The cryptocurrency market is made up of various assets, including utility tokens, NFTs, DeFi tokens, and the often-discussed stablecoins. In this guide, we explore what stablecoins are, why they matter, how they are backed, which are the most popular, and what advantages they offer.
What Are Stablecoins?
A stablecoin is a token whose value is linked to a reference asset, typically the US dollar (USD) or another fiat currency. Stablecoins play a vital role in global cryptocurrency markets, accelerating digital innovation worldwide.
Reports indicate that USD-linked stablecoins circulating on public blockchains have seen rapid growth. By mid-2023, their market capitalization reached $123 billion. In just one year, that number has climbed to $151 billion. USDT alone accounts for two-thirds of this total.
Stablecoins vs. Fiat Money
Stablecoins differ from traditional digital money records in two main ways. First, stablecoins are cryptocurrencies, allowing instant settlements without intermediaries. They operate on systems similar to Bitcoin, based on blockchain technology.
Second, most stablecoins function on public networks that enable non-stop 24/7 operation. Unlike the international banking system, where transactions are limited to banking hours, stablecoin networks are always accessible.
Unlike fiat money, which is issued without backing by central banks, stablecoins are supported by commodities, fiat currencies, cryptocurrencies, or other tokens. This backing generally allows them to maintain a 1:1 parity, though this balance can be disrupted, as seen during the Silicon Valley Bank collapse.
A common question about stablecoins is how they function and maintain stability compared to volatile assets like Bitcoin or Ethereum, which are subject to market fluctuations.
How Do Stablecoins Work?
It’s important to know that stablecoins can be classified based on their issuer and operational model. The main categories include:
- Company-collateralized stablecoins on public networks – USDT, USDC, BUSD
- Algorithmic stablecoins – UST and DAI
- Private stablecoins – JPM Coin
Company-Collateralized Stablecoins
Most stablecoins circulate on public blockchains like Ethereum or Binance Smart Chain and are backed by cash-equivalent reserves, including bank deposits, Treasury bills, and bonds. Examples include USDT, BUSD, and USDC. Some are even backed by gold and BTC.
These reserve-backed stablecoins are also known as custodial or centralized stablecoins. They are issued by private companies that hold cash-equivalent assets and offer 1:1 redemption of their stablecoin liabilities for US dollars or other fiat currencies.
USDT
USDT, issued by Tether, is the most controversial and widely used stablecoin globally. It has the highest market capitalization among stablecoins, according to CoinMarketCap. Despite its liquidity, questions have been raised about its solidity and reserves. A New York court even ordered Tether to prove its backing.
Tether agreed to pay $42.5 million to settle a dispute with the US CFTC, which alleged that Tether misrepresented the sufficiency of its dollar reserves. Tether has denied these claims through various audits and now maintains a transparency page to display its reserves in real time.
Algorithmic Stablecoins
While reserve-backed stablecoins are issued as liabilities on a company’s balance sheet, algorithmic stablecoins are maintained by smart contract systems operating exclusively on a public blockchain.
Control over these smart contracts is often granted through governance tokens that allow voting on protocol changes. These governance tokens can also serve as cash flows for the stablecoin protocol.
The US Federal Reserve has noted that algorithmic stablecoins are innovative and challenging to classify. Generally, their design relies on two mechanisms: (1) collateralization and (2) algorithmic stabilization.
Public collateralized stablecoins like Dai are minted when a user deposits a volatile cryptocurrency, such as Ethereum, into Dai’s smart contract protocols. Dai was launched by MakerDAO, a decentralized autonomous organization (DAO) operating on the Ethereum blockchain.
Users receive a loan of DAI, pegged to the dollar, against their crypto collateral, with a collateral ratio of 181%. Currently, DAI is backed by several assets, including ETH, WBTC, real-world assets, USDC, and others.
Another example of an algorithmic stablecoin was UST. Its parity was maintained through the buying and selling of LUNA tokens from the Terra protocol. This fragile balance was broken, leading to the collapse of TerraUSD and the international flight of its co-founder, Do Kwon.
Private Stablecoins
Private stablecoins are issued by commercial companies, with access centralized through the issuer. So far, private companies have been pioneers in stablecoin development. One well-known example was Libra, now called Diem. Since Diem was acquired by Silvergate from Meta in early 2022, little has been heard about the project.
Traditional financial institutions have also developed reserve-backed stablecoins, known as “1:1 tokenized deposits.” These institutional stablecoins are implemented on private blockchains and used for efficient wholesale transactions.
The most famous institutional stablecoin is JPM Coin. JPMorgan and its clients use JPM Coin for intraday settlements and internal liquidity management. The latest update is that in June 2023, JPMorgan enabled euro payments.
These private, reserve-backed stablecoins are functionally and economically comparable to products offered by some money transmitters. PayPal and Venmo, a PayPal subsidiary, allow users to execute instant transfers.
Advantages of Stablecoins
The key difference between stablecoins and cryptocurrencies like Bitcoin is that a private company works to stabilize their value by pegging it to another digital or physical asset, such as the US dollar. This foundational difference offers several advantages:
- Stability in the face of crypto volatility without converting to fiat. As explained, these tokens are often backed by currencies like the dollar or euro at a 1:1 ratio, though other assets like gold can also serve as backing. For example, BUSD, the stablecoin created by Binance (though no longer issued by Paxos), represents a crypto dollar, allowing users to transact in dollars without leaving the blockchain ecosystem.
- Stable value makes stablecoins more suitable for day trading compared to volatile cryptocurrencies like Bitcoin or Ethereum. However, maintaining stable value isn’t simple. A major challenge involves the mechanisms controlling these coins and how their value is backed by real assets.
- Trust for adoption. People wary of exposing their savings to crypto volatility can enter the crypto industry by exchanging constantly depreciating fiat money for stablecoins. While they may not generate significant returns, activities like staking can provide a good store of value.
How Are Stablecoins Regulated?
In some cases, stablecoins fall under the same regulations as cryptocurrencies. However, very few regulations focus specifically on this type of digital asset. This is an issue regulators worldwide are closely examining.
Given that stablecoins are quite different from traditional cryptocurrencies, specific regulations are needed for them to exist as they are. Laws tend to vary by jurisdiction, making regulation a highly localized concern.
Recent actions by the US, including the SEC’s lawsuits against Binance and Coinbase, have increased regulatory attention. These legal actions against two industry giants could influence how stablecoins are regulated in the US.
For now, stablecoins remain the predominant exchange medium within the crypto ecosystem. Despite growing regulatory pressure, there are stablecoins for every preference, and it remains to be seen which will dominate in the future.
Frequently Asked Questions
What is a stablecoin?
A stablecoin is a type of digital asset, usually a token on a blockchain network. Its value is linked to an external asset or reference, such as the US dollar or another currency.
What was the best stablecoin in 2023?
Due to regulatory challenges faced by BUSD and USDC in the US, the stablecoin that appeared most stable and reliable in 2023 was USDT, issued by Tether.
Which is the most used stablecoin?
The most widely used stablecoin in the entire cryptocurrency industry is USDT. As of July 3, 2023, it held a market dominance of over 67% among stablecoins.
Which is better: USDT or USDC?
Each stablecoin serves a different niche. USDC is more widely accepted on reputable DeFi platforms, while USDT is the most used stablecoin on centralized exchanges globally. Whether USDT or USDC is better for you depends on your intended use.
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Disclaimer: This content is provided for general informational purposes only. BeInCrypto prioritizes high-quality, unbiased information, and any actions taken based on this information are solely at the reader’s risk.