Bitcoin

How Stablecoins work?

Are Stablecoins still the backbone of crypto even after the crash of UST (losing its peg and in oblivion), one of the highest-rated algorithmic Stablecoin this year? I truly believe Stablecoins are essential for crypto markets to survive and form the backbone of the industry. In this post, we will explore what Stablecoins are and how they work. Also, we will discuss what are the various kinds of Stablecoins available today and do we need regulations for Stablecoins to survive?


Photo by CoinWire Japan on Unsplash


Why are StableCoins important

Stablecoins are tokens that are designed to maintain a stable value. These tokens maintain their stable value by pegging with stable assets such as US Dollar, government bonds, etc. Some tokens are pegged to other cryptocurrency tokens such as Ether. We will talk about different kinds in the sections below.

We can compare Stablecoins to Fiat Money in the crypto world. We use fiat money to purchase items and the sales proceeds from these items are realized in fiat money. Similarly, Stablecoins such as USDC can be used to purchase other tokens such as Bitcoin, ADA, etc and the sales proceeds from the tokens can be stored as Stablecoins. In a nutshell, Stablecoins are important because they provide a stable and reliable way to store value in the crypto world. When prices are volatile, it can be difficult to know how much your investment is worth. With Stablecoins, you can be sure that your money is safe and sound.


Types of StableCoins

Today, there are more than 250 Stablecoins available tied to various stable assets such as currencies (USD, AUD, Euro, etc), Gold, etc. Broadly, most of the Stablecoins can be classified as 3 types

Asset Based

These coins are backed by stable assets such as currencies (USD), gold, etc. Let us consider top Stablecoins by market capitalization- Circle’s USDC and Tether’s USDT.

USDC is straightforward. The number of coins in circulation is backed by the same amount of US dollars.

USDT is a little bit complex. Its value is backed up by a reserve consisting of cash, money market funds, US Treasuries bills, commercial paper, corporate bonds, loans, and, other investments such as digital currencies. USDT seems to have a lot of controversies so far as there has not been a clear audit report so far disclosing the asset types. And, it is very challenging to consider it as a Stablecoin as its value is backed by corporate bonds ( not as stable as US dollar and treasury bills) and other digital currencies.

BUSD is another popular one backed up by USD operating on Binance smart chain.


Algorithmic Based

These coins don’t require assets to remain stable. They can efficiently regulate the number of coins in circulation depending on demand. Ideally, an algorithmic Stablecoin represents how blockchain and crypto should operate, with code controlling the cryptocurrency and zero human input.

Primarily, there are three types of Algorithmic based stablecoins


Rebase

Controls the supply of coins to maintain its peg to the underlying asset. Ampleforth is one of the most popular rebase coins. The number of coins in your wallet may vary every day to maintain the value.


Seigniorage

Uses a burn mint multi-coin structure. Minting/burning of one coin controls the value of the other. Terra Luna and UST is a classic example of this kind.

Whenever UST went below the peg, UST was burned and LUNA was minted. This decreased the supply of UST which bought it back to the peg. Similarly, when UST went above its peg with USD, UST was minted and LUNA was burned. This increased the supply of UST and brought it back to the peg. This was controlled algorithmically whenever the UST deviated from its peg.

In this context, let us discuss how UST downfall happened. Terra Labs announced that they would change the interest rates offered to a variable rate of max 15% from 20%. This has caused a mass exodus of investors( whales) from this protocol and had caused UST to go below its peg. This was algorithmically detected and as a result, UST was burned and LUNA was minted. As more whales were dumping their positions, this has caused a huge increase in LUNA and a reduction in UST. Terra Luna’s circulation went from 350 million to 1.4 billion in a couple of days during the crash. One week after, Luna’s circulation stood at over 6 trillion, and the price is effectively irrecoverable.


Fractional-algorithmic

partially collateralized by a stable asset. Frax is one example that is partially collateralized by USD

The crash of LUNA and UST brought the whole concept of algorithmic Stablecoins into question. Since these coins are not backed by real assets and can be manipulated by the market emotions based on supply and demand, it is considered very risky.


What is the Future of Stablecoins?

As discussed, Stablecoins are essential for crypto markets to survive. However, it becomes much more important for some kind of regulations to be in place to protect investments in these coins ( after Terra LUNA black swan event) across all countries. Today, countries are having different stances toward crypto markets. Countries like Singapore are embracing cryptocurrency whereas countries like UK and US are neutral. Some countries like China are opposed to it.

However, there are regulations like MiCA (Markets in Crypto-Assets) in the European Union coming up which are focussed on protecting the investment assets of Europeans by scrutinizing the practices of exchanges and issuers of Stablecoins pegged to currencies.


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