What are stablecoins

Stablecoins are the cryptocurrency that is least subject to market fluctuations. Algorithms and users themselves can be responsible for stability, as well as the peg to real assets (for example, dollars or gold) smoothes out jumps in supply and demand.

Now, due to the decline in the cryptocurrency market, lots of people have started to pay attention to stablecoins. Let's figure out whether stablecoins are really the best option on a bear market and which one to give preference to.
 

What a stablecoin is

A stablecoin is a price-stable digital crypto asset, pegged to another asset (which is called ‘the reserve asset’). The reserve asset might be fiat (dollars, euro, francs), a precious metal (gold, platinum), or another cryptocurrency.

Stablecoins allow the crypto community to survive on a bear market without having to convert assets to fiat. Tokens also allow you to circumvent restrictions on the financial market. For instance, people from the countries under sanctions use them for cross border transactions.

We can split stablecoins into two camps: centralized and decentralized. Let’s take a look at both of them.
 

🎯 Centralized stablecoins 

Centralized stablecoins are controlled by top-managers. Such coins are pegged to the reserve asset through the collateral. Let's say each token costs $1. In order to keep its value at the same level, the company must have reserves equal to the supply of issued cryptocurrency, so they need to have money or other assets that are stored in a real repository.

Information about the storage location is usually published on the stablecoin’s issuer website. Also there you can find reports with the results of reserve attestation.

Arbitrageurs, market participants who profit from differences in coin values, ensure the rate stability of such stablecoins. When the price falls, they buy out cheap stablecoins in order to sell tokens after the exchange rate stabilizes. In cases where prices rise, arbitrageurs, on the contrary, earn by selling tokens at a better price.

Examples of centralized stablecoins: Tether (USDT), Binance USD (BUSD), and USD Coin (USDC).
 

🕸️ Decentralized (algorithmic) stablecoins

Decentralized stablecoins are controlled by algorithms. They keep the exchange rate stable and, if necessary, regulate emissions. There are different schemes for stabilizing such coins. For instance, the algorithm can maintain a balance with collateral tokens (which the coin is pegged by) and arbitrage systems that help market participants earn on the rate differences (buy cheap, sell high, and vice versa). Here's how it works:

 📉 When the price falls, arbitrageurs can earn with a profitable purchase of a coin in order to sell it after the exchange rate stabilizes.

📈 If the price, on the other hand, grows, arbitrageurs can profitably convert the stablecoin into the asset it is backed by. The decline in stablecoin supply and selling pressure help algorithms stabilize the rate.

Examples of decentralized stablecoins are Neutrino USD (USDN), Fei USD (FEI), and USDD (USDD).
 

Stablecoin standards

The same stablecoin can be represented by different standards: for example, there are USDT ERC-20, USDT TRC-20, USDT TIP-3, USDT BEP-20. It means that tokens work in different networks: USDT ERC-20 is in Ethereum, USDT TRC-20 is in Tron. It is important to know about networks: if you send USDT TRC-20 to a wallet that works only with USDT ERC-20, the coins will not reach the recipient.

There are several popular standards for tokens on the digital asset market: ERC-20, BEP-2, BEP-20, TIP-3, and TRC-20. They differ by popularity and other factors, including the average speed of transactions.

One of the oldest and most widely used token standards is ERC-20. It was created in 2015 by Vitalik Buterin, the creator of Ethereum (the second most valuable cryptocurrency in terms of capitalization), and programmer Fabian Vogelsteller.

The ERC-20 creators unified the issuance of tokens within the same network. Previously, developers had to write new code for each coin every single time. As a result, there were many incompatible tokens on the market. A single standard solved this problem: created on a single code base, ERC-20 tokens are fully compatible, and now you can store several different tokens of the same standard in one wallet, and not create a new one every time.

The popularity of Ethereum is largely dependent on the developers' interest in creating a universal standard cryptocurrency. The project's network was overwhelmed by the demand for its solutions. As a result, it reduced transaction speed and increased fees. Other market participants took advantage of the project’s problems by promoting their ERC-20 alternatives.

For example, Binance, a major cryptocurrency exchange, presented its token standard. Amid the launch of its own blockchain, the company released the BEP-2 standard for decentralized crypto exchanges and then made the BEP-20 standard, which can be used on centralized platforms. Both standards enable you to create distinct but compatible network tokens on the Binance blockchain.

