Cryptocurrencies like BTC (bitcoin), ETH (ethereum), and DOGE (dogecoin) have been characterized by their volatility. Bitcoin at times can even become hyper volatile due to certain factors and has even resulted in market crashes. This is caused by two factors: no reserve is backing their valuations and the lack of central authority that controls prices when required. And to counter this, stablecoins were created with the main purpose to bridge this gap between fiat currencies and cryptocurrencies.
But what are stablecoins? Are they also cryptocurrencies? Let us first define what are stablecoins and closely examine if they have actually served their purpose.
According to Investopedia, stablecoin is another class of cryptocurrency that offers price stability and is backed by a reserve asset. Stablecoins have gained popularity as they try to offer the convenience of both worlds: the instant processing and security or privacy of payments of cryptocurrencies, and the volatility-free stable valuations of fiat currencies.
Currently, there are more than 60 stablecoins available in the crypto market today. They can be exchanged on a 1-to-1 ratio for one U.S. dollar. But aside from the US dollar and other fiat currencies, they are also backed by other crypto-assets. According to data by Coinmarketcap, the major stablecoins include:
- USDT (Tether)
- USDC (USD Coin)
- BUSD (Binance USD)
- UST (TerraUSD)
- DAI (Dai)
- TUSD (TrueUSD)
- USDP (Paxx Dollar)
- USDN (Neutrino USD)
- RSR (Reserve Right)
- FEI (Fei USD)
USDT (Tether) is the largest stablecoin with a circulating supply of 68.80B and with a market cap of $76,779,737,417 in recent data by Crypto.co. It is also the fourth-largest cryptocurrency to date. But how stable are your stablecoins?
Stablecoins Stability and Structures
Fiat currencies’ stability is backed by reserves and the regulation by financial authorities like central banks. Also, they are pegged with underlying assets, such as gold or forex reserves that act as collateral, their valuations remain free from wild swings. The stability of a stablecoin may depend on its structure. Let’s take a look at the four main types of stablecoins according to their work mechanism.
- Reserved based on the U.S. dollar or other fiat currency
This type is the most popular among stablecoins and is backed by 1:1 fiat currency. The fiat collateral should always be proportionate to the number of stablecoin tokens in circulation. USDT (Tether), GUSD (Gemini Dollar), and USDP (Pax Dollar) are examples of this type and they have a one-to-one ratio with the U.S. dollar.
- Collateralized by other virtual assets like Bitcoin
This type of stablecoin is backed by other cryptocurrencies and is over-collateralized due to the volatility of the crypto assets to serve as a buffer for price fluctuation. In this case, a larger number of digital assets is maintained as a reserve for a lower number of stablecoins. DAI (Dai) is an example of this type.
- Backed by a commodity like gold
This type of collateralized with underlying assets like precious metals, oil, and real estate. The XAUT (Tether Gold) and PAXG (Paxos Gold) are two of the most liquid gold-backed stablecoins. But commodities can fluctuate in price and have the potential to lose value.
- Modified by a smart contract algorithm
This type does not have any reserve but involves an algorithm to maintain its price. An algorithmic stablecoin system in place will reduce the number of tokens in circulation. If the market price falls below the price of the fiat currency it tracks. Also, if the price of the token exceeds the price of the fiat currency it tracks, new tokens will be added into circulation to adjust the stablecoin value downward.
Each stablecoin has its own structure so before using one, it is very important to know their differences. Although these are tagged as stablecoins, they are still cryptocurrencies that may present a risk for users.
But the stability of stablecoins was once again put into question following a controversy involving USDT (Tether), the world’s largest stablecoin after receiving a $41M fine from Commodity Futures Trading Commission in October along with Bitfinex. In a statement by the regulatory body, Tether company made “misleading” statements that it is being fully backed by US dollars and that Tether reserves were not “fully-backed” the majority of the time. CFTC further states:
“The order further finds that Tether failed to disclose that it included unsecured receivables and non-fiat assets in its reserves, and that Tether falsely represented that it would undergo routine, professional audits to demonstrate that it maintained “100% reserves at all times” even though Tether reserves were not audited”.
In December 2020, the US Congress introduced a bill called the “STABLE ACT” that requires that stablecoin issuers give the Federal Reserve their bank charters and reserve funds equivalent to their stablecoin amount. The reserves should have a dollar amount equal to the stablecoin amount. They also need to apply for FDIC insurance and that the financial regulatory body should also perform audits to assure compliance. Non-compliance will incur a fine of $1000,000 and other criminal penalties. But the drafted legislation was faced with heavy criticism in the crypto community and failed to be passed into law. But with the recent controversy, regulation should be in place to guarantee that stablecoins are really stable to live up to their reputation as being stable digital assets.