Stablecoins: what they are and how the market relies on them

“A rising tide lifts all boats” — a quote often used to highlight Bitcoin’s dominance in the crypto market. Whether or not the market is blooming in greens or drowning in reds depends on Bitcoin’s price action, and as little as a 5% dip in its price could spell the end for small projects.

However, there’s dominance, and then there’s liquidity. As much as BTC is coveted and valued, when exiting an investment, people seek a more stable and safer asset that is readily accessible. Bitcoin may be undisputed in terms of a long-term, store of value investment, but its volatility and price fluctuations (not to mention slow transaction speeds on the base layer and high gas fees) make it impractical for day-to-day use.

Enter Stablecoins

Stablecoins are cryptocurrencies that, through some form of backing, maintain a constant value equal to the fiat currency they are pegged to. In most cases, the underlying fiat currency is the US Dollar, but a variety of other major currencies have a stablecoin of some sort.

Although users can easily purchase a variety of cryptocurrencies directly with fiat on most centralized exchanges, stablecoins maintain an important role in a wide range of DeFi ecosystems. They allow users to withdraw stable assets outside of CEXes (and stablecoin issuers) into various DEXes and DeFi ecosystems that aren’t as integrated with the traditional monetary systems we have in place.

As a result, decentralized exchanges see more liquidity and stability, and this translates to a myriad of benefits for DeFi users. Whether it’s for asset swaps, liquidity pools, lending, borrowing, collateralizing… Stablecoins provide the much-needed lubrication to ensure such processes occur smoothly and somewhat predictably.

Scope and Volume

It shouldn’t come as a surprise, therefore, that stablecoins see the highest trading volume in the entire crypto market. USDT — the most popular of its kind — consistently sees a higher volume than the next 5 cryptocurrencies combined! At the time of writing, the top 5 stablecoins saw a combined 24-hour trading volume of over $80B; and of that amount, around $70B was performed by USDT alone.

The top 5 stablecoins in terms of trading volume are USDT, USDC, BUSD, UST, and DAI. These are, of course, subject to change as attitudes and trust towards stablecoin variants shift and evolve depending on market needs and conditions.

Like any other token, stablecoins can and do exist on a variety of different blockchain networks — especially on those with fairly developed and vibrant DeFi ecosystems. Ethereum, Binance Smart Chain, Avalanche, Solana… are just a few of the many networks that demand the sort of utility and liquidity that stablecoins offer.

Stablecoin Types

While all stablecoins practically function the same, there are fundamental differences between them, particularly when it pertains to their backing scheme. Although they’re pegged to a particular currency on a 1:1 ratio, how they’re collateralized, i.e. what guarantees their value, makes all the difference.

Ideally, one would want a stablecoin backed by cash Dollar reserves, and such coins certainly do exist. These are referred to as Fiat-Backed Stablecoins and may sometimes also be partially backed by precious metals and commodities, as well as investments, loans, bonds, and funds. Examples of such stablecoins include USDT, BUSD, USDC, and TUSD.

Conversely, there are stablecoins backed by crypto reserves, and these are referred to as Crypto-Backed Stablecoins. The principle here is to allocate enough of a relatively safe crypto asset as collateral for a stablecoin, enough to account for price swings and fluctuations. Examples of crypto-backed stablecoins include DAI and VAI.

The last category of stablecoins is the Algorithmic Stablecoin, where a protocol ensures the stability of the token price through a clever mechanism that manages the reserve. Such processes involve using smart contracts to burn or issue cryptocurrencies depending on demand. UST is a popular example of an algorithmic stablecoin and continues to see a consistent increase in volume and supply.

CBDCs, Trust, and Regulation

The main differences between CBDCs and stablecoins are the issuers, the degree of centralization, and the extent of regulation. CBDCs are issued by central banks or their equivalent, and are therefore governmental and not a third-party product. While this is a more reliable and secure means of digital currency, it is significantly more centralized and thus, under the full control, surveillance, and influence of the government issuing them.

Stablecoin issuers on the other hand aren’t regulated to the same extent, which may leave room for legal loopholes. To gain the trust of users, such companies are constantly audited by independent parties and accountants and have the findings published frequently.

Stable Enough?

It is easy to issue new stablecoins when the market is booming and capital is flooding in; but when the market witnesses a black swan event, unreliable issuers that use questionable means of backing their stablecoins may find themselves unable to fulfill the overwhelming number of withdrawal requests. Thankfully, no such event appears to be in sight for the foreseeable future, but if you are one to invest in relatively meaningful amounts, it doesn’t hurt to dive into audit reports and validate their findings under a closer lens.

Eager to deposit your stablecoins in an AI-assisted, machine-learning trading algorithm? Stay up to date with Precog Finance via the links below!










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