Stablecoins: Exploring the Benefits, Risks, and Regulatory Landscape

Muhammad Naeem

Blogger

Inflation is on the rise. Prices are going up, and the value of our hard-earned money is going down. In times like these, people are looking for alternative ways to protect their wealth and investments. Bitcoin has been around for over a decade now and is known for its volatility. Volatility is great so long as it is not against your holding position. What if you checked your wallet and you had $40, then only $37 and when you opened your wallet next time to buy something, your wallet now had only $50? How would you deal with this? That’s how the price of Bitcoin and other crypto can change in a volatile market. With these major price swings, Bitcoin is less suitable for common transactions and everyday use. That’s where stablecoins come in. Here we’ll walk you through:

• What Stablecoins are and how they work
• Their role in the crypto ecosystem
• Their benefits
• The dark side of Stablecoins

What are Stablecoins?

Stablecoins are designed to be more stable than Bitcoin and other cryptocurrencies. The value of stablecoins is pegged to, or tied to, another currency, commodity, or financial instrument. Most of the stablecoins are pegged to the US dollar. Their value remains equal to that of the dollar, or at least that’s how it should stay. The stability of stable coins is achieved through various types of algorithms and collaterals. Stablecoins are of various types like centralized, decentralized, algorithmic, and commodity-backed stablecoins. Stable coins are a way to make cross-border payments in seconds, to buy cat food, or to hedge against the insane volatility of other assets – in short, to enjoy all the perks of decentralized finance (DeFi) without any volatility. Like Bitcoin, stablecoins are also a cryptocurrency, after all, so how do they manage to achieve price stability? Can we mint an infinite number of stablecoins? And should we keep our investments in these digital assets? To answer all these questions, let’s first understand the working of stablecoins.

Stablecoins: Working and their Role

Moving to a bit more technical part, how do stable coins work? Stablecoins follow different working algorithms; the most famous are Collateralization or Smart Contract manipulation. Collateralization or specifically Fiat collateralization-based stablecoins are backed by collateral like gold or some currency like the euro or dollar. In dollar-based collateralization protocols, each stablecoin is backed by a US dollar. Tether or USDT is the most famous stablecoin in the market that uses USD collateralization. Smart contract-based stable coins or algorithmically pegged stable coins are simpler as they use blockchain codes (smart contracts) to keep the price of each coin equal to 1 dollar. If the price goes up, the smart contract mints more stablecoins, and if the price goes down, the smart contract burns some coins to reduce the supply. Smart contract-based stable coins are much more volatile because of their working algorithm.

Stablecoins are basically cash but they are transferable and tradable like crypto. These hybrid features of both fiat currency and crypto give stable have trust, value, stability, and security. In short stable coins act as a bridge between the crypto and traditional finance worlds. Suppose you held two Ethereum in your wallet and you were told that the market was going to crash in the next few hours. Your first thought would be to sell all your crypto holdings and cash out, but soon after you doing so, you realized that it was just a FUD. Then you’d again have to convert your fiat currency into crypto, go to the exchange and buy your Ethereum back. But stablecoins can avoid all the hassle. You can simply convert your Ethereum into a stable coin and never really exit crypto. Even in the harsh crypto winter, stablecoins can help you protect your assets from market volatility.

Advantages of Stablecoins

Stablecoins can offer a lot more than protection against volatility.

Let's understand this with an example of Jack, who just sold his property in the U.S. for 200 million dollars and now is moving to Europe with his family. After all the clearance by the local authorities, Jack needs to pay a fee of up to 5% to transfer all his money to Europe. What’s even worse, it will take 2 to 4 working days for the payment to arrive. It’s frustrating to know that almost all the traditional money transfer methods charge almost the same amount and require the same time. That’s when a friend introduces him to stablecoins for cross-border transactions within a few minutes. After doing his own research, Jack decides to use stablecoins to transfer his $200 million to Europe. Not only is his money transferred in less than 2 minutes, but Jack also pays only 10 cents for transferring 200 million dollars. He saves thousands of dollars on a single transaction. Now imagine if Jack was a businessman who had to do multiple transactions -- he would be paying millions of dollars in fees and unnecessarily delaying his transfers.

