Coinsights #19: Stablecoins - the good, the bad, and the ugly
Thank you to Kristen and Sridhar for their contributions to this article.
Welcome back to Coinsights!
In today’s article, I cover a crucial part of the web3 world: stablecoins. Let’s get to it!
What is a stablecoin?
A stablecoin is a type of digital currency that “pegs” its value to a different, typically stable, asset. The most popular stablecoins are the ones that peg their value to fiat currencies. In fact, 2 out of the top 5 cryptocurrencies by market cap are stablecoins!
Fiat-collateralized stablecoins are typically expected to maintain a currency reserve equal in value to their market cap. For example, say issuer X mints (the crypto word for create) stablecoin Y that’s pegged to the U.S. dollar. If issuer X decides to mint 10 Y coins, they should also have $10 USD in a bank account somewhere as collateral.
Another way to collateralize stablecoins is through other cryptocurrencies. From Investopedia:
Crypto-collateralized stablecoins are backed by other cryptocurrencies. Because the reserve cryptocurrency may also be prone to high volatility, such stablecoins are over-collateralized—that is, a larger number of cryptocurrency tokens is maintained as a reserve for issuing a lower number of stablecoins.
For example, $2,000 worth of ether may be held as reserves for issuing $1,000 worth of crypto-backed stablecoins, which accommodates up to 50% of swings in reserve currency (ether).
Why are stablecoins useful?
Protects against volatility. One of the main ideas behind stablecoins is that they are, well, more stable than non-pegged cryptocurrencies.
While it’s well understood that stablecoins protect against crypto volatility, they also enable people to gain exposure to foreign currencies in ways that traditional financial systems don’t allow. In an earlier article, I drew attention to the fact that Bitcoin is a (relatively) safer store of value for Venezuelans experiencing 4-digit inflation of the bolívar. However, as the above graph shows, Bitcoin is volatile too! Stablecoins provide another way for people in developing countries to store value by relying on more stable fiat currencies.
Creates a low-risk onramp. The stability of stablecoins make them a low-risk onramp for people new to the crypto space. Once someone has successfully bought a popular stablecoin, such as USDC, they are then able to more quickly interface with the rest of the web3 world. In fact, there are many projects that transact in stablecoins so that if you don’t want to be exposed to the price volatility of other cryptocurrencies you don’t have to be!
Increases velocity. Moving money from the fiat to the crypto world is slow, which can be frustrating when performing time sensitive tasks like buying a newly dropped NFT. By storing value in stablecoins, people have a quick way to access funds in the crypto world with which they can do as they please. Furthermore, stablecoins can also serve as a “middle ground” when trying to trade a cryptocurrency for another one – a direct swap is not always supported. Instead, it’s often easier to convert a cryptocurrency into a stablecoin and then buy the other one.
These three factors have contributed to a large increase in the use of stablecoins over the past few years. Grant Martel says that:
This [increased stablecoin] volume has had a proportional effect on liquidity, making the cryptocurrency market quicker to maneuver as well as making it more efficient. Increased efficiency also brings more accurate asset pricing, resulting in fairer asset prices and tighter bid and ask spreads.
Stablecoins are crucial in maintaining a healthy crypto ecosystem by providing low-risk onramps from fiat currencies and enabling more efficient crypto markets.
What are some problems with stablecoins?
Lack of Decentralization. The most popular stablecoins today, Tether and USDC, are pegged to the U.S. dollar. For all of the hype around how cryptocurrency is going to liberate us from the whims of governments, 2 out of the top 5 coins are mirrors of U.S. monetary policy! I talked a few articles ago about recent U.S. inflation:
Unsurprisingly, the CPI (a metric that tracks inflation) rose 7% from December 2020 to December 2021, the highest year over year jump since 1982.
This means that Tether and USDC also experienced 7% inflation last year. While one could argue that this is exactly how stablecoins are supposed to work, I find it disconcerting that the most stable assets in the web3 world rely on decisions made by 4 people at the Fed.
Mysterious Fiat Backing. USDC issuers are audited every month by a third party to ensure that they actually have enough USD to back the USDC in circulation. However, not all stablecoins adhere to such strict guidelines. Just search “Tether scam”:
Tether (the organization) is currently under investigation by the Department of Justice for illegally printing Tether (the coin, a.k.a. $USDT) without an appropriate amount of USD to back it. In October 2021, the Commodity Futures Trading Commission announced this order:
The order requires Tether to pay a civil monetary penalty of $41 million and to cease and desist from any further violations of the Commodity Exchange Act (CEA) and CFTC regulations, as charged.
One of regulators’ main concerns is a bank run: if many Tether holders try to convert their Tether back into USD at the same time, and there is not enough USD on reserve, there will be widespread panic since Tether will essentially become illiquid. If you’re curious to learn more about Tether and the related investigations, check out this Bloomberg article.
Stablecoins aren’t stable. Prices of stablecoins fluctuate at a small scale in both directions.
Wait a minute… aren’t stablecoin prices supposed to stay constant? They’re called stablecoins! Well, the market forces of supply and demand cause stablecoins prices to fluctuate, as some individuals may sell at a discount or buy at a premium based on market activity. For example, if the supply of Tether in an exchange is 3, and the demand for Tether is 5, the price of Tether will go up! Note that these price fluctuations last for only seconds at a time.
Demand for stablecoins can increase for a variety of reasons. One reason is when a volatile currency like Bitcoin is dropping fast and people want to exit their position into a safer asset as soon as possible. For a more in depth discussion on stablecoin prices, read this Reddit thread.
Conclusion
Despite the legal troubles, Tether is still the third most popular coin in the world. To be honest, I’m not really sure how Tether is still so popular – perhaps one of you could educate me on why. Furthermore, there are many products that enable institutions and individuals to start earning money by lending their USDC, such as Circle Yield and Securitize. Check them out!
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