This article is a part of IOV Labs DeFi series that aims to provide free knowledge about DeFi to individuals and businesses alike. Read to explore what stablecoins are, the different types and how they work, associated benefits and risks, and how businesses are adopting this DeFi use case.
The volatile price fluctuations of leading cryptocurrencies, such as Bitcoin and Ethereum, have made them unsuitable for the numerous use cases that are now coming to prominence in the space. Users looking to use crypto for saving, trading, and everyday transactions are turning to stablecoins.
Talk to us if you’re looking to build inflation-protection solutionsWhat are stablecoins?
Stablecoins are a type of digital asset that maintains a stable price pegged to a real-world asset (usually the US dollar). The overall market cap for stablecoins has increased from $5.8B at the start of 2020 to over $133B in February 2023. This correlates directly with the increased usage of DeFi applications, indicating users and businesses around the world are discovering the benefits stablecoins have to offer when accessing decentralized finance services.
In this research article, we explore how stablecoins work, their use cases, the various types of stablecoins and their risks, and what the future holds for this ever-expanding asset class.
Stablecoins’ Market Cap Growth Over The Years. Source: Coingecko
How do stablecoins work?
Stablecoins, as counter-intuitive as it may seem, are (usually) not “coins” at all. The majority of stablecoins, such as USDT, USDC, or USDRIF, are tokens issued on one or more established blockchain networks (e.g. Ethereum or Rootstock). This ensures that the stablecoin remains stable, as the issuer can create and remove tokens from the supply at any time.
For example, if there is a sudden increase in demand for the stablecoin, the issuer will create more units of the stablecoin and sell them to buyers, increasing the supply and keeping the price stable. Conversely, if there is a sudden decrease in demand for the stablecoin, the issuer will buy back units of the stablecoin, reducing the supply and again keeping the price stable.
Types of stablecoins
There are currently four different methods issuers use to maintain a stablecoins peg:
Fiat-Collateralized
Fiat-collateralized stablecoins are backed by fiat currencies like the US dollar or the Euro. For every stablecoin issued, the issuer holds an equivalent amount of fiat currency in reserve. The fiat collateral usually remains in a reserve with a central custodian or financial institution. This method is used by the two most popular stablecoins, USDT and USDC.
As of February 2023, fiat-collateralized stablecoins account for ±94% of the overall stablecoins market, with USDT dominating ±52% of the market.
Commodity-Collateralized
These stablecoins are backed by commodities such as gold, silver, or oil. Similar to traditional central banks, for every stablecoin issued, the issuer holds an equivalent amount of a commodity in reserve. For example, Tether Gold (XAU₮), is backed by gold reserves, and Digix (DGX), is backed by physical gold stored in a vault in Singapore. These stablecoins are useful for crypto users who want exposure to commodities without having to deal with the complexities of owning physical assets. stablecoin issuers often use a combination, or “basket,” of both commodities and fiat to collateralize their stablecoin.
Crypto-Collateralized
Crypto-collateralized stablecoins are backed by other cryptocurrencies. Initially popularized by MakerDAO’s “DAI” stablecoin, crypto-collateralized stablecoins automate the process of issuance by using smart contracts. Users deposit a certain (accepted) crypto asset into the smart contract and receive the equivalent value in a stablecoin in return. This method allows for greater decentralization and transparency as all assets are held on the blockchain.
On the other hand, Crypto-collateralized stablecoins come with their own challenges, such as:
- Volatility: Crypto-collateralized stablecoins are backed by other cryptocurrencies, which, themselves, are prone to price changes due to market changes. A significant drop in the price of the collateral cryptocurrency can cause a situation where the collateral becomes insufficient to maintain the stablecoin’s peg to its intended value.
- Over-collateralization requirement: To mitigate the volatility risk, crypto-collateralized stablecoins require over-collateralization, which means that the value of the collateral must exceed the value of the stablecoin. This requirement can limit the growth of these stablecoins as it can be expensive for users to acquire enough collateral.
Algorithmic stablecoins
Algorithmic stablecoins — the dark horse of the stablecoin world. Algorithmic stablecoins do not rely on collateral to maintain their stability. Instead, they use complex algorithms to adjust the supply of the stablecoin in response to changes in demand. This method was most infamously used by TerraLuna’s UST stablecoin — the hybrid algorithmic/under-collateralized stablecoin that lost its peg in early 2022, causing the entire crypto market to crash. Despite the bad reputation surrounding algorithmic stablecoins, there is still optimism that such a method could be successful and achieve mainstream usage again in the future.
What are the use cases for stablecoins?
Stablecoins provide a stable, reliable, and decentralized alternative for numerous users around the world who lack access to traditional financial tools, as they can be used for:
Saving:
One of the most relevant use cases for stablecoins is as a safe store of value. In 2022, inflation rates around the world reached all-time highs. Citizens in Argentina (88%), Venezuela (156%), and Turkey (88.5%) witnessed some of the hardest hits. Stablecoins, pegged to either USD or gold, act as a hedge against this hyperinflation.
People in the most heavily affected areas are often also restricted from exchanging their savings into foreign currencies through the country’s traditional financial system during periods of hyperinflation. stablecoins are a low-risk, easily accessible alternative that, like all cryptocurrencies, exist independently from any nation’s government or central bank — making them an ideal solution for people looking to protect their earnings.
This shift towards stablecoins in Latin America and countries that have witnessed hyperinflation has been confirmed in multiple reports in 2022; Mastercard showed that more than a third of Latin Americans said they have made an everyday purchase with a stablecoin, compared to just 11% of those responding worldwide.
