What Are the Top 3 Things People Get Wrong About Stablecoins?

What Are Stablecoins?

Stablecoins are types of cryptocurrencies that are backed by, or linked to real-world assets. These cryptocurrencies are designed to achieve the stability of fiat currency while leveraging the security, privacy, and fastness of cryptocurrencies.

While you can use cryptocurrencies for daily transactions, they are not very ideal as their value fluctuates. Also, cryptocurrency denominations such as 0.0001 BTC can be too confusing for the average person. If a grocer tells you the value of a loaf of bread is $1, you have a pretty good idea of what that means. But if they tell you it’s 0.000045, it presents a “unit bias” challenge. Stablecoins can fill that gap by complementing the best of crypto and the best of Fiat.

Tether, the first-ever and most popular stablecoin, is almost the poster child for the niche. Other stablecoins have sprung up, including DAI, USDC, Paxos Dollar, and BUSD.

Here are some of the biggest misconceptions about stablecoins.

1. Stablecoins Are Always Backed by Fiat

The impression out there is that all stablecoins are backed by just fiat currencies. Indeed, some of the biggest and most successful stablecoins, such as Tether and Binance USD are backed by the US dollar. However, stablecoins can also be backed by fiat, crypto, or commodities. Here’s a breakdown of different types of assets that can back stablecoins.

Fiat-backed stablecoins

Fiat-backed stablecoins are anchored by fiat currencies, such as the US dollar or the Euro. Such stablecoins are associated with the value of the fiat currency in question, with fiat currency reserved in proportion to the number of tokens issued.

Fiat-backed stablecoins are pegged at a 1:1 ratio with the currency. For example, developers of a fiat-backed stablecoin might hold $2 million while distributing an equal amount of tokens. People can utilize fiat-backed stablecoins the same way they would normal cryptocurrencies — from trading to transactions. Users can redeem their tokens for fiat at any time.

Developers of fiat-backed have control of every aspect of the stablecoin. This is a disadvantage since it means there’s no way for users to know if their tokens are actually backed by “real” money. Fortunately newer stablecoins are starting to undergo audits to help alleviate their users’ concerns.

Examples of fiat-backed stablecoins include Tether (USDT), Binance USD, USDC, and True USD.

Crypto-backed Stablecoins

These stablecoins are backed by cryptocurrencies. The volatility of the underlying cryptocurrency is mitigated via “over-collateralization” which means a greater value of the cryptocurrency tokens is held as a reserve.

Say, $4 million worth of ether can be held in reserve while $2 million worth of a stablecoin is issued. If the value of the underlying currency loses less than 50% of its value, the stablecoins can be recovered.

If you’re holding a crypto-backed stablecoin, you want to keep an eye on the market dynamics of the underlying currency. An example of a crypto-backed stablecoin is DAI. Crypto-backed stablecoins are the most decentralized of all.

Commodity-backed Stablecoins

These stablecoins are backed by precious metals such as gold and things like oil and real estate.

Some people may gravitate more towards commodity-backed stablecoins because they’re collateralized by something that may appreciate over time, and because such commodities possess “real value”, which some see as lacking in cryptocurrencies. An example of a commodity-backed stablecoin is Digix Gold, whose gold reserve is vaulted in Switzerland. Pax Gold is another popular example of a commodity-backed stablecoin.

Algorithmic or Non-collateralized Stablecoins

Algorithmic stablecoins are not pegged to any collateral. These stablecoins rely on an algorithm to regulate the supply — in a process called seigniorage.

Depending on market movements, the algorithm will respond by increasing or decreasing the number of tokens in circulation. This model works the same way as central banks, which reduce or increase the amount of money in circulation. An example of an algorithmic stablecoin is Ampleforth and Terra USD.

2. Stablecoins Are Always Stable

Given their name, you’d think stablecoins are the epitome of stability in the super volatile world of crypto. In reality, stablecoins are only as stable as their underlying asset.

All types of currencies, as well as precious metals and real estate, can decline in value. For example, extreme events may impact a country’s currency negatively.

Due to their relative stability, stablecoins can provide a false sense of safety. A massive decline in an underlying asset can prove devastating. For this reason, it’s important to keep abreast of the price developments of your stablecoin.

Furthermore, extravagant market events such as black swans can cause a spike in demand for stablecoins, ever so slightly increasing their price. Some USD stablecoins have been known to reach $1.01 or as high as $1.05. On the other hand, stablecoins can fall to $0.99, $0.80 or even $0 in the case of an outright collapse in the mechanisms or algorithms keeping the coin stable.

2. Stablecoins have a Definite 1:1 ratio With Their Underlying Asset

At least, this is the ideal scenario. But if Tether is anything to go by, this is hardly always the case. The currency has been embroiled in controversy about what is backing its tokens, if there is anything at all.

It all began in 2016 when the International Consortium of Investigative Journalists blew off the lid by leaking the “Paradise Papers” — which posited that Tether Ltd, the company behind Tether, had the same CFO, CEO, and CSO. This revealed that the two entities actually belonged to the same company — while the crypto community had been made to believe otherwise.

In 2017, the CFTC issued a subpoena to the company for lack of audit. In 2019, the New York Attorney General’s office issued a court order against the two companies for an alleged cover-up of the loss of $850 million.

Tether had given about $700 million of its reserves to Bitfinex. That event triggered a barrage of questions that persist to-date. If Tether had emptied $700 million to Bitfinex, what remained of its reserves?

The truth was revealed in April of 2019 when Tether’s lawyer filed an affidavit, fessing up that just 74% of the stablecoin was actually backed by Fiat.

In October 2021, Bloomberg was hit with a report citing the number of tokens in circulation. If 69 billion tethers were in circulation, then where is the corresponding $69 billion? Bloomberg reporter Zeke Faux couldn’t trace this money.

This shroud of secrecy plus Tether’s lawyer’s admission means, in truth, that Tether is not actually pegged 1:1 to the US dollar. That means a stablecoin might not actually have a reserve backing its tokens just because the company says so. In reality, this is no different than the practice of fractional reserve banking. Fractional reserve banking is used by all major US banks to lend out more money than what they have in their reserves. An issue arises if the holders of USDT ever want to exchange their USDT for USD at the same time. This is known as a bank-run.

Final Words

The stablecoin niche is relatively complicated, so much that its inner workings baffle the public.

That has led to bits and pieces of information in the media being taken as the truth. As it turns out the stablecoin world is unlike how people imagine it is. Additionally, the stablecoin ecosystem is constantly evolving. New ways are being developed to have algorithmic or collateralized stablecoins.

These methods are arguably better than the 1:1 backing method taken by USDT and USDC. There are no audits of real-world ledgers that need to be done in order to evaluate the efficacy of collateralized or algorithmic stablecoins, everything is able to be audited transparently on the blockchain.

One thing is for sure, stablecoins are here to stay as they perform a vital role in the cryptocurrency ecosystem.