Beginner’s Guide to Crypto: Massive World of Stablecoins
Cryptocurrencies have long been characterized by volatility. As far back as 2013 – when Bitcoin rose from US$550 to US$1,200, and back down to US$800 in a matter of weeks – it became clear that a more stable form of cryptocurrencies was needed in the crypto space.
In traditional finance, they range from commodities such as gold and silver, to fiat currencies such as the US dollar. Investors use these assets to hedge and manage their risk exposure in times of uncertainty.
As with any investment, knowing what you’re investing in is key – so far in our beginner’s guide to crypto we’ve talked about the relationship between blockchain and cryptocurrencies, gone through a number of different blockchain applications such as NFTs and DeFi – from blue chips like Bitcoin and Ethereum, to higher risk meme coins like Shiba Inu, as well as explored why people pay extraordinary amounts for NFTs.
In collaboration with Luno’s educational center, Luno Discover, let’s now take a look at stablecoins – another important segment of the crypto space.
What are stablecoins and how are they used?
A stablecoin is a cryptocurrency that, as the name suggests, is designed to maintain a relatively constant price. This is usually achieved by tying the value of the coin to another asset class such as gold, or currency such as the US dollar.
Stablecoins are often used to interact with assets that are more prone to sharp price movements. Just as the name suggests, the stability of stablecoins helps minimize volatility and provides more security for the value of the respective portfolio.
They are also used to facilitate trades on crypto exchanges – most often thought of as a “bridge” between fiat currency and cryptocurrency. Instead of buying cryptocurrency with fiat currency which requires multiple steps, time and/or costs, traders exchange fiat for a stablecoin and execute trades.
Especially in countries experiencing political-economic crises where local currencies lose extreme value, stablecoins are limitless, easily transferable and maintain value wherever you are in the world. Because of that, the application for payments and remittances is also another good use case.
How and what are stablecoins connected to?
Stablecoins can be classified into one of four different categories:
1. Fiat-backed stablecoins
These are the most widely used variety of stablecoins, usually backed 1:1 by fiat currency.
For example, Tether (USDT) – which was one of the first stablecoins launched back in 2014 – is backed by the US dollar. Every issued unit of USDT is matched by an equivalent amount of US dollars stored in Tether’s reserves. This ensures that holders can redeem 1 USDT for 1 USD, and vice versa.
As of now, USDT has the highest market capitalization among all stablecoins and is the third largest cryptocurrency, behind Bitcoin and Ethereum.
USD Coin (USDC) is next in the ranking and is also fiat-backed. 80 percent of the total stablecoin supply is split between these two coins.
It is worth noting that the reserves of fiat-backed stablecoins do not always consist of cash. They may also contain cash equivalents such as government bonds and debentures. These reserves are a good indicator of how secure the link between a stablecoin and its underlying currency is.
As a rule of thumb, the more liquid the reserves, the more stable the stick. Imagine a panic situation where thousands of investors want to convert their stablecoins back to fiat currency. If the stablecoin has cash reserves, it will have no problem meeting this demand and maintaining its peg.
But say the reserves partly consist of bonds that can only be converted into cash in a few months. In this case, the reserves would not have enough liquidity to meet the sellers’ demands. This can cause the stablecoin to de-peg and lose its value.
For Singaporeans, XSGD is the SGD-backed stablecoin of choice. The issuing company, Xfers, is licensed by the Monetary Authority of Singapore (MAS) under the e-money issuance framework. As part of this framework, XSGD is required to be backed 1:1 by Singapore dollars stored in a local bank.
Xfers also publishes an attestation report – prepared by an independent accountant every month – detailing the number of XSGD tokens in circulation and the amount of Singapore Dollars held in the company’s reserves.
2. Commodity backed stablecoins
There are also stablecoins backed by assets such as precious metals or oil, which share the same volatility as their underlying assets. They allow investors to access real goods without having to leave the crypto space.
PAX Gold (PAXG) is one of the most well-established stablecoins in this category, ranking among the top 100 cryptocurrencies by market capitalization. Each unit of PAXG represents one troy ounce of a gold bar stored in a professional vault.
This is a convenient way to gain exposure to gold as the minimum investment required is as low as $20 and there are no additional storage costs. Investors who would be priced out of buying commodities in traditional markets can access them using stablecoins.
PAXG can be redeemed for physical gold bars and US dollars, or traded in exchange for other cryptocurrencies. As a result, it provides investors with much more liquidity than other forms of gold investment.
Tether Gold (XAUT) is another popular gold-backed stablecoin, issued by the same company that launched USDT.
3. Crypto-backed stablecoins
These stablecoins have their value tied to a fiat currency or commodity, but are backed by crypto assets instead.