If you want to learn how you can use stablecoins for savings solutions, talk to our experts hereSending/Payments:
Stablecoins can be used to make cross-border payments, bypassing the traditional banking system. As stablecoins are sent over the blockchain, they are not subject to fluctuations in foreign exchange rates or the lengthy wait times faced when sending money through traditional methods.
Beyond this, as most stablecoins function as a digital representation of fiat, they are ideal for making everyday payments and purchases. Multiple online marketplaces, such as Kripton Market, are now accepting more and more stablecoins as a form of payment.
Learn how businesses are integrating crypto and stablecoins into their payments and remittances solutions in our data-driven report.
Trading:
Stablecoins are commonly used as a base pair on decentralized cryptocurrency exchanges, meaning that they are used as a reference currency to price other cryptocurrencies. For example, a trader could use a stablecoin like USDT or USDC to buy Bitcoin, Ethereum, or other cryptocurrencies. Additionally, they provide a highly liquid pairing for purchasing and trading other cryptocurrencies which allows for faster and more efficient trading compared to traditional fiat currencies, which can take days to settle.
Stablecoins provide the foundation for the DeFi economy — working hand-in-hand with the blockchain network they are built upon. As the next phase of DeFi services evolves, stablecoins will play an integral role in providing a stable ground for the global DeFi ecosystem to thrive.
Examples of Stablecoins
Tether (USDT): The most well-known and widely used stablecoin. USDT currently ranks as the third largest cryptocurrency by market cap behind BTC and ETH. Originally launched in 2014, it has maintained a 1:1 peg with USD ever since. It is a fiat/commodity-backed stablecoin (mostly USD and gold). The company behind issuing USDT has seen its share of controversy in the past, with claims they did not have the equivalent in collateral to back up the circulating supply of USDT. However, recent audits and actions to improve transparency have helped to repair Tether’s reputation.
USDC: The second biggest stablecoin, USDC gained popularity as a more transparent alternative to USDT. It is backed entirely by fiat currency and maintains a 1:1 peg with USD. The company behind USDC utilizes smart contracts to automate (and somewhat decentralize) the process of issuing the stablecoin.
DOC: A Bitcoin-collateralized stablecoin that maintains a 1:1 USD peg. DOC is the stablecoin issued by Money on Chain. It uses a system of smart contracts to issue DOC based on the amount of BTC deposited. All DOC tokens are over-collateralized by Bitcoin in order to protect the peg of this stablecoin.
USDRIF: The RIF-based fully decentralized stablecoin. Issuance of USDRIF works in the same way as DOC, but the RIF token is used as collateral rather than BTC.
Is Bitcoin a stablecoin?
Bitcoin itself is not a stablecoin. The price of Bitcoin is determined by supply and demand, which can be influenced by a variety of factors, including economic and political events, regulatory changes, and investor sentiment. This makes Bitcoin prone to rapid price swings, accomplishing precisely the opposite of what stablecoins are intended to achieve.
However, Bitcoin has its own unique advantages in light of its volatility. Most notable is the fact that it is not pegged to the price of any centralized fiat currency, as many stablecoins are, shielding it from over-inflation.
Current state and future of stablecoins
Stablecoins have demonstrated a real product-market fit, even despite the entire wipeout of UST and the market instability that came with it. This is because stablecoins serve two main purposes; Firstly, they offer capital efficiency to cryptocurrency High-Frequency Trading (HFT) and market-making companies. Secondly, they provide a way for people in regions without traditional banking infrastructure, such as LATAM and South Africa, to access stable digital assets.
This has been confirmed by the steady increase in the total volume of transfers, which hit a new record in December. And with this increase in growth and market need, come different factors that affect this use case of DeFi:
Regulations:
The regulatory environment surrounding stablecoins has been a hot topic of discussion in recent years, with regulators worldwide grappling with how to manage their use. The United States SEC released a report in 2021 that suggests that some stablecoins may be considered securities, which could have implications for their use and distribution.
However, regulators elsewhere are taking a more progressive approach towards stablecoins. The European Union released a comprehensive regulatory framework for cryptocurrencies, including stablecoins, which aims to provide clarity and certainty for both users and issuers.
Fintech Use of Stablecoins:
In general, the sentiment around stablecoin regulation is positive, with most experts believing further regulatory clarity will help with their mainstream adoption. Furthermore, the continued growth of DeFi is set to further expand the use cases for stablecoins, making them an attractive option for accessing financial tools and services in both established and emerging markets.
CBDCs:
Future Central Bank Digital Currency (CBDC) implementation from countries around the world will pose another issue for stablecoins. Like stablecoins, CBDCs are intended to serve as a digital representation of fiat. However, unlike stablecoins, which are created by private companies and are backed by a specific asset, CBDCs are issued by central banks and are backed by the government.
However, it is to be noted that CBDCs will not be the same as stablecoins. Stablecoins are designed to provide a stable alternative to traditional cryptocurrencies, while CBDCs are fiat currency in a digital form. Many of the benefits stablecoins offer will likely not be the case for heavily centralized CBDCs — including being an easily accessible hedge against inflation and acting as a cornerstone for decentralized financial applications.
Stablecoins combine the advantages of traditional cryptocurrency and fiat currency into one. They provide a low-risk, easily accessible way for people to hedge against inflation and send money abroad. The coming years will undoubtedly see even more use cases for stablecoins arise as further regulatory clarity is established and adoption increases across the globe.
Want to learn more about businesses and fintechs using stablecoins to create inflation-protection products? Stay tuned for our in-depth report on taming hyperinflation.
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This article is for general information purposes only. It does not constitute legal, financial, or other professional advice, and should not be relied upon as such. IOV Labs accepts no responsibility for any loss or damage that may arise from reliance on information contained in this publication. Readers should seek independent professional advice before making any investment or financial decisions based on the information contained in this publication.
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