Imagine if your salary was paid in Bitcoin. This was approximately how much you’d receive in SGD throughout 2021, assuming your monthly pay is 0.1 BTC:
Although your pay would have risen quickly in the early months of 2021, June and July would have felt like horrible months. Plus, it sucks to be unsure about how much you’ll be paid each month and whether or not you’d be able to afford to pay your bills.
Although interest in cryptocurrencies has exploded in recent months, let’s face it: nobody wants to use a currency that fluctuates all the time to buy their groceries.
Enter Stablecoins.
What is a stablecoin?
Stablecoins are cryptocurrency that has been specially engineered to mirror the value of a real currency.
The purpose of stablecoins is to limit the volatility experienced by its users while allowing users to enjoy the benefits that cryptocurrencies provide.
Owning stablecoins is like owning cash, and it functions as a store of value that can be used to support margin calls in the real world or act as a war chest to exploit a market downturn. Stablecoins are an essential component of the cryptocurrency ecosystem because traders need to temporarily convert volatile crypto into US dollars before positioning themselves in another trade.
The first stablecoin Tether (USDT) was launched in 2014. Since then, the scene has expanded to include a wider variety of stablecoins.
So how do stablecoins achieve the best of both worlds?
In this article, we’ll explore the world of stablecoins, from the different types of stablecoin to their use cases, the role they play in the world of cryptocurrency and how (and why) you can invest in them.
This guide was first published in Sept 2021 and most recently updated on Mar 2022.
How are Stablecoins used?
Stablecoins are usually designed to be used as everyday currency. Hence, they should have the following properties:
- Be a medium of exchange
- Be a store (and maintenance) of value and wealth
- Provide a unit of account. I.e. have a definite unit of measurement.
Stablecoins allow its users to transact and interact using cryptocurrency despite market volatility.
They are also being used in decentralized finance (DeFi) for yield farming, making loans, and liquidity provision where you can earn a return by lending your crypto out.
Why use stablecoins over cryptocurrencies like Bitcoin and Ethereum?
Stablecoins are well…stable, in comparison to Bitcoin and Ethereum. Hence, they are commonly seen as a store of value in the crypto market.
Owning Tether allows you to buy and sell different coins more quickly instead of having to wait for your cash to be converted into cryptocurrency at the point of transaction. You could do the same with Bitcoin or Ethereum, but who knows what the value of BTC or ETH will be when you need to transact.
However, keep in mind that stablecoins serve a vastly different purpose compared to other cryptocurrencies. They should be used as a transaction tool rather than an investment vehicle.
Are stablecoins safe?
The irony is that most stablecoins are not 100% stable. There’ll still be fluctuations from time to time.
Ultimately, when you get stablecoins, you are placing trust in the team behind the stablecoins.
Tether, the OG stablecoin had revealed that as of 31 Mar 2021, only 79% of its reserves are in cash or cash equivalents. The rest are in investments that include Bitcoin, commercial paper and other asset types.
Are you comfortable owning a stablecoin that is not 100% backed by fiat cash? (The counterargument is: “are you comfortable holding fiat cash that’s not backed by gold?)
It’s important to understand the thesis behind a stablecoin and your risks before you use or buy it.
4 Types of Stablecoins
There are four types of stablecoins, categorised by how they define their value; Fiat-backed, Commodity-backed, Crypto-backed and Algorithmic stablecoins. We explore each type in this section:
1) Fiat-backed stablecoins
Fiat-backed or Fiat collateralised stablecoins are the most common type of stablecoin in the market currently, with a government-issued currency or commodities such as gold serving as their backing currency.
These are usually pegged with a fixed 1:1 ratio and their value is based on the value of the underlying asset.
The concept is fairly easy to grasp. It’s like having a 1:1 exchange rate between two currencies, much like Singapore dollars and Brunei dollars, (almost) always 1:1.
As mentioned above, the first stablecoin to ever launch is Tether (USDT). It was launched in 2014 and has since grown to be one of the largest cryptocurrencies in the world.
