Stablecoins: The lifeblood of crypto

Despite the name, cryptocurrencies do not tend to provide a good currency. They are volatile, not always liquid, difficult to use and can suffer from terrible transactions.

Take the benchmark cryptocurrency Bitcoin, which can only process around seven transactions per second.

Why? Because a block of transactions can only handle so many, and each block is only mined every 10 minutes, leading to wait times that can stretch into hours!

As for volatility, how can a gas pump advertise in bitcoin prices when the assets can swing 10% in a day? It will require a full-time team member to adjust the billboard every 30 minutes.

Not all blockchain networks are as horrendously inefficient as bitcoin, and to its credit, bitcoin is generally viewed as an asset or commodity, not a medium of exchange.

In the years that followed bitcoin’s rise to power, hundreds of competitors came to the fore.

Some, like Solana and Cosmos, can handle tens of thousands of transactions per second.

But this does nothing to fix crypto’s other inherent flaws. In fact, their speed often comes at the expense of price stability and network reliability.

This is where stablecoins come in.

How do stablecoins work?

Stablecoins are a class of cryptoassets pegged to the price of another asset, usually the US dollar, but there are gold-pegged, euro-pegged, even Mexican peso-pegged stablecoins as well.

The advantages are obvious – you can engage in decentralized finance (DeFi) without worrying about volatile price fluctuations, but also without having to go through a dreaded financial institution (this is crypto after all).

To maintain this peg, there must be some kind of underlying protocol, and there are two ways a stablecoin’s peg is maintained: Algorithmically or with security.

Algorithmic Stable Coins
Algorithmic stablecoins maintain the link through supply and demand with a sister token via a process called arbitrage.

Theoretically, when an algorithmic stablecoin loses its peg, arbitrage traders can step in to sell their stablecoins for a sister token, thereby limiting supply and driving the price back to the peg.

When the supply runs short and the stablecoin goes above the peg, arbitrage traders can sell their sister tokens to increase the stablecoin’s supply, thus driving the price back to the peg.

If this sounds like unsustainable nonsense, that’s because it is.

Terra USD was an algorithmic stablecoin and LUNA was its sister token. Their collapse in May 2022 caused the two trillion dollar market breakout from which the cryptocurrency sector has yet to recover.

Since Terra’s collapse, algorithmic stablecoins have all but gone the way of the dodo.

Stablecoins with security

Collateralised stablecoins, on the other hand, are more popular than ever.

Tether (USDT), the OG stablecoin since 2015, is the most traded cryptocurrency in the world, often exceeding $100 billion in trading volume in a day.

Of the five most traded cryptocurrencies, three are hedged stablecoins – Tether (USDT), Binance USD (BUSD) and USD Coin (USDC).

Bitcoin and Ethereum make up the other two slots.

Collateralized stablecoins *theoretically* work because they are backed 1:1 or higher by the real asset they are meant to be tied to.

USDT, for example, is *backed* by cold hard Washingtons.

Why all these stars? Because the actual amount of collateral backing USDT has been the source of controversy at a level too deep to get into here.

By and large, Tether played fast and loose with the nature of the collateral backing USDT, with much of this so-called collateral being short-term, unsecured debt.

This could have been a disaster. What would happen if everyone decided to redeem USDT, but there wasn’t enough liquidity to support a bank run?

Who knows… e-riots maybe?

New York Attorney General Letitia James fined Tether and sister company Bitfinex USD 18.5 million for failing to disclose their reserves and ordered mandatory reporting standards.

Tether has since reduced its reliance on commercial paper and published regular attestation reports.

Tether’s rocky road aside, stablecoins have clearly proven their usefulness, and reporting standards have greatly improved.

So why are they persistently controversial?

Centralized securities?

In February 2023, stablecoin issuer Paxos was instructed to stop minting BUSD, the dollar-pegged cryptocurrency developed for premier cryptocurrency exchange Binance, by the New York Department of Financial Services (NYDFS).

The order came after the Securities and Exchange Commission (SEC) announced legal action against Paxos for issuing what it considered unregistered securities in the form of various stablecoins, including BUSD.

The move was surprising, if not entirely unexpected, given how hawkish US regulators were on crypto markets at the time.

According to the SEC, BUSD constituted an unregistered security under US law and should be treated as such.

Paxos “categorically disagreed” with this, while Binance CEO Changpeng ‘CZ’ Zhao warned that the enforcement “will have profound consequences for the crypto industry”.

Anyway, at the time of writing, BUSD has stopped making a mark in the US, and there are fears that the regulators will take the fight to Tether next.

Stablecoins are also reviled by some corners of the crypto community, primarily due to their centralized nature.

Collateralized stablecoins require a central issuing authority, and they often partner with major financial institutions like BNY Mellon (NYSE:BK) (in Circle’s case) to provide custody services.

One day a truly algorithmic stablecoin may emerge, but given the continued fallout of Terra USD, that could be a long time coming.