This has been one of the best years for our training in cryptocurrencies, since most of the events that have occurred have given us valuable lessons every month. Among other things, achieving a bear market implies that the market capitalization of cryptocurrencies is drained into stablecoins to minimize the impact of volatility and losses. But have you ever really wondered what stablecoins are and how they work? Don't worry, in today's cryptocurrency training we are going to talk about what stablecoins are and how they work.
What is a stablecoin?路♂️
Stablecoins are digital assets that correlate with the value of fiat currencies or other assets. With these stablecoins we can buy tokens linked to the dollar, euro, yen and even gold and oil. A stablecoin allows us to secure profits and losses to transfer its value at a stable price on blockchain networks that allow its custody. All major cryptocurrencies have a historically high volatility rate. While this has allowed many to gain a lot from it, it has certain drawbacks in terms of adoption in general. Volatility makes it difficult to use cryptocurrencies for daily payments and that is really one of the points that gives us users the most peace of mind.
For example; We go one day to buy a new TV and we pay the store in BNB. 2 days pass and BNB has lost 30% of its value, so the seller has lost with this sale. These cases are what make it challenging to plan and operate a business allowing payment in cryptocurrencies. Before the advent of stablecoins, cryptocurrency investors had no way to avoid volatility without converting cryptocurrencies back into fiat money. The creation of stablecoins provided a simple solution to both of these problems. Today, we can easily get in and out of the volatility of the cryptocurrency market using stablecoins like BUSD, USDC or USDT.
How do Stable Coins work?⚙️
Stable Coins have different ways of working compared to the way they were designed. Within this type of assets we can differentiate three types of stable currencies:
1. With fiat support.
Fiat-backed stablecoins, such as BUSD, are pegged to traditional fiat currencies such as the US dollar, euro, Japanese yen and many others. They maintain a peg by holding fiat reserves that can be exchanged for the stablecoin at any time. That is, let's say we buy 100 units of USDC; This amount is backed by its value in dollars within the fiat currency reserve of the protocol that issued the asset. If the price of the token deviates from the fiat with which it has been collateralized, the arbitration mechanisms will quickly return the price to the fixed rate with the collateral. Examples of those backed by fiat could be BUSD from Binance, USDC from Coinbase or USDT from Tether Treasury among others.
2. Algorithmic.
They control the supply without the need for reserves. Algorithmic stablecoins take a different approach by eliminating the need for reserves. Instead, algorithms and Smart Contracts manage the supply of the issued tokens, similar to the way a central bank proceeds with monetary policies. The algorithmic stablecoin model is not very common because it has an extra degree of difficulty to be executed successfully. The algorithm for these tokens works similarly to the previous two; reduces the circulating supply if the price of the token falls below the price of the fiat currency it tracks. This is possible thanks to staking locked tokens or buyback or token burn programs. In turn, if the price of the token exceeds the price of the currency it tracks, new tokens enter circulation to lower their price towards the initial value.
3. Cryptographically backed.⚖️
Crypto-backed stablecoins work similarly to the stablecoins we have explained in the previous paragraph. But instead of using fiat currencies as backup, there are stablecoins that act as backup collateral. Given the volatility that inhabits the cryptocurrency ecosystem, stablecoins backed by cryptocurrencies guarantee us excess reserves as a measure against the price swings that are usually seen in the market.
Crypto-backed stablecoins use Smart Contracts to manage the creation and burning of stablecoins. This allows users to independently audit contracts to provide more confidence. Some of them are run by Decentralized Autonomous Organizations (DAO), so the same community can vote to introduce or revoke changes to the project of said stablecoins. In such a case, we should join the governance of the DAO or simply trust in the viability of the DAO's operations.
Main advantages of stablecoins.✅
Stablecoins are a great tool for investors, business owners, and cryptocurrency users. Now that we know what a stablecoin is and in what ways they achieve parity with (for example) the dollar, let's continue the cryptocurrency training listing the main advantages of stablecoins:
1. They can be used for daily payments.
Stores, businesses and people value stability. Due to high volatility, cryptocurrencies have not achieved widespread use for payment processing. Large stablecoins have a history of stability in their peg, making them quite reliable and suitable for daily use.
