A Dive Deep On Stablecoins In 2021

Let’s dive deep into the stablecoin forest and find out what makes stablecoins such an incredible powerhouse for the crypto market

Despite such growth, the crypto market is still notorious for its high volatility when it comes to price action. An issue that the industry is now trying to address through stablecoins like the USDT, USDC, PAX and DAI. This emerging class of crypto coins started gaining popularity back in 2015 when USDT was listed by a few exchanges that were active at the time.

Stablecoins

By definition, stablecoins are crypto assets that are backed by a relatively stable asset to minimize the price volatility associated with crypto markets. This class of crypto coins rose to fame as an alternative for accommodating less volatility while trading crypto assets. Today, they are among the leading crypto trading pairs with most market makers opting to take profits through stablecoins.

As expected, the idea of stablecoins has sparked different reactions from innovators and regulators that are keen on the crypto industry. Some believe in their value proposition while others hold on to traditional economics, where only central banks have the mandate to supply money. Nonetheless, stablecoin supply increased by around 322% in 2020 to hit $24.8 billion from $5.9 billion.

Types of Stablecoins

Stablecoins have evolved over the years and now exist in 3 main types; fiat-backed, crypto-backed and non-collateralized (algorithmic stablecoins). Let’s take a look at the fundamentals of each type and how they work in the crypto ecosystem.  

Like the name suggests, fiat-backed stablecoins are pegged to a particular currency and in most cases the U.S dollar. Ideally, the coins should be backed on a 1:1 basis such that the amount of circulating stablecoins balances with the reserves held by the issuing entity at any point.

Other stablecoins that are backed by the U.S dollar include Gemini Dollar (GUSD) and the USDC coin by Circle and Coinbase. These two came a bit later and are yet to challenge USDT’s market dominance in cumulative and daily traded volumes.  

Crypto-backed stablecoins are collateralized by cryptocurrencies as opposed to fiat currencies. Well, you might be wondering how this provides stability or value retention?  

Just like the U.S dollar which is known for its stability, some crypto assets like Bitcoin and Ether have gained a ‘stable’ status compared to the rest of the market. In fact, most crypto-collateralized stablecoins are backed by one of the two digital assets.

DAI Stablecoin

Of course, such fundamentals come at a cost; DAI’s collateral ratio is much higher due to the volatility in crypto prices. For example, minting (triggering supply) 1 DAI would require a deposit ratio of 1.5:1 (ETH to Debt) which basically counts as overcollateralization.

Liquidation is triggered in the event where collateral-to-debt ratio goes below the collateral liquidation ratio, where in the case of DAI it should always be over 150% (1.5:1). The liquidation is carried out by the underlying smart contracts which automatically execute based on the pre-coded conditions.

With Decentralized Finance (DeFi) gaining popularity, DAI stablecoins have become a favorite for Ethereum blockchain users. Most players mint DAI stablecoins to perform other profitable operations while placing their ETH as collateral. However, they have to pay a ‘stability fee’ for holding such positions.

Non-Collateralized/Algorithmic Stablecoins

Algorithmic stablecoins are largely theoretical as most of the innovations are still in early stages. This type of stablecoin borrows fundamentals from Seigniorage Shares, a concept that was first published by Robert Sams in 2014.  

Basically, they are not backed by any asset and depend on smart contracts to ensure that their value remains stable at any time. To paint a picture, think of the smart contracts as a central bank which maintains stability through quantitative easing.

In this case, quantitative easing involves supply of new algorithmic stablecoins when the value goes above the pegged target and burning some of the coins in circulation when it goes below. This way, a stable value of the underlying crypto asset is maintained throughout.

Some of the project examples in this niche include Basis, Ampleforth, Celo and Terra. All these innovations enjoy the backing of heavyweight investors, although the idea of algorithmic stablecoins may take a while before stakeholders get a hang.

A New Powerhouse for the Crypto Market

Stablecoins are gradually taking over the crypto market with more volumes being supplied to exchanges on a daily basis. Last year, the transactional volume for stablecoins grew by 316% to hit $248 billion according to data from Coin Metrics. Notably, the number of addresses that hold more than $100K in stablecoins also shot up by 201%.