Though the story of Jack is hypothetical, but on October 15, 2018, someone actually transferred 30,0000 bitcoins worth 200 million dollars for just 10 cents and the transaction went through in just 2 minutes. The traditional system of finance is plagued with outdated centralized methods, and cryptocurrency, particularly stablecoins, provide an up-to-date form of modern finance. Stablecoin benefits include the following:

1. Protection against volatility
2. Efficient global transactions
3. Buying goods and services
4. Hedge against inflation
5. Enables decentralized finance (DeFi) applications
6. Offers greater privacy and anonymity compared to traditional payment methods

Potential Risks

Pretty attractive, isn’t it? Sadly, utopian worlds don’t exist. While stablecoins offer so many perks, they also have a dark side. Now picture this: the world's most popular stablecoin, with billions of dollars in circulation, suddenly crashes to zero within just a few days.

This is the well-known story of UST. UST was a smart contract-based algorithmic stablecoin. UST coin used LUNA and collateral to maintain the peg to the US dollar. The smart contract followed the demand and supply of LUNA and UST in such a way that most of the volatility damage was taken by the LUNA coin. When the price of UST was less than 1 dollar, the algorithm (smart contract) would burn UST and buy back LUNA to increase demand and raise the price of UST. And if the price of UST was greater than 1 dollar, the algorithm would mint a new UST and sell LUNA to buy back UST. This would increase the supply and decrease the price of UST until it was pegged to the US dollar again. However, there was an exception that caused the death of both coins. If the price of UST fell below a dollar, the algorithm would start selling LUNA and buy back UST to increase the demand and increase its price equal to the dollar again.

But if the price of LUNA, an asset backing UST, were to fall too soon before the algorithm could buy back, a liquidation event would occur. This means the algorithm would sell LUNA to repay the UST holder as compensation. However, selling LUNA would further decrease its price, triggering another liquidation event. The chain reaction would start the “Death Spiral”. This is a situation where the price of the stablecoin fell below the US dollar and triggered a self-reinforcing feedback loop that drove the price of the stablecoin further down.

UST had depegged many times in the past and the price was recovered by the algorithm. This eventually built trust among the investors and buyers of the stablecoin UST.

In the first week of May, UST started to waiver from the USD peg, and within a week it lost over 90%. The biggest fear -- the death spiral – was in action, bringing down the stablecoin along with its collateral LUNA. In one month, we saw prices as low as $0.0065 - less than one penny vs the USD.

The LUNA fall was considerably worse; if you were holding LUNA, you should count yourself lucky to have held UST instead.

The UST example alone is enough to show the dark side of the stablecoins and shock investors’ trust. Sadly, there are many more. There are three well-known stablecoins each experiencing different controversy. The fairest and most trusted of them all is the USDC coin which has been more transparent about its reserves. USDC is relatively more regulated globally. Still, this coin is prone to regulatory crackdowns.

Tether, aka USDT, has faced its fair share of controversies and regulatory scrutiny. People have always been suspicious of USDT holdings. Since there are billions of coins in circulation, does Tether really back each coin with a United State dollar? Where is that money reserved? Isn’t it too bad to lock so much money in one place with no interest? USDT has depegged multiple times in history; luckily, it has recovered every time. SEC has always been on the tail of crypto assets, and it recently declared that BUSD, a stablecoin of the Binance ecosystem, is an unregistered security. The FUD sent a wave of fear among the community causing BUSD to depegg from USD for a moment and recover. Binance has a monopolist approach toward the crypto community. It has tried either to acquire projects with potential or to counter them in the market. Binance understands the competition. It has even delisted USDC from its platform, citing concerns about regulatory pressure. The real problem is that even if some rumor or news is fake, the impact on the stablecoin always makes it unstable. The stability and reliability of stablecoins have been called into question, particularly in light of these recent controversies. But what are the wider implications for the crypto ecosystem? The sudden influx of fiat currency from the sale of stablecoins could cause a drop in the value of other cryptocurrencies, leading to a market crash; As we have seen in the case of LUNA, this not only hurts the associated ecosystem; it damages the trust of investors in the entire crypto ecosystem.

Conclusion

Nonetheless, all these drawbacks cannot overshadow the importance of stablecoins and their role in the wider perspective. Stablecoins can significantly reduce the time and effort to transfer assets, provide the security and speed of blockchain and stand strong against the current wave of inflation. However, “A decentralized economy needs decentralized money." Stablecoins are a great effort to decentralize our finance system in a big way, but as we found out in recent depeggs, particularly UST and LUNA, this particular model still has a long way to go.