In this article we are taking a deep-dive into the world of Stablecoins and assess the definition, values and risks of those tokens. We will evaluate use cases and shed light on their current position in the grand scheme of crypto currencies.
A Stablecoin is a special breed of crypto token which depends on an underlying asset to limit value fluctuation (i.e. price volatility).
Very few crypto currencies are backed by real world assets. They therefore tend to undergo massive price fluctuations and are predominantly driven by demand and supply. Stablecoins aim to mitigate that problem by being pegged to a real world asset which is held in reserve. The asset in reserve is acting as collateral so that in theory the token always reflects the value of this reserve.
The most commonly known stablecoins are linked to fiat currencies such as USD, EUR or CHF. However, this does not mean that stablecoins are digital versions of official currencies also know as fiat money. It simply means that the protocol aims to maintain a price peg to the underlying fiat asset (e.g. 1 Coin = 1 USD).
The protocol of a stablecoin can be linked to any real world asset, although fiat is the most commonly used reserve. An example for a non-fiat stablecoin would be XAUT which is pegged to the price of one fine ounce of Gold.
While fiat currencies are regulated by central banks and their governing bodies, stablecoins are largely unregulated and simply represent a digital protocol that mimics and tokenizes the underlying asset.
Although following the same principle idea, not all stablecoins are created equal. The main difference is in how the protocol defines the underlying reserve asset and the way the peg is maintained. This small yet important detail has encouraged regulators to increasingly assess the situation of stablecoins.
As the name suggest these coins are backed by traditional fiat currency such as USD, EUR and CHF to name a few. This term also includes coins backed by other real world assets such as precious metals. Fiat-collateralized stablecoins are the most widespread type in terms of adoption and volume. The peg between reserve and stablecoin is usually on a 1:1 ratio, although the author of the protocol is entirely free to define the peg otherwise.
The reserves of stablecoins are maintained by independent custodians, rather than a central bank. Ideally the custodian is regularly audited and properly governed to ensure the safety and stability of the protocol and the token.
Examples for Fiat-Collaterized Stablecoins are BUSD from Binance and USDC from Circle.
These stablecoins are backed by other crypto currency. The high volatility of the reserve usually leads to an overcollaterization. Meaning the custodian s required to hold more reserves than it issues tokens to prevent collateral shortfall. Some crypto-collateralized stablecoins use a basket of reserve currency to diversify the risk of volatility.
An example here would be MakerDOA’s DAI.
Non-Collateralized stablecoins don’t depend on a reserve to maintain their value. Instead an algorithm manages the valuation by interfering with supply and demand, similar to central banks. At this stage non-collateralized stablecoins are limited and have not seen a widespread adoption.
A list of stablecoins filtered by market capitalization can be found here:
coinmarketcap.com
Why would I use a stablecoin instead of buying or holding the real world asset directly you may ask? To answer this question, let’s take at the usability of Stablecoins.
Transferring fiat currency can be cumbersome, slow and expensive. Stablecoins aim to mitigate these problems by using blockchain technology. Since stablecoins are already digitized versions of real assets moving them between wallets, platforms and even different blockchains is simple, quick and efficient. Transfers on the blockchain happen almost instantaneously and often come at the fraction of the price. Movements are recorded on the blockchain, which means they are immutable and can be easily traced. Having assets decentralized and hence not relying on the global banking system can be another advantage. However, this also means that any transfers happen outside the usual jurisdictions and regulatory frameworks. This can have implications when it comes to fraud and malicious behavior.
Since stablecoins are pegged to real world assets they can be used as digital store of value. Many participants in the crypto space use stablecoins as their digital reserve currency for buying and selling other crypto currencies and crypto assets such as NFTs. Brining real world assets on and off the blockchain can be complicated and is subject to KYC and AML. Stablecoins provide a bridge solution to keep idle assets digital over a long period of time.
Some of the larger crypto exchanges, such as Binance, have launched their own stablecoins. Issuing their own stablecoin allows these platforms to offer additional services, more efficient balance sheet use and helps binding users to their ecosystem.
Stablecoins have little to no volatility and thus only provide little appeal for investment. However, some investors seek stablecoins since they can offer higher yields than the real world asset.
Thus stablecoins can be appealing to conservative investors to earn interest via yield farming. The concept of yield farming in crypto is similar to traditional financial markets, where participants willing to hold a certain asset provide liquidity to the market will get rewarded.
At the time of writing many of the stablecoins provide higher reward rates than traditional fiat currency deposits. In an environment where real world interest rates are well below inflation, investors can turn to stablecoins to mitigate asset depreciation.