Some of the developmental highlights in this space include Facebook’s proposed Libra stablecoin. This stablecoin was to be backed by a basket of stable currencies, although Libra later pivoted to the U.S dollar only. It has since been rebranded to Diem in an effort to make a second debut during the first quarter of 2021.

Unsurprisingly, the trend has caught up with regulators who are now looking at the possibilities and shortcomings presented by stablecoins. The Bank of International Settlements (BIS) published a detailed research back in 2019 to investigate the impact of global stablecoins.

Since then, authorities including the U.S government have narrowed down on this emerging class of crypto coins. The U.S Office of the Comptroller of Currency (OCC) recently issued an interpretive letter that allows banks to use stablecoins for settlements. 

As highlighted earlier, stablecoins are fundamentally designed to minimize the volatility associated with crypto markets. They are a critical part of this market’s infrastructure, especially in maintaining a stable portfolio value. 

Volatility Hedging 

Take for instance miners who are paid in BTC, but require to purchase the mining equipment in USD. It makes sense to hedge for this move by holding stablecoins as opposed to BTC which is exposed to the crypto market volatility. In doing so, the miners are protected from any price movements that might reduce the portfolio value of the committed funds. 

Medium of Exchange 

Stablecoin Yield Generation

When it comes to making money, everybody loves a lucrative yield (interest) on their capital. Stablecoins present multiple opportunities for crypto market participants to make decent yields than they would have through traditional finance instruments. 

Another burgeoning trading niche where stablecoins can be used to earn yield is crypto derivatives, which includes products such as perpetual contracts and futures. The crypto derivatives market has especially gained traction within the past year and is now a fundamental part of the whole market. 

Liquidity Mining 

Last year saw the rise of DeFi as a hot trend in crypto, its momentum peaked in summer when liquidity mining was introduced. This basically involves the provision of liquidity to an Automated Market Maker (AMM), most of the active projects run on Ethereum blockchain. 

Despite being a young market, crypto is really giving traditional finance a good run for its money. Die-hard enthusiasts believe that the digital asset economy will eventually surpass the volumes done in today’s financial markets. This would mean that most financial activity will have shifted on-chain while stablecoins might have assumed a similar role to the U.S dollar in this ecosystem. 

Trading/Leverage

– The upside potential of taking a trade could be a huge profit realization, which can still be cashed in through stablecoins. 

– Leveraged trading through stablecoins creates an opportunity to make more money than what the initial capital would have yielded. 

Cons 

– Trading crypto assets is extremely risky given the high volatility; in some cases, traders have lost all their capital in minutes as the market swung aggressively. 

– Leveraged trading increases the probability of liquidation and could end up wiping out a trader’s capital if they are given a margin call and fail to top up the account on time.  

Lending & Borrowing

– Using stablecoins to lend or borrow can be an effective market strategy to enter into potential positions and repay the debt later. 

Cons 

– The risk associated with crypto and especially DeFi projects means you could lose all your deposited capital altogether. And on top of that, you would have no one you could talk to or seek help from. And that’s of course because the biggest advantage of DeFi – the fact that it’s decentralized without a central organization you could turn to for support – becomes in that specific case, it’s biggest disadvantage too. 

– Stablecoins fail to hold the exact peg value at all times, this could trigger a quick liquidation if the value deviates a bit too much.  

Liquidity Mining

– It offers higher yields than the average crypto market return.

– Liquidity providers are rewarded with governance tokens, which give them a voice/vote on the future of a particular DeFi protocol. 

Cons 

– High probability of being duped in what the crypto community refers to as a ‘rug pull’. According to the latest security report by crypto intelligence firm Cipher Trace, ‘half of all 2020 crypto hacks were DeFi protocols – a pattern that was virtually negligible in all prior years’. 

– The infrastructure is still complex and can easily cause the loss of funds while carrying out operations. Some of the DeFi protocols are highly savvy – users can lose money through operations like moving funds from one smart contract to another. 

Summary 

As per this breakdown, you can already see that there are multiple opportunities to generate yield through stablecoins. Interestingly, some innovators in the crypto space have leveled up the game by offering interest accounts on stablecoins. This is a more convenient and less stressful way to make money in the crypto market while preserving the value of your portfolio.