An understanding of stablecoins is necessary for any investor within the crypto space as they play an instrumental role within the space, facilitating money transfer, trading, and investments. To describe stablecoins as the oil that greases the crypto markets, albeit a useful analogy, likely understates its importance. Even at a cursory level, many can see that some of the most popular stablecoins Tether (USDT) and USD Coin (USDC) are within the top-5 tokens in terms of market cap1. USDT daily trading volume often tops all tokens including bitcoin and ether. In this article, we will examine the inner workings and intricacies of stablecoins and how they relate to the overall crypto market.
Generally, a stablecoin tries to bring stability to the crypto market where various tokens and digital assets experience high price volatility. Stablecoins are often tied or pegged to an underlying asset that makes the coin’s value “stable.” The underlying asset is often a fiat currency, such as the US Dollar (the most popular). Stablecoins allow users to park funds in a stable asset and stay within the crypto ecosystem without the need to convert to fiat currency. This mitigates the need in many global crypto platforms to have on/off ramps to fiat currency. Stablecoins offer users, traders, and investors flexibility and efficiency in their fund management. Stablecoins have also been playing a role within developing countries where users are not only subject to the volatility of digital asset prices but also of their government fiat currencies. Users in those countries have found stablecoins to be useful as a store of value and for payment transfers.
There are numerous stablecoins within the market, and while their intentions may be the same, there are significant differences and risks among them. A key differentiating factor among different stablecoins isn’t the underlying asset but the mechanism that ties the stablecoin’s value to the underlying asset. We will examine the two main categories: asset-backed versus algorithmic.
The prominent examples are the top two stablecoins, Tether (USDT) and USD Coin (USDC). USDT is issued by Tether, an HK-based company2. USDT was launched in 2014 and currently has a market cap of $83bn. USDC is managed by a consortium called Centre, which was founded by the U.S. company Circle and includes members such as Coinbase. USDC was launched in 2018 and currently has a market cap of $30bn.
Asset-backed stablecoins are the most common and most popular. As the word suggests, these stablecoins are backed by the underlying asset. A U.S. dollar asset-backed stablecoin, for example, would hold dollars in reserve for the stablecoins in circulation. Asset-backed stablecoins are conceptually straightforward. If the stablecoin falls below the asset price, then one could buy the cheaper stablecoin and then redeem (submit the stablecoin to the issuer and ask for the underlying asset) at the higher asset price. This drives the stablecoin price back to the 1:1 peg to the asset. If the stablecoin price rises above the asset price, minting new stablecoin at fair value and then selling them at a higher price will drive the stablecoin price back to the 1:1 peg.
However, while conceptually straightforward, asset-backed stablecoins suffer from a major drawback. Asset-backed stablecoins are not decentralized and are run by companies and corporations. This is especially true for fiat currency-backed stablecoins. The issuer company manages the fiat currency reserves and there can often be a lack of transparency on actual reserves. The trust is placed in the stablecoin company's internal management. The most popular stablecoin Tether (USDT) has experienced multiple investigations into its stated reserves. So far, USDT has survived these investigations but the risks due to its centralized control will always remain.
The second largest stablecoin, USD Coin (USDC), also faced issues when its cash custodian bank, Silicon Valley Bank, went into FDIC receivership in early 2023. USDC’s peg briefly deviated from 1:1 before the news that all Silicon Valley Bank funds were safe and that the custody of the reserves has been moved to another bank3.
Well-known examples of algorithmic stablecoins are MakerDAO’s Dai (DAI) and the failed Terra USD (UST). DAI was launched on MarkerDAO in 2017 and currently has a market cap of $5bn. UST was launched on Terra blockchain in 2018 and had a market cap of approximately $18bn before it failed in 2022.
Decentralization is one of the cryptocurrency foundations, where no one person, company, or entity has full control. Algorithmic stablecoins attempt to track the underlying asset price by various self-adjusting algorithms rather than solely relying on currency or asset reserves. Usually, the stablecoin mechanisms operate on market mechanics and attempt to drive the stablecoin price higher or lower towards the 1:1 peg to the underlying asset price. The upside is that the stablecoin is not subject to failure, whether due to errors, mishaps, or even fraud, from the stablecoin issuers. However, the downside is that these algorithmic stablecoins mechanisms are often untested, especially in stressed market conditions. UST (not to be confused with USDT) is an example of possible implosion of an algorithmic stablecoin when its mechanisms cannot keep up with the spiraling market conditions4.
Does one put trust in a centralized issuer or faith in a decentralized algorithm? So far, by market cap and trading volume, the answer appears to be the former. Tether has been the most widely used stablecoin by far, followed by USDC, which is also asset-backed.
Given the functional importance and large market caps of stablecoins, they have not escaped regulatory scrutiny and are subject to focused attention within new legislation. U.S. House Financial Services Committee recently released a new draft of legislation to regulate stablecoin issuers5. It aims to restart stalled negotiations last fall on an area that has a bipartisan agreement in its need for regulation. Stablecoins are also treated with a specific focus within the White House fact sheet6 released in September 2022. New regulations or regulatory action could severely affect issuers of asset-backed stablecoins and in turn their stablecoins. Regulatory actions announced in 2023 by both the New York Department of Financial Services (NYDFS)7 and the Securities and Exchange Commission (SEC)8 had targeted Paxos Trust, related to its issuance of the centralized stablecoin Binance USD (BUSD). BUSD was first issued in 2019 in a partnership between Paxos and the cryptocurrency exchange Binance. BUSD’s market cap has since dropped to $5bn (from its high of $23bn in late 2022).
Market Data Picture
Before we conclude, let’s look in more detail at the market cap and trading volume data of the largest stablecoins, USDT and USDC. The charts below demonstrate the utility and importance of stablecoin in periods of distress and market upheaval.
Tether (“USDT”) Market Cap and Daily Traded Volume
USD Coin (“USDC”) Market Cap and Daily Traded Volume
These two graphs clearly depict the critical functions that stablecoins play during periods of crypto market disruptions.
The importance of stablecoins within the crypto space is likely to persist. Asset-backed stablecoins will remain popular in the foreseeable future, while algorithmic stablecoins will continue to evolve. We also expect regulatory scrutiny to continue and legislation to develop. Stablecoin benefits are significant for the crypto space and have further potential to disrupt traditional financial systems. There are many stablecoins to choose from. Users, traders, and investors should assess the benefits, risks, and suitability to see which stablecoins can best achieve their objectives (and keep an eye on future stablecoin developments).
1 All market data as of May 2023.
2 Tether itself is owned by HK-based iFinex Inc, which also owns Bitfinex exchange.
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