How Stablecoins Work: Everything You Need to Know in One Article
Imagine a world where you can sell a $150,000 investment, transfer $20,000 of it to family living across the globe, move $10,000 into a new investment, and use the remaining $120,000 as a down payment on a new apartment — all in less than a day and for less than $10 in fees. This is the promising future in which the financial infrastructure is built around digital currencies and stablecoins, but is it truly possible?
The following article is a written record of my exploration into the use-value of stablecoins currently and in the future. It’s not intended to be for or against stablecoins. It’s simply conveying relevant information to help you understand this new technology and empowering you with a better capability to take advantage of it. As I learn about this subject, I hope you can too.
The Breakdown:
A Macro Look
- What Are Stablecoins?
- How Do They Work?
- What Makes A Successful Stablecoin?
- Why Are They Important For The Future?
- How Are They Dangerous?
A Micro Look
- How Can They Offer High-Interest Rates?
- Are Stablecoins Safe Enough For Emergency Funds?
- What Are The Best Stablecoins Right Now?
- Final Thoughts: The Current Circumstances
What Are Stablecoins?
Stablecoins are a form of cryptocurrency, but just as their name suggests, their purpose is to eliminate the typical volatility tied to other common crypto assets like Bitcoin and Ethereum (both having the ability to shift up or down 10%-30% in a day). They do this by collateralizing against other assets, so their value remains steady.
Over the last decade, the popularity of cryptocurrencies has grown tremendously, and so too did a problem. The crypto market is open 24/7, but banks are not, so traders couldn’t reliably exit investments into cash anytime they wanted. They had to hold onto their volatile crypto asset until the bank re-opened. Stablecoins provided a solution — safe assets to store and transfer profits during off-hours. However, other advantages were quickly realized, like sending money across borders in milliseconds for relatively low fees. Things traditional banks couldn’t perform. As a result, their popularity expanded rapidly along with the rest of the crypto-asset market. They became essential to the space. Fast forward a decade-ish, and governments are now launching their own stablecoins named CBDCs (Central Bank Digital Currencies) pegged to their domestic currencies along with companies like VISA and Facebook entering the space. What started as a niche crypto solution has grown into a global innovation.
How Do They Work?
The most common stablecoins peg themself to real-world assets like the US dollar. Under this circumstance, the concept is quite simple; 1 coin equals 1 US dollar. In a perfect world, a stablecoin issuer will hold onto $1 worth of collateral for every coin issued, which means the token supply is backed 1:1 by the issuer’s reserve. If a coin is pegged to something else, like gold, then 1 coin will represent a stated measurement of gold. Unfortunately, we don’t live in a perfect world. Most stablecoin issuers have controversy surrounding their 1:1 ratio and/or quality of reserves (more on this later).
How Are They Backed?
There are three forms of stablecoin right now. All work differently to achieve the same result — provide a reliable and steady store of value and/or medium of exchange to the crypto market. Let’s explain their differences:
Off-Chain Backed (Fiat & Commodity)
These are coins backed by real-world assets like gold or nation currencies. They tend to align themselves with the value of their real-world counterparts with minimal fluctuations to be a dependable form of exchange for investors. Coins pinned to the US dollar (Ie. USDT, USDC) make up 90% of this category. The remaining 10% are coins pegged to commodities like gold (PAXG), silver (SLVT), and even petro (PTR — failed) — these simply tokenize specific resources to offer investors a straightforward way to hold them.
The benefits of fiat-backed stablecoins are that they’re the most reliable and steady. They have the longest track record of success. The concern is you’re trusting a central organization to hold safe and secure reserves for all the issued coins, which becomes problematic when there are billions of dollars held.
Cryptocurrency Backed
Cryptocurrency-backed coins are supported by other crypto-assets like Ethereum, intended to pair themselves to a specific value (like the US dollar or Chinese yen). There are few of them, and it’s a problematic approach to remaining stable because what they use as backing (cryptocurrencies) is so volatile. Often, they overcome this obstacle by over-collateralizing, meaning they might hold 1.5x the value of coins issued. Still, market fluctuations pose a real threat. DAI is a popular type of crypto-backed coin, and its reserves are backed by 62% of the above USD stablecoins, arguably for this very reason.
They’re still steady but more decentralized (not under the private control of one organization). For example, DAI is operated by the MakerDAO, which is a software code that runs itself — a desirable feature in the space. The concern is these coins are more vulnerable to price fluctuations and market conditions.
Algorithmically Backed
These coins are the newest but offer promising improvements to the space. Unlike the former two, algorithmic-backed coins are not supported by any other assets. Instead, a program code increases or decreases the circulating supply to adjust the coin value and keep it within a specific price range.
These are transparent and decentralized coins because everything operates via open-source code. Everybody can look up the program’s decisions in real-time, making it easier to trust in reserves. Still, the concern is they’re the most vulnerable to price fluctuations and largely untested. The most popular stablecoin that represents this form in its purity is AMPL.