Tether claims backed by actual USD that is stored in Tether’s reserves and its value is pegged to the US dollar so that every USDT token is always valued at USD$1. But buyers of USDT need to beware as Tether has no contractual requirement to allow USDT to be traded for USD. Auditors have also found that only a tiny amount of USDT was backed by actual cash – a large amount is supported by commercial paper instead. Audit issues have not stopped USDT from becoming the third-largest cryptocurrency by market capitalisation. Currently, there is over $80b USDT in circulation.
Owners of USDT can lend it out for 12% returns on a platform like Hodlnaut.
- Pros: Simple to understand and use.
- Cons: May be centralised depending on its design.
There are now several stablecoins for investors to choose from, you can find the latest stablecoins statistics here.
2) Commodity-backed stablecoins
Commodity-backed stablecoins are like fiat-backed stablecoins, except their value is collateralised by commodities instead. The most common commodity so far is gold.
Each commodity collaterlised coin is set up differently, so be sure to read their whitepaper or website to find out what you’re paying for.
For example, Tether Gold’s “one full XAUt token represents one troy fine ounce of gold on a London Good Delivery bar” while CACHE (CGT) token represents 1 pure gram of gold. Fun facts, CACHE is based in Singapore and is certified shariah compliant.
- Pros: Relatively simple to understand. Has transparency and traceability to actual commodities.
- Cons: May be more expensive per token, depending on its design.
3) Crypto-backed stablecoins
Crypto-backed stablecoins are an innovative approach to creating low volatility digital assets by using other cryptocurrencies as collateral.
To maintain price stability, they utilise a higher ratio of coins against reserve cryptocurrencies. Eg. users may need to swap $200 worth of say Bitcoin to get $100 worth of stablecoin. This ensures that even if Bitcoin drops by 50%, there’s still $100 worth of Bitcoin backing the stablecoin.
At this point, you’d probably notice the major risk of using crypto-collateralised stablecoins: when markets tank and the value of the underlying cryptocurrency drops too much or becomes worthless, the stablecoin could collapse.
A popular crypto collateralised stablecoin is Dai, which is issued by MakerDAO. It is pegged against the US dollar but is backed by Ether instead of actual USD.
Basically, it is backed using Ethereum, but its price will follow the value of USD. But, for every $1 worth of DAI, a user has to post $2 value of collateral (ETH).
You may wonder why anyone would want to put up collateral of $2 to get $1 that does not even go up in value? The reason is that users want to continue to own the $2 of ETH and yet borrow another $1 of DAI that they can convert to get even more ETH. When there is a bull market for cryptocurrency, those who post collateral can make a lot of money if the volatile cryptos run-up.
Confused already? If not, here’s another interesting thing about MakerDAO. Not being backed by fiat currency will resolve some audit problems as a system can be built up from the ground up with smart contracts. DAI’s stability is maintained automatically by smart contracts, meaning that it will ownself check ownself.
- Pros: Decentralised.
- Cons: Complex. Risk of collapse is relatively higher.
4) Algorithmic stablecoins (aka non collateralised stablecoins)
Finally, we have algorithmic stablecoins which are not actually backed by anything. Instead, the stablecoin’s peg is maintained through algorithms.
A common approach to non-collateralised stablecoins is the use of “seigniorage shares” which relies on smart contracts that programmatically expand or shrink the supply of the stablecoin in order to keep its value constant.
Sounds complicated, but it actually works like the central bank – just think of the Fed printing money to control the rate of inflation. The difference in the case of algorithmic stablecoins, is that this process is done in a decentralized manner and executed algorithmically. Risky? Yes. Functional? Also yes.
Currently, algorithmic stablecoins have not been proven to function sustainably. The closest we had to a successful model was TerraUSD (UST). Where to mint $1 of UST, you had to exchange an equal value of LUNA.
