to the dollar but backed by ether using a smart contract. Cryptocurrency-backed stablecoins have a higher degree of decentralization as they do not rely on third parties. However, there is an additional risk due to the volatility of the underlying asset.
- Backed by precious metals, commodities, etc, there is a growing number of stablecoins whose prices are linked to gold. For example, the value of the Ethereum-based cryptocurrency DigixDao is backed by gold coins held by banks in Singapore. They are safer and more reliable because their underlying assets are physical and less exposed to external factors. The reserves were managed by a third party.
- Algorithmic: Such stablecoins have no reserves from which to back them. Their price is tied to the underlying asset by issuance and redemption of the linked cryptocurrency. Such tokens are considered the riskiest to buy.
Use Cases and Adoption of Stablecoins
Stablecoins are highly adaptable and influential instruments for investors, traders, and cryptocurrency users. Their ability to withstand exchange rate fluctuations renders them impractical for utilization in various cryptocurrency-related domains.
Stablecoins are a liquid asset: they are available in large quantities on almost every platform. Popular stablecoins are also a universal unit of exchange and capital storage among crypto investors and traders. They are easier to trade in pairs with other cryptocurrencies than with fiat currencies. Unlike fiat currencies, stablecoins can be transferred between accounts and addresses more quickly and easily, or used as a store of value, protecting their users from market volatility.
Besides cross-border payments or stores of value, stablecoins are also used in DeFi applications. They can be used for lending and staking, providing liquidity for crypto traders, holding money as savings, or facilitating microtransactions, allowing people to make small payments for goods and services without the need for a traditional banking infrastructure.
Future Outlook for Stablecoins
After the failure of Terra, centralized projects such as Tether and USDC remain the main players in the stablecoin segment. However, many countries, including the United States and the European Union, are planning to introduce extensive regulation of stablecoin token issuers, which could make their use more difficult.
Stablecoins are regularly criticized by regulators and government agencies. In late 2021, the US Treasury issued a report on the risks of stablecoins, noting the opacity of their reserves and assessing them as a threat to investors. The Fed believes that stablecoins pose a risk because of potential problems with their conversion into fiat currency.
As stablecoins have become more widely accepted, they are likely to be integrated into traditional financial systems. For example, banks may begin offering stablecoin accounts alongside traditional bank accounts. This integration could make it easier for people to use stablecoins for everyday transactions such as paying bills or buying groceries.
Banks and other financial institutions are exploring the use of stablecoins. For example, some banks partner with stablecoin issuers to offer their customers the ability to send and receive stablecoins. As stablecoins become more widely adopted, we expect to see more collaboration and partnerships between stablecoin issuers and traditional financial institutions. Overall, we expect stablecoins to become more widely adopted, integrated into traditional financial systems, and used in various ways.
Regulation of Stablecoins
The rapid expansion of the $130 billion market has led to the increased regulation of stablecoins, raising concerns about their potential impact on the broader financial system. In October 2021, the International Organization of Securities Commissions (IOSCO) recommended that stablecoins be regulated as a financial market infrastructure alongside payment systems.
The proposed rules are primarily aimed at stackable coins that regulators consider systemically important, as they have the potential to disrupt payment and settlement transactions. There is also growing political support for the stricter oversight of stablecoins. Many government officials have supported the imposition of rules similar to those applied to traditional banks.
Like other cryptocurrencies, Stablecoins are regulated by jurisdiction. In the US, the SEC issued guidelines for companies wishing to become stablecoin issuers. In addition, many exchanges require users to comply with AML and KYC protocols when trading stablecoins.
Disadvantages of Stablecoins
There are also disadvantages that users should be aware of before investing.
- Lack of regulation: Because stablecoins are decentralized and often operate outside traditional banking systems, they may be subject to less regulation than other forms of digital currency. This means that users must be particularly vigilant when using them, as they do not have the same level of protection as traditional currencies.
- Third-party Risk: Users may be exposed to third-party risk if the issuer does not properly manage or protect its reserves. Therefore, it is important to research and understand the project before investing in any stablecoins.
- Ponzi Schemes: As with any new technology, there is a risk that some stablecoin projects may turn out to be fraudulent or Ponzi schemes.
Conclusion
Currently, it is difficult to find investors or traders who do not own stablecoins. They are usually stored in cryptocurrency exchanges so that users can quickly find new market opportunities. Stablecoins also allow you to open and close positions without having to transfer funds to the fiat. In addition to trading and investing, stablecoins can also be used for payments and international transfers.
Although stablecoins have become an integral part of the cryptocurrency world and have enabled the creation of a new financial system, their risks should not be underestimated. Some stablecoin projects have failed to maintain pegs, squandered reserves, or faced lawsuits. Although stablecoins are extremely versatile and carry similar risks. To mitigate risk, diversify your portfolio and conduct research before trading.