Popular crypto project Tron released its own token standard, TRC-20, too. Technically, the TRC-20 is the twin of the ERC-20. You can use it to create compatible coins on the Tron blockchain. TRC-20 tokens’ transactions are cheaper and faster than ERC-20.

TIP-3 is an Everscale (ex Free TON) blockchain standard, which is based on solutions made by Pavel Durov’s Telegram team. TIP-3 is also technically a twin of ERC-20.

ERC-20 tokens are more widely spread, but their transactions are more expensive and last longer. Analogs are faster and cheaper but less common.
 

A few words about stablecoins' possible depeg

Sometimes stablecoins decline from the reserve asset. Such changes are called losses of parity. Unfortunately, there is no single scale for its measurement: for each cryptocurrency, these will have their own values.

Small deviations, by tens of percent, are normal. For example, a temporary depeg of a USD-pegged token to $0.98 is simply a fluctuation, not a loss of parity. This is how a stablecoin reacts to market activity.

A stablecoins' gap from the underlying asset by a dozen or more percent is usually referred to as a complete loss of parity. For instance, the fall of the USD-pegged token to $0.88 can already be considered a complete loss of parity.
 

Stablecoins’ collateral

There are three main types of stablecoins peg: fiat currencies, precious metals, and other cryptocurrencies. There are also tokens pegged to natural resources, large companies’ shares, and other assets, but they are not very common. Let’s take a closer look at the three most popular stablecoin collateral options.
 

🪙 Fiat-backed stablecoins 

Such a token’s rate can be pegged, for instance, to the US dollar or to the euro. We can take Pax Dollar (USPD) as an example. It is a stablecoin of the Paxos Trust Company, which also issues Binance BUSD, regulated by the New York State Department of Financial Services.

The USPD is pegged to the US dollar at a ratio of 1:1. This means that 1 USPD always costs 1 dollar. The company publishes stablecoin’s Proof-of-Reserve every month. It is 100% backed by fiat and US Treasury bonds. Reserve assets are supervised by Paxos Trust Company.

The USPD rate is regulated by arbitrageurs. When the cost drops below $1, the buyers who are interested in cheap tokens, which can be sold at the higher price after stabilization, help to return the rate to its previous position. When USPD growth exceeds $1, buyers are no longer interested in the overvalued stablecoin. When the number of people who’d like to purchase coins drops, it also helps to return coins to parity with the US dollar.

The Pax Dollar over the past year has repeatedly deviated from the reserve asset. The maximum growth up to $1.0060 was in May, and the deepest drop up to $0.994 was in April. Tiny short-term losses in parity were nothing more than market fluctuations.

Pax Dollar chart. Source: CoinMarketCap.

There are several Pax Dollar alternatives pegged to the US dollar: Tether (USDT), Binance USD (BUSD), and USD Coin (USDC). They are powered by the same technology as USPD.

You can also find anonymous stablecoins on the market. One of them is BOB. The token is backed by stablecoins pegged to the US dollar, such as Binance USD and USD Coin. BOB operations’ anonymity is secured by the zkBob algorithm. It helps to authorize and verify transactions without revealing the specific details of these transactions.
 

🏆 Precious metals-backed stablecoins 

Such tokens are pegged to gold, silver, and platinum. An example is Pax Gold (PAXG). The token is backed by physical gold. Each PAX Gold is equal to one troy ounce (31.1034768 grams) of a 400 oz London Good Delivery standard gold bar.

It is a stablecoin of the fully regulated blockchain platform Paxos Trust Company. Brink's, an American private security company, is in charge of the real gold that the issuer used to peg the stablecoin.

PAXG is following the gold price. There are no mentions of Pax Gold's deviations from its reserve asset, which indicates token reliability.

Pax Gold chart. Source: CoinMarketCap.

There are other stablecoins pegged to gold: Tether Gold (XAUT), Goldcoin (GLC), and Digix Gold (DGX). They use the same technology as Pax Gold.

Earlier, there was a wide range of stablecoins on the market, with the rate pegged to other precious metals, such as silver. Unfortunately, most of them have not survived. For example, the Silver Coin (SC) pegged to silver turned out to be unclaimed, and announced in 2018 Tiberius Coin, pegged to a basket of metals, also died young due to lack of demand. That’s how gold-backed stablecoins became the most popular.
 

