What is Stablecoin?

What is Stablecoin?

A stablecoin is a cryptocurrency with a stable price, which is often pegged to a legal tender in the real world. Take USDT, currently the most commonly used stablecoin, for example, USDT is pegged to the US dollar, with 1 USDT = 1 USD.

From an overall market cap of less than $500 million in 2017 to $100 billion today, stablecoins have certainly become an essential part in the crypto world, they account for two of the top five cryptocurrencies by market capitalization.

source：Coinmarketcap

The Creation of Stablecoin

Virtual currencies were created with the goal to replace traditional currencies and challenge the centralized financial system. However, mainstream crypto assets, including Bitcoin and Ethereum, had been found to be too volatile to completely replace fiat currencies as a means of global exchange, so they were more of speculative assets. At that time, transactions between crypto assets either followed the primitive rule of “barter” or had to be swapped via fiat currencies.

In order to facilitate transactions between cryptocurrencies and find a common unit of account for most crypto assets, it is necessary to invent tokens with more stable value. That’s why stablecoins came into being. The earliest one in history is USDT, which was issued by Tether Limited in 2014.

The Function of Stablecoin

Stablecoin is considered to be one of the technical foundations of DeFi, which makes it easier to exchange various assets. Cryptocurrencies with volatile prices could exchange with each other through stablecoins. Therefore, stablecoins function as a unit of account to some extent.

Also, traders can trade their risky digital assets into stablecoins during bear markets, so as to manage risks without leaving the crypto ecosystem.

The bridge between blockchain and real-world

Stablecoin has extended the boundaries of fiat currency and is a bridge between blockchain and the real world. As a means of payment, stablecoins’ prices are more stable than other digital assets so they act closer to fiat money.

In addition, since stablecoins are based on various blockchains, anyone can receive or send stablecoins anywhere around the world simply by connecting to the blockchain network, which guarantees them multiple possibilities in cross-border payment and financial inclusion.

The Classification of Stablecoin

There are three types of stablecoins: Off-Chain-Backed Stablecoin, On-Chain-Backed Stablecoin and Algorithmic Stablecoin.

Off-Chain-Backed Stablecoin

Among them, the most popular one is the off-chain-backed stablecoins including USDT and USDC, which are issued and managed by a centralized organization and endorsed by financial assets such as U.S. dollars. Users can exchange fiat currencies for stablecoins and vice versa. Endorsed by real assets, there is generally little change in the off-chain-backed stablecoin prices which are affected by short-term supply and demand. However, as the management of these stablecoins is highly centralized, the transparency can not be ensured. For example, Tether Limited, the company behind USDT, has long been accused of being an opaque “unsecured money printing machine”, although it claims to have a 100% USD asset reserve for its USDTs.

On-Chain-Backed Stablecoin

While off-chain-backed stablecoin involves real assets, the remaining two types are more “pure” cryptocurrencies. On-chain-backed stablecoin is a digital currency issued to anchor the price of fiat currency by staking digital assets such as BTC and ETH (often over-collateralized) on smart contracts. DAI, published by Maker on Ethereum, falls into this category.

Algorithmic Stablecoin

Algorithmic stablecoins are pretty special in mechanism as their value isn’t supported. They maintain price by adjusting supply and demand through algorithms, much similar to a real-world central bank.

A typical example is AMPL, the first algorithmic stablecoins, which was launched in 2018. Algorithmic stablecoins control their supplies through open market operations, rebasing, and issuing secondary tokens. With no other value base and relying only on its own consensus support, algorithmic stablecoins have little resistance to price fluctuations caused by speculation.

The “Unstable” Stablecoins

Although stablecoins, by definition, should be able to maintain price stability, there is still the possibility of “instability”.

For off-chain-backed stablecoin, even if there is a sufficient amount of fiat assets as collateral, it does not mean that the price will always be anchored to the fiat currency. There will be a negative or positive premium as the demand for stablecoins is constantly changing. It is also uncertain whether the collateralized stablecoin has sufficient capacity to resist extreme market conditions.

Again taking USDT as an example, a large number of investors chose to leave the market by selling USDTs in the extreme event that occurred on May 12, 2021, which caused the depeg of USDT from US dollar by nearly 2%. In addition, investors’ distrust of the issuer could also lead to bank runs.

source：Coinmarketcap

The So-called “Holy Grail of Cryptocurrency”

Algorithmic stablecoins are extremely difficult to implement because they rely solely on supply and demand regulation, making them the “holy grail of cryptocurrency”. Unfortunately, most algorithmic stablecoins are not truly “stable” while “unstable” has become the norm.

On May 8, 2022, UST, an algorithmic stablecoin project on Terra blockchain, began to depeg from the US dollar, dropping to $0.69 on May 10 and $0.29 on May 11. The value of LUNA, UST’s associated token, plummeted to near zero in just 10 days at the same time. Relying on an arbitrage mechanism based on LUNA, UST was previously able to maintain stability against the US dollar. Users can use $1 of LUNA for one UST and vice versa on Terra Official at any time. To be specific:

When the price of UST is above $1, users tend to buy more LUNA and exchange it into UST, increasing the supply of UST in the market and finally reducing the UST price. When the price of UST is less than $1, users tend to buy more UST and selectively exchange it for LUNA, increasing the demand for UST and reducing the supply of UST in the market, which ultimately increases the UST price.

source：Coinmarketcap

However, the market value of LUNA kept falling, as a result of the overall downward market pressure and negative news, making it difficult to be a value support for UST, which also suffered a serious depegging. The arbitrage mechanism turned into the death spiral of LUNA and UST following the collapse of holders’ confidence.

It is certain that the search for the “holy grail of cryptocurrency” will not stop even if the road ahead is bumpy. Algorithmic stablecoin projects are looking for more complex and advanced algorithms to achieve long-term price stability.

Conclusion: Regulation has Arrived While the Road Ahead is Not Yet Determined

Stablecoins occupy an extremely important position in the cryptocurrency ecosystem. And as the crypto market grows, the influence of stablecoins is gradually expanding into the real world.

Since 2021, the overall direction of stablecoin regulation has become clearer with the in-depth discussion of stablecoins by governments, especially the U.S. The depegging of UST in May became an opportunity for a number of regulators, including the Federal Reserve, to begin considering the issue of stablecoin regulation. This is also a great chance for stablecoin to eliminate public distrust and achieve standardization.

In the future, the stabocoin industry may embrace regulation to achieve transparent auditing and adequate collateral, thus reducing the overall risk in the cryptocurrency market.