2. They are based on blockchain. ⛓️
You can send a stablecoin to anyone around the world who has a compatible crypto wallet (which can be created for free in seconds). Double spending and fake transactions are also almost impossible to do. These qualities, and more, make stablecoins incredibly versatile.
3. Protect ourselves from market volatility.️
Allocating a certain percentage of a portfolio to stablecoins is an effective way to reduce overall risk. Our wallet as a whole will be more resilient to market price fluctuations and will also have funds available in case a good market opportunity arises. We can also sell cryptocurrencies for stablecoins during a market correction and buy them back at a lower price (or short them…). Stable coins allow us to open and close positions without the need to withdraw money from the blockchain.
Main disadvantages of stablecoins.❌
Not everything is as pretty as it seems. As we have seen in the previous section, they have many advantages, but they do not skimp on the disadvantages at the same time. Let's continue the cryptocurrency training by listing the main disadvantages:
1. There is no guarantee that stablecoins will maintain their peg to fiat currency.
While some large projects have a good track record, there have also been many projects that have failed. When a stablecoin has constant problems maintaining its peg, it can completely lose all its value and therefore harm the value of your wallets.
2. Lack of transparency with the support.
Both Tether (USDT) and USD Coin (USDC) have yet to release full public audits, and most large stablecoins only provide periodic certifications. Private counts are carried out on behalf of stablecoin issuers. That shows a lack of transparency in the support of said stablecoins.
3. Fiat-backed stablecoins are often highly centralized.
The collateral is held by a central entity and may also be subject to external financial regulation. This gives them significant control over the currency. As we have mentioned previously, we also have to trust that said stablecoin has the support of the liquidity that they say the token has.
4. Crypto-collateralized and uncollateralized stablecoins are not sustainable.
It is common to have open governance mechanisms in crypto projects, meaning that users have a say in the development and execution of each project. As such, you must engage or trust the developers and community to run the project responsibly. At the same time, no one insures our funds if they are lost. In turn, we have already seen how UST parity went to hell when did it happen the collapse of LUNA in the month of May of this same year.
And without going any further, our “beloved” Justin Sun, CEO and founder of the TRON blockchain, launched a stablecoin (USDD) that meets the same parameters as the stablecoin of the failed Terra project. As we see in the graph below, in the month of May it lost parity to 0,93 dollars, and really almost in its entire existence it has never achieved close parity with the dollar...
Are stablecoins regulated?⚖️
Stablecoins have captured the interest of regulators around the world due to their unique combination of fiat and crypto currency. How they maintain a stable price is useful for reasons other than speculation. They can also be transferred internationally cheaply and quickly. For this reason, some argue that stablecoins could act as a competitor to fiat, although they cannot be directly controlled by a country's central bank. Additionally, with the recent collapse of FTX, regulators are going to be heavy-handed with regulations, such as MiCA law (Markets in Crypto Assets) that will be voted on for implementation in February 2023.
Some countries are even experimenting with creating their own stablecoins in response to these. As a stablecoin is a type of cryptocurrency, it is likely to be subject to the same regulations as cryptocurrencies in the area where we reside. Issuing stablecoins with fiat reserves may also need regulatory approval. One of the most advanced countries in terms of creating and testing stablecoins issued by a central bank, better known by their acronym in English. CBDC, are China with the Digital Yuan, which they have been developing for more than 3 years.
Conclusions from this cryptocurrency training on stablecoins.
After finishing this cryptocurrency training on stablecoins, let's review the key points about this innovative crypto asset. As we have seen, stablecoins allow us to hedge against the usual presence of volatility that characterizes the cryptocurrency market. At the same time, we have also reviewed the ways in which different stablecoins achieve their parity with fiat currencies. Finally, we have listed both the main advantages and disadvantages present in this asset class and the open front of an upcoming regulation by voting on the MiCA law next February 2023.
These crypto assets have established themselves very well in the cryptocurrency market, as we can see in the market capitalization of stablecoins ($143.000 billion), representing about 18% of the total market capitalization of cryptocurrencies. Also remember that, to protect ourselves from possible collapses such as the one suffered in the month of May with the UST stablecoin of the Terra protocol, we recommend having our stablecoin capital diversified. Above all, we should also stay away from those that do not have their support verified and that are surrounded by controversies, such as USDT, whose support has always been questioned since long ago.