🔗 Crypto-backed stablecoins

Stablecoins pegged to cryptocurrencies are a little bit more complicated. Let’s investigate one of them, DAI (DAI). It is a decentralized stablecoin of the MakerDAO lending DeFi-protocol. Its exchange rate is pegged to the US dollar at a ratio of 1:1. At the same time, its reserve asset is not the national currency of America, but other digital assets.

The MakerDAO protocol automatically releases stablecoins at the request of users. In order to get coins, you need to block your cryptocurrency in a special smart contract. Tokens become collateral for MakerDAO to issue DAI.

The developers used the excess collateral principle. For example, if a user wants to issue DAI secured by Ethereum, the collateral rate will be 130%. This means that $130 worth of ETH can be turned into $100 worth of DAI.

A stablecoin can be generated using other crypto assets, including USDC, MANA, LINK, and MATIC, as collateral. The collateral rate depends on the token you used. You can check it for the cryptocurrency you are interested in using the link.

DAI assists market participants in earning money by holding assets. Here's how it works with an example:

🧔 John has $130 in Ethereum. He believes that ETH can show growth, and that’s why he doesn't want to sell coins. At the same time, John noticed a perspective token with a high potential that could also bring profit.

🧮 Instead of selling Ethereum, he blocks ETH on MakerDAO to get $100 DAI, which he then uses to buy the coin with the highest potential.

💰 Let’s say that the coin which John bought showed a 20% growth. He sells it immediately for DAI and earns $20 (20% of the previous investments in DAI). At the same time, Ethereum, as expected, also grew. John returned $100 to MakerDAO in DAI and got back his ETH. He caught the benefit of Ethereum’s growth and earned $20 by using coins as collateral.

​​Regardless of the behavior of the cryptocurrency locked in the protocol (whether it demonstrates growth or decline), when returning the full amount of loaned DAI, the user will receive back the same amount of coins that he deposited for the issue of stablecoins (minus commissions).

The DAI’s history knows only a few small depegs from the underlying asset’ price. One of the year's largest pedeg was at the end of December 2021. DAI fell to $0.996 amid a general decline in the digital asset market, but quickly regained parity with the US dollar. The fall to $0.996 was preceded by the growth of the stablecoin to $1.0100 in November 2021 during Bitcoin’s and many other most capitalized coins’ new ATHs.

The DAI rate is regulated through the MakerDAO interest rate on loans. When the price of stablecoin falls below $1, the system incentivizes protocol users to redeem their collateral assets ahead of schedule by increasing the interest rate, reducing the asset lockup benefit. The increasing demand for DAI helps to restore the stablecoin rate.

For example, John blocked $130 worth of Ethereum in the protocol, for which he received $100 DAI at 5% per annum. DAI fell below $1 per annum and the developers, in order to restore the exchange rate of the coin, announced an upcoming rate increase to 8% per annum. In order not to pay more, John decides to close the loan early. To do this, he buys DAI and takes his collateral assets from the protocol. The purchase of stablecoins against the background of the upcoming rate increase helps to lower the exchange rate.

When DAI growth exceeds $1, the system, on the other hand, offers users a lower interest rate, which reduces the demand for a stablecoin. The lack of demand helps to get its rate back to $1.

DAI chart. Source: CoinMarketCap.

There are many more crypto-backed stablecoins to choose from, including Neutrino USD (USDN), Fei (FEI), and TerraClassic USD (USTC).

The choice of stablecoins depends on many factors, including the purpose of investing and personal beliefs. For example, for those who prefer to keep their savings in gold, tokens pegged to the precious metal are suitable. For those who usually save in foreign currency, fiat-pegged stablecoins should be considered.

The choice between centralized and decentralized stablecoins also depends on beliefs. If you do not trust top managers, you should consider algorithmic tokens. But keep in mind that centralized stablecoins are more common, which means they will be easier to exchange or use as a payment tool.

Pay attention to the stablecoin standards. The most popular is ERC-20, but transactions of such tokens are more expensive in comparison with alternatives. The cheapest and fastest standard are TRC-20, developed on the Tron blockchain, and Free TON-based TIP-3.

This article is not an investment recommendation. The financial and other transactions mentioned in the article are not a guide to action. Itez is not responsible for possible risks. The user should independently conduct an analysis on the basis of which it will be possible to draw conclusions and make decisions about conducting any operations with cryptocurrency and / or tokens.