What Is a Stablecoin?

4 mins read

A stablecoin is a cryptocurrency that offers a stable price. Stablecoins are usually backed by a reserve asset that keeps them pegged to the asset they track. In other words, stablecoins are cryptocurrencies whose value is linked to real-world assets, such as the U.S. dollar. 

Since BTC and Co. were too volatile, the market needed less volatile assets. Many observed this problem and came up with the solution: stablecoins. These assets worked as an entry point to crypto and allowed users to use them as payment methods.

Since their inception, stablecoins have been gaining popularity among investors. They offer the best of both worlds: they have the security and instant processing of cryptocurrencies, plus the stable valuations of fiat currencies.

They also offer yields that the traditional financial world does not. Stablecoins have gained popularity as a way to beat inflation. 

Tether, Regulation, and Alternatives

When we talk about stablecoins, there is one token we can't ignore: Tether. Tether is a blockchain-based cryptocurrency backed by U.S. dollars — in theory. 

Tether paved the way for other stablecoins. It became the world's leading stablecoin by market capitalization and trading volume. Tether's high demand has positioned it behind significant cryptocurrencies such as Bitcoin and Ethereum. 

But this great success also has its drawbacks. Tether has been in the eye of regulators for quite some time. They have been involved in controversies that have put their reputation on the line. In fact, Tether long ago stopped claiming that they were 100% backed by real U.S. dollars. 

Eric Chen, CEO of Injective Labs, a Mark-Cuban-backed project, had something to add on this topic. According to Chen, there is some speculation that USDT is not backed 1-to-1. This lack of transparency has led to new alternatives emerging. However, while contenders such as DAI and UST have their respective advantages over USDT, USDT remains the most liquid stable currency.

Now, could this almost eternal scrutiny and possible regulation dethrone Tether? Ultimately, yes. The No. 1 spot is no longer as secure as it seems. 

According to Chen, depending on the time horizon, Tether may not hold its no. 1 position due to competition from CeFi and DeFi alike. USDC, DAI, BUSD, UST, and DAI may overtake Tether with their unique offerings.

Commodity-Backed Stablecoins

On the one hand, the first solution is a commodity-backed stablecoin. These stablecoins are backed by exchangeable assets. We can talk about precious metals, real estate, oil, etc. 

Tether Gold (XAUT) and Paxos Gold (PAXG) are two of the biggest gold-backed stablecoins. Proposals like these have an added value proposition. They allow users to exchange their stablecoins for gold. 

However, these must meet certain conditions: the number of coins is the principal one. Also, they are limited by location, i.e., you cannot exchange them for gold anywhere in the world.

Cryptocurrency-Backed Stablecoins

Cryptocurrency-backed stablecoins are similar to fiat stablecoins. They keep their value tied to a linked asset. However, as their name suggests, they are backed by other cryptocurrencies. This makes them a bit more complex to understand. 

For example, they may use ETH or another cryptocurrency instead of U.S. dollars. However, they do not give a 1:1 ratio due to volatility issues. This is known as over-collateralization. Said over-collateralization means that the backing is worth more than the stablecoins in circulation.

MakerDAO takes the prize as the most popular cryptocurrency-backed stablecoin. MakerDAO is based on a smart contract that allows people to create DAI in exchange for cryptocurrencies. Such a process is known as collateralized debt position (CDP). 

With CDPs, the user takes out an overcollateralized loan to create DAIs. If the cryptocurrency drops sharply, his position is liquidated. If the user wants to get his ETH back, he must return the same amount of DAI plus commissions.

While cryptocurrency-backed stablecoins are highly secure, they have a higher barrier to entry. 

Algorithmic Stablecoins

The last option is the algorithmic stablecoin. This type of stablecoin maintains its stability through decentralized and self-sustaining protocols. Algorithmic stablecoins usually maintain their stability through coin-burning protocols. 

Coins of this type need a base coin to create them. Users burn this coin to make the stablecoin. Burning this coin in exchange for stablecoins balances the supply and demand. They are also much more effective than stablecoins with collateral. 

Also, this allows the base tokens to maintain a deflationary trend. This last point helps the price of the base token to remain bullish. 

The best example of this type of coin is UST, the stablecoin of the Terra ecosystem.

UST was born in 2019 and is pegged to the value of the U.S. dollar. Terra ecosystem users can burn a dollar equivalent of LUNA in exchange for one UST. 

In case the UST falls below one dollar, users can take advantage of this arbitrage to make a profit. Once they take advantage of the arbitrage, the UST gets closer to one dollar.

The demand for UST has increased immensely in recent months. This demand is due to Anchor Protocol, a DeFi protocol that generates about 20% APY. This has also allowed LUNA to reach the top 10 by market capitalization. 

Is This the End for Tether?

Truth be told, Tether's constant appearances in the news have driven many investors away. These investors have hundreds of alternatives, so it is sometimes difficult to choose.

It is natural for the market to spread its market capitalization among several projects. However, Tether is still alive and kicking — An USDT crash could happen, but it all seems a long way off.