What Makes a Successful Stablecoin?
Transparency is key. The future of these coins relies on their issuers being open and transparent about their reserves. If they aren’t, users will eventually get hurt, and the entire space will have a black eye. The other factors to consider are centralization and the backing formula used to remain steady and reliable.
Crypto lovers idealize decentralization because, rightly, they’re sick of a tiny minority of people controlling a majority of wealth distribution. They seek fair decision-making and equal opportunity. But that characteristic alone does not make for the most useful protocols in the digital asset space. Bitcoin is an outlier, it’s a decentralized wonder, but many other successful coins (Ethereum, Solana, Avalanche) have proven a combination of central authority and decentralized procedures can still make a powerful, positive change. A great stablecoin will follow this model. It will balance centralization with decentralization to create a safe, fast, and reliable token.
Off-Chain backed coins are the most dominant and hold the best track record on the field because they’ve proven to be the most reliable and stable. On-Chain (algorithmic & crypto-backed) have struggled to gain adoption due to their vulnerability to market fluctuations. However, crypto holders are still eager to see them succeed because of their decentralized nature. Off-Chain issuers will likely, remain centralized because managing the physical reserves requires it. On-Chain issuers can use smart contracts (code) to operate, eliminating the need for central decision-making. As innovation breaks new ground, stablecoins combining the forms of backing (all three), like Terra (UST), are exciting up-and-coming stars in space.
Why Are Stablecoins Important to The Future? The Optimal Use Case
Stablecoins have the power to employ a complete overhaul of the current global financial infrastructure and then some. They offer the potential to make secure transfers of value in real-time, worldwide, for pennies or less. It won’t matter if it’s 5 US dollars or $5 million. Note, however, that this is not currently the case, but it’s not due to a lack of desire or ability from stablecoin issuers. The friction of the legacy financial system creates barriers that hold back the progression of this new technology. Fees for converting dollars to crypto and vice versa still tally up. Also, the highly adopted Ethereum blockchain (which many stablecoins utilize) presents further complications with congestion and gas fees (ironically, their form of bank charges). The potential is real, but the process is iterative, and we’re incredibly early. The innovation and adoption will arrive.
The Takeover
It’s already started in the global remittance market (individuals who work abroad and send money back home), a 540 billion dollar market in 2020. That industry is prime for replacement because of the outrageous fees from companies like Moneygram and Western Union. However, it’s not just cross-border transactions that are ripe to be disrupted; credit card transactions cost merchants 2 to 3% (Visa/Mastercard), which is exponentially higher than what future stablecoins will charge. This will be an enormous uprooting; global revenue from merchant transactions was valued at 1.9 trillion dollars in 2020, less than 2019 ($2 trillion) due to COVID, but historically growing 7% year over year. Then those payments end up at issuing banks, which charge excessive fees on bank balances and transactions. These, too, will see significant changes.
Crypto technology will rebuild the financial infrastructure we understand today. There won’t be a need for banks or payment processors. You will seamlessly send value from your wallet to any other wallet address on the planet. Stabelcoin growth will continue in 2022, with legacy financial companies like VISA losing share to hybrid companies embracing Bitcoin, stablecoins, and cryptocurrencies like Stripe and Block (Square).
How Are They Dangerous?
Countries launching CBDCs source
Countries will also utilize the technology as best they can to create Central Bank Digital Currencies (CBDC = A digital form of the domestic dollar), but this will present some significant problems. Some of the advantages stablecoins offer also give governments some dangerous levers of power. With a centralized digital currency in your wallet, an authority could transfer or eliminate your money in the blink of an eye. You could get a speeding ticket on the way to work, and before you reached the office, the money could already be withdrawn. They could have access to see every transaction you make without jurisdiction. These are just some aspects of the potential risk. There are also questions on whether a CBDC even helps western countries.
On the other end, the lack of government oversight could mean more extensive problems. Tether is the largest stablecoin issuer; it’s involved in 85% of all crypto transactions and 70% of Bitcoin trading activity. It’s ludicrous that a coin so integral to the space is yet to be audited by a third party. Tethers’ reserves might not have an actual 1:1 value, or the assets they hold might be junk. Currently, this has not negatively affected their users, but if the world markets took a big enough hit, Tether might not have the ability to issue dollars back for coins. If Tether implodes, it would also cause a massive drawdown to the crypto market and put a nasty stain on stablecoins, adding excessive regulation and stunting future growth.
There is also the problem of insurance. Sending coins to the wrong address (wallet) will often lose them forever. I find it challenging to see mainstream adoption of stablecoins where such risk is involved. I suspect deposit insurance and transaction returns are prerequisites for mainstream adoption (not a complex problem to solve by centralized protocols).
With Great Power Comes Great Responsibility.
The question is, will we trust governments or companies to act in the public’s interest?
