Stablecoins aim to bring the benefits of cryptocurrencies – digital transfers, transparency, programmability – while minimizing volatility. By pegging to assets like the US dollar, stablecoins promise price stability amidst crypto‘s swings. However, as adoption has skyrocketed to over $100 billion, stablecoins bring risks related to transparency, technology, and regulations.
What Are Stablecoins and How Do They Maintain Pegs?
A stablecoin is a cryptocurrency pegged to a more stable asset, typically fiat currencies like the US dollar. The stablecoin is designed to have a stable value connected to the pegged asset.
For example, a USD-pegged stablecoin aims to maintain a 1:1 ratio with the US dollar. One unit of the stablecoin should always be redeemable for $1. Stablecoins attempt to tackle one of the main criticisms against cryptocurrencies like Bitcoin – extreme volatility.
There are a few main mechanisms used by stablecoins to maintain their pegs:
Fiat Collateral
The most straightforward method is for the issuing entity to hold fiat currency reserves equal to the number of stablecoins in circulation. For example, if there are 1 billion USDC stablecoins in circulation, the issuer Circle should hold $1 billion in bank accounts to back up the coins.
Holding fiat collateral allows the issuer to maintain the 1:1 peg by standing ready to redeem each coin for $1. However, users must trust that the issuer actually holds the reserves. Fiat-collateralized stablecoins are also subject to fractional reserve risks. If the demand for redemptions exceeds reserves, the stablecoin will break from its dollar peg.
Examples of fiat-collateralized stablecoins include Tether (USDT), USD Coin (USDC), and Binance USD (BUSD).
Crypto Collateral
Instead of fiat currency, some stablecoins use cryptocurrencies as collateral. The stablecoin is overcollateralized to absorb volatility in the collateral.
For example, MakerDAO‘s DAI stablecoin is backed by Ethereum deposited into Maker smart contracts. To mint 100 DAI, users typically need to deposit $150 worth of Ethereum to maintain the 1:1 dollar peg if Ethereum‘s price falls. If Ethereum drops 50%, the excess collateral covers the loss so 1 DAI is still worth $1.
The main benefit of crypto collateral is decentralization since reserves are programmatically controlled by smart contracts rather than a centralized party. The drawbacks are exposure to the collateral‘s volatility and risk of liquidations if collateral drops too much.
Algorithmic
Algorithmic stablecoins use built-in mechanisms to automatically adjust supply to maintain the peg rather than collateral. If demand rises and the stablecoin trades above $1, new coins are issued to bring the price back down. If the price drops below $1, coins are bought back and taken out of circulation.
In theory, algorithmic stablecoins can maintain the peg without any collateral. However, they need continuous growth and adoption to succeed otherwise contractions can lead to death spirals. There are not many examples of algo stablecoins with significant adoption yet.
Analyzing the Stablecoin Industry Growth
Stablecoins were first introduced around 2014 but have seen tremendous growth starting in 2020. As of July 2022, the total stablecoin market cap sits around $160 billion after peaking above $180 billion in May.
For comparison, Bitcoin‘s market cap is around $370 billion. Stablecoins make up a significant portion of the overall cryptocurrency market cap:
| Cryptocurrency | Market Cap (Billions) |
|---|---|
| Bitcoin | $370 |
| Ethereum | $190 |
| Stablecoins | $160 |
| Other Crypto | $520 |
The largest stablecoin by far is Tether (USDT) making up nearly 50% of the total stablecoin market cap at over $70 billion. USDC, BUSD, and DAI are other top dollar-pegged stablecoins with market caps between $10-50 billion. There are also euro, gold, and other currency pegged tokens.
What is driving this meteoric growth? Stablecoins are touted as solutions for the following use cases:
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Trading/Speculation – Traders need a way to move in and out of crypto positions without converting back into slow and expensive fiat transfers. Major exchanges adopted stablecoins as trading pairs allowing faster trades. Stablecoins are the main tool for speculative trades.
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Global Transactions – Cross-border payments using stablecoins are faster, cheaper, and easier than traditional bank wires. Stablecoins allow instant settlement anywhere.
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DeFi Protocols – Decentralized finance apps like lending and borrowing need stable assets uncorrelated to crypto volatility. Stablecoins provide the stability and liquidity underpinning these apps.
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Avoiding Volatility – In volatile markets, traders move capital into stablecoins to avoid downside rather than fully cashing out into fiat. Stablecoins provide liquidity while staying in crypto.
However, as discussed below, such rapid growth fueled by promises of stability merits closer scrutiny of whether stablecoins truly deliver on their promises.
Examining the Risks and Challenges Facing Stablecoins
While stablecoins market themselves as superior replacements for fiat, they come with distinct risks and limitations including:
Lack of Transparency and Audits
Most stablecoins are issued by private companies that are not subject to the auditing and transparency standards of banks or financial institutions. Yet users must trust these entities to properly manage reserves and maintain the peg.
Tether for years claimed to be fully backed 1:1 by the US dollar yet refused to provide full audits. In 2021, the NYAG investigation finally forced Tether to admit they relied on riskier assets instead of cash to back USDT for periods of time.
Even stablecoins claiming regular attestations like USDC and BUSD provide much less transparency than real banks. The stablecoin ecosystem desperately needs greater accountability and visibility into reserves if it wants to uphold claims of being superior to fiat.
Regulatory Gray Area
Government regulators around the world are still deciding how to treat stablecoins. While stablecoins peg to fiat, they are not considered legal tender. Many regulators see stablecoins as securities that need to comply with strict laws.
In 2022, we saw both the UK and EU propose legislation covering stablecoin regulations. The Biden Administration issued a report calling on Congress to pass laws regulating stablecoin issuers similar to banks. The regulatory framework for stablecoins remains uncertain.
Technology and Security Risks
Like all cryptocurrencies, stablecoins rely on a mix of complex technology like blockchain networks, cryptographic keys, and software protocols. Technology bugs or exploits can lead to huge losses like the $600 million Poly Network hack. If the underlying technology fails, the peg and promised stability quickly vanish.
Centralized stablecoins also rely on traditional IT infrastructure like servers which also pose cybersecurity risks. In 2022, both Tether and Circle suffered outages halting transfers when their systems went down temporarily. Stablecoins carry all the cyber risks of crypto plus fintech.
Loss of the Peg
Stablecoins have broken their peg many times despite their claims of maintaining a stable value. DAI lost its dollar peg in 2020 during volatility. Algorithmic stablecoins like TerraUSD (UST) and Iron Finance‘s TITAN protocol saw total collapses of their pegs leading to billions in losses.
When market stress and volatility increases, stablecoins struggle to maintain their pegs. Even fiat and crypto-collateralized stablecoins can lose their pegs if their