For example, Dai (DAI) tracks the US dollar and is issued only in exchange for crypto-based security.
To receive 10 DAI (worth US$10), a user may have to deposit over US$15 worth of Ethereum or another cryptocurrency. This is to protect against crypto volatility. Even if the value of the deposit were to fall to 33 percent, it would still be worth enough to account for issued DAI.
If the value of the security fell even further below, it would be liquidated via an automated process. For example, a platform may require that the value of the collateral must always be 1.2 times the value of the loan. In this case, if the value of the user’s Ethereum deposit fell below US$12, it would be liquidated and they would lose the entire amount.
Despite these safeguards, crypto-backed stablecoins tend to be riskier than their fiat counterparts. When investing in such coins, it is important to measure the strength of their bond by checking how much excess collateral is held in the reserves, and which choices of cryptocurrencies are accepted as collateral.
4. Algorithmic Stable Coins
Finally, there are algorithmic stablecoins, which also rely on other cryptocurrencies, but not for security.
The most famous stablecoin in this category is one that no longer exists. In fact, its demise was a major catalyst that led to the 2022 crypto crash.
TerraUSD (UST) used to be the official stablecoin of the Terra blockchain. It maintained its link to the US dollar through an algorithmic relationship with its sister cryptocurrency Terra (LUNA).
If the value of UST ever exceeded 1 USD (due to high demand), LUNA holders could exchange LUNA worth 1 USD for 1 UST. Similarly, if the value of UST went below 1 USD (due to lack of demand), UST holders could exchange 1 UST for 1 USD worth of LUNA.
This arbitrage facility was intended to ensure that any deviations in UST’s price would correct themselves and the value would always return to USD 1. But in May of this year, a different reality emerged.
After experiencing an extremely high volume of sales, UST’s price began to decline. Immediately, users started converting UST to LUNA to take advantage of the arbitrage opportunity.
Unfortunately, the algorithm could not produce LUNA coins fast enough to recover UST’s pin. This caused further panic and accelerated the UST selloff. At the same time, users also started selling LUNA coins due to the rapidly increasing supply.
Both LUNA and UST lost almost all of their value within a few days due to its interconnected nature, causing what they call a “death spiral”. This is not to say that all algorithmic stablecoins are doomed to fail, but they do indeed come with risks that may not be readily apparent.
Since they are not backed by any collateral, these stablecoins are only as strong as their underlying smart contracts. Any weaknesses in their algorithms can be exploited by users or inadvertently triggered by market volatility.
The Terra incident has highlighted the importance of having and practicing regular investment habits – knowing what you’re investing in, only investing what you can lose, especially for higher volatility assets like cryptocurrencies.
The future of stablecoins
After wiping out over $17 billion in value, the LUNA/UST crash brought stablecoins to the notice of regulators around the world.
In June, Japan passed a key piece of legislation where only licensed companies will be allowed to issue stablecoins in the country. It will be necessary for stablecoins to be pegged to the Japanese yen or another legal tender, and companies will also need to provide a guarantee of full redemption.
The UK plans to regulate certain stablecoins under the payments framework. The goal is to make these cryptocurrencies safe and stable enough for consumer use.
In Singapore, MAS believes that most stablecoins do not meet the criteria to be classified as e-money. Even fiat-backed coins – while more stable than their algorithmic counterparts – experience price fluctuations when traded on different exchanges.
Nevertheless, as seen with Xfers’ XSGD token, MAS recognizes the potential for stablecoins to serve as e-money when they meet the stated criteria.
As countries come up with their own regulatory frameworks, it remains to be seen how stablecoins will play a role in shaping the future of cross-border transactions.
It is key to always know what you are investing in; it’s one of many ways to reduce your risk! To learn more about stablecoins, head over to one-stop crypto education hub Luno Discover, and subscribe to Luno’s Telegram channel for bite-sized crypto updates.
This article is part of a six-part series on a beginner’s guide to crypto without the hype. You can check out the other articles here:
– Part One: Blockchain and Cryptocurrencies
– Part Two: Coin Types and How to DYOR
– Part Three: NFTs, DeFi and the Metaverse
This article was written in collaboration with Luno.
This partnership between Vulcan Post and Luno is for educational purposes only. Luno Singapore has been granted an in-principle approval by the Monetary Authority of Singapore (MAS) under the Payment Services Act 2019. Cryptocurrency is a high-risk investment. The value of cryptocurrency may fluctuate significantly and you may lose the capital you invest. Before investing, we encourage you to educate yourself about cryptocurrencies and familiarize yourself with the risks involved, which are detailed in Luno’s risk warning.