Lets look at a simplified example and assume;
A regular bank deposit of $1.000 in 1 year from now would be worth $950 since your real interest rate is negative 5%. i.e. you would gain $10 in interest on your $1000 deposit, but loose around $60 of purchase power due to inflation.
The same $1000 deposit in USDC on the other hand would be worth $1.040 since the real interest rate is still positive (+4%) despite inflation.
Many centralized and decentralized crypto platforms offer the ability to earn interest on stablecoin deposits. While the terms and conditions differ depending on the platform, interest rates often significantly outperform regular capital markets.
You might ask the question, why stablecoins are able to provide higher interest rates than traditional deposits?
Interest rate mechanics for stablecoins work similar to traditional financial markets and the interest paid on stablecoins depends mainly on two factors. The demand and supply for lending and how the protocol defines the reserve.
For a functioning lending market we require at least two participants. First we need a “Lender”, someone who owns an asset and is willing to lend it against a fee. Secondly we need a “Borrower” i.e. a market participant which is in need of liquidity. Usually there is a third party or “Intermediary” connecting lender and borrower. The intermediary ensures the integrity of the market, collects fees and interest and redistributes them.
In crypto currency terms the “Lender” is the owner/holder of the stablecoin. The “Borrower” could be a trader or someone looking to borrow stablecoin against another crypto currency. “Intermediaries” can come in different forms such as wallet providers or crypto currency exchanges.
The higher the demand for borrowing the higher the price the intermediary will charge for borrowing. In turn, this increases the amount the intermediary is able to pay to the lender for providing the liquidity.
Some intermediaries offer additional rewards to lenders who are willing to lock their deposits over a longer timeframe. Similar to how a fixed term deposit at your bank will earn a higher rate than your regular account.
By providing liquidity and distributing rewards, stablecoins fulfill an important role in the world of crypto assets, not much different traditional financial markets.
For every unit of of stablecoin purchased by the lender, the intermediary will receive an equivalent in real world assets. These real world assets can produce returns themselves in the form of interest and/or asset appreciation. Redistributing these returns presents an additional mean of income for both, lender and intermediary.
High demand for lending and borrowing combined with the efficiency of the blockchain and relatively low costs for intermediaries allow stablecoins to produce interest rates far superior to traditional fiat currencies. It is important however, to understand that this is the current situation and may change over time!
Similar to any other asset stablecoins have certain risks associated to them. Besides traditional risks such as counterparty risk, stablecoins are still a very young asset class. They are largely unregulated and heavily rely on their underlying protocol.
The existence of stablecoins is purely based on the underlying protocol. This means that the value of the stablecoin relies on how the protocol defines the reserve and how efficient the protocol handles the peg to the real world asset. No stablecoin protocol is the same and it is therefore important to understand the abilities and limitations of each protocol to assess the benefits and risks.
Since the value of the stablecoin is pegged to the reserve it is important to understand the definition of the reserve itself. The more volatile the reserve holdings are the higher the risk that large market movement pose to the stablecoin holder. Heavy price depreciation of the reserve can lead a breach of peg which in turn risks to devaluate the stablecoin value. A deteriorating reserve value can force the protocol to restrict liquidity in the stablecoin and pose a risk to investors.
Crypto and blockchain are in the crosshairs as regulators scramble to assess the current situation. Stablecoins in particular, since they share many similarities to fiat currencies. Many governing bodies dislike the idea of a digital currency outside the reach of central banks and financial market regulators. In our view, restrictive regulations would undermine the benefits of stablecoins and lead to interference with their protocols which ultimately poses a risk for investors. On the other hand, no regulation nor framework could prevent the widespread adoption due to the risks of fraud and manipulation.
The situation on taxation of crypto in general is complex and fragmented. Stablecoins are no different.
Buying, selling and exchanging fiat collateralized stablecoins usually trigger little to no tax events since there is no price volatility and hence no capital gains.
Crypto-collateralized and Algorithmic stablecoins on the other hand can trigger taxes based price volatility of the coin.
Depending on your tax residence interest earned on stablecoins might be subject to income tax.
Many jurisdictions require crypto holdings to be reported. The US for example treats stablecoins and other crypto assets as property, meaning any sale or exchange has to be reported to the IRS.
Taxation on stablecoins and crypto in general is a highly dynamic topic and constantly changes. We therefore strongly recommend to closely study the tax laws in your jurisdiction prior to make any investments.
Cons:
Stablecoins play an increasingly important role, no only in the space of crypto currency but in addressing some of the shortcomings of the current financial system. Whether this is speed, immutability or regulatory issues. In order to unlock the full potential of stablecoins it is of crucial importance however, that market participants understand the risks, benefits and limitations associated with stablecoins and blockchain in general.
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