The value of UST was maintained at US$1 algorithmically through the balance of LUNA in the reserves. UST is added into circulation by trading in LUNA to decrease its value relative to the USD. Whenever the value of UST was to stray away from the value of USD, LUNA will be the crypto that will be used to incentivise users to maintain the peg. UST is removed from circulation for LUNA to increase its value relative to the USD.
Owners of UST could lend it out for 19%+ returns in a platform like Anchor Protocol. This turned out to be its Achilles Heel. You can read more about Terra’s fall here.
- Pros: No collateral required.
- Cons: No collateral required. High level of trust and faith is required. High risk, and most have fail.
P.S. Curious about cryptocurrencies and their future prospect? Before you part with your money, learn the essential fundamentals in 2 hours. Limited Runs, click to register your interest.
Now that you have been introduced to the different types of stablecoins, you may be wondering:
What are the major stablecoins?
Here’re the top 4 stablecoins by market capitalisation:
| Stablecoin | Type | Market Cap (USD) | Trading Volume (past 24hrs) | No. of exchanges offering it | Launch Date |
|---|---|---|---|---|---|
| Tether (USDT) | Fiat-backed | $72,375,582,375 | $58,589,436,955 | 348 | Oct 2014 |
| USD Coin (USDC) | Fiat-backed | $53,724,182,471 | $5,024,382,739 | 304 | Sep 2018 |
| Binance USD (BUSD) | Fiat-backed | $18,296,452,609 | $5,326,912,275 | 115 | Sep 2019 |
| Dai (DAI) | Crypto-backed | $6,902,743,485 | $272,388,038 | 202 | Dec 2017 |
All of the stablecoins above are pegged to USD, numbers were accurate at the point of update, you can refer to Coingecko or CoinMarketCap for the latest data.
How to own Stablecoins?
There are two ways you can own stablecoins:
1) Buy from an exchange
You go to a money changer to change your SGD for USD. To get stablecoins, you go to a cryptocurrency exchange like Coinbase, Gemini, Binance, etc to change your SGD into coins.
Not every exchange offers the same coins, you’ll need to check if the exchange you’re on offers the stablecoin you want.
2) Mint it fresh
This is the process of making new stablecoins. Oftentimes, you’ll need to provide the actual underlying collateral in order to mint the stablecoins.
I.e. you have to deposit fiat currency or other cryptocurrencies to get the stablecoin.
Are stablecoins a good investment?
As they are usually pegged to an underlying asset, you shouldn’t expect to make much (or any) from their price fluctuations by hodl-ing.
However, stablecoins allow you to convert your fiat dollars into digital coins which you can easily use to start buying cryptocurrencies and moving across different blockchain. It’s like changing your SGD into USD before your trip to US, so that you can spend in the local currency.
Also, stablecoins play a bigger role across DeFi where you can use them to generate yields in many forms:
- lending them out for extra yields (or storing them in crypto savings accounts),
- staking stablecoins on various exchanges or platforms,
- provide liquidity to blockchain protocols for returns in a process known as yield farming.
The returns could be as high as 30%, but there are risks involved. This is a topic for another article.
What’s the future of Stablecoins?
Stablecoins are relatively new and offer a relatively simple way for the masses to accept and utilise digital currencies. We have been seeing governments experimenting with digital money, who knows, maybe stablecoins could become a solution to digital money.
Another use case for stablecoins is decentralised finance or DeFi. With a coin that is expected to maintain its peg to the USD, users can expect the ecosystem to mirror real-world financial institutions without the expensive overheads such as the following:
- A fixed deposit business to arise that will not have the problem of expensive intermediaries. Owners of UST can deposit their stablecoins to earn up to 19+% interest into Anchor protocol.
- Stablecoins can be used as collateral to generate synthetic assets like parking UST in Mirror Protocol to make an mMSFT, a token that mirrors the performance of Microsoft stock.
- Also in Mirror Protocol, stablecoins can be paired 1:1 with synthetic equities like mMSFT to support liquidity pools to earn profits from enabling an exchanges business.
There are many potential uses for stablecoins, and I’ll be looking to explore them in future articles.