Neither show an excellent track record, but the optimal solution lies between the two. A properly (and minimally) regulated decentralized stablecoin where the government acts more like a referee than a player. Ultimately, adoption will decide the winning stablecoins. All we can do is hope that the masses adopt the coins that serve the greater good. In this effort, education on the subject helps.
How Can Such High Interest Be Offered on Stablecoins?
The way lending works with stablecoins mirrors that of the banking sector. The fundamental model is the same. There is no magic or Ponzi to uncover (although that’s not to say all the platforms are ethical). When you lend your stablecoins to crypto lending platforms they lend it out to institutions in need of crypto assets for higher rates. They give you the promised interest rate and keep the spread. The increased yields come from two factors primarily: De-Fi and supply and demand.
Decentralized Finance (De-Fi) Models: While traditional banks have operational costs that eat 40–60% of their revenue (Ie. rent, staffing, administration), new De-Fi institutions use computer code that operates as a bank and is entirely digital. This allows them to return up to 80% of interest revenue to customers. Traditional banks top out around 25%.
Supply and Demand: Legacy lending institutions don’t see crypto assets as safe. They don’t allow you to borrow crypto or use it as collateral to take loans out, but the demand to do these things is tremendous — fueled by retail and institutional borrowers. Institutions borrow at high rates because there is a lot of opportunity in the market to make greater returns (I.e. shorting, arbitrage trading, and other market-making activities). Retail demand is high because thousands and thousands of newly minted crypto millionaires want to realize some of their gains without selling their coins.
LendIng rates are high right now, but they won’t always be. Like standard interest rates, they’re determined by market forces like leverage, supply, and demand — as money pours into the crypto space, conditions change, and so to will interest rates. Although, right now, you can still take advantage of rates far higher than your savings account offers (here’s a guide).
Is It Crazy to Consider Stablecoins & Their High-Interest Yields for Emergency Funds?
The short answer is probably not. It depends on your risk tolerance and understanding of stablecoins. Ultimately, this is your money and your decision. The risk level of holding funds in a stablecoin and lending them out is low, especially when you factor in the high-interest yields compared to typical safe investments like bonds and mutual funds. But the risk is not zero, and it’s higher than holding the same funds in a large banks’ savings account.
I have two personal examples that might help clarify (not financial advice). Scenario #1 is day-to-day: I use stablecoins as short- to long-term savings. I don’t deposit all funds into them because I have Canadian tax haven accounts (TFSA/RRSP), but still, I use USDC for all other savings. If I don’t need the funds for a year or more, I’ll look for a dip in Bitcoin and buy. If it’s money I might need, I’ll leave it in a stablecoin earning interest on Celsius. Scenario #2 is a bit different; there was a time I came into a large sum of funds and looked to buy property. A purchase I was going to make within six months ideally. In this scenario, I kept the funds in a traditional savings account.
It’s essential to keep in mind the situational facts. Stablecoins and lending platforms provide a ton of value to the digital asset market but don’t have the supervision or regulation traditional banks have. They also don’t offer deposit insurance. It’s a great way to earn on savings that otherwise sit and depreciate over time (from inflation), but it’s hardly a set it and forget it strategy. You should maintain awareness of what’s happening in the crypto space, specifically in stablecoin protocols. Be sure to invest in the safest, most transparent coins and lending platforms.
What Are The Safest and Best Stablecoins Right Now?
Out of the top 10 stablecoins, I believe Circle’s (Coinbase) USDC has the most robust use case. It isn’t without criticism, but it has a long-standing track record, and its transparency and reporting are far better than Tether (USDT). The safest and best rising coins, in my opinion, are Gemini and TerraUSD.
TerraUSD (TUSD) is an algorithmic crypto-backed coin which makes it particularly interesting. It’s decentralized. Although it’s currently operated centrally out of the Terralabs, the founder has stated the coin can work without a central authority and likely will in the future. It also offers a 20% interest rate which is incredible for a top 5 stablecoin, but that rate won’t last much longer.
Gemini (GUSD) is easily the most transparent fiat-backed coin; it’s regulated and audited. It still offers 8%+ yields, and it has the most credible 1:1 reserves on the market. GUSD represents the space well; it’s a future contender for the safest stablecoin and is regulation friendly.
All three of these coins are pegged to the US Dollar.
Where Are We Now? Final Thoughts
As of January 2022, stablecoins make up 5 of the top 20 crypto assets by market cap globally (roughly 11% of total market cap), but their trade volume is over 50% of the daily trade value of all top 20 assets. They provide tremendous liquidity to the crypto market and are vital to the ecosystem’s health. The technology will upheave the entire legacy financial infrastructure, and it opens the door to new paths of generating high-interest yields. The danger is that the concept is in its infancy and has a lot of growing to do. They will be a part of our future. Their use case is too valuable not to be, but the speed at which the takeover occurs lies in how issuers and regulators navigate the next five years. Finally, the major players of the traditional system will not go out without a fight (and lots of lobbying). The transition into this new era will encounter speed bumps, but the locomotive has already left the station. A revolution has begun, and it won’t be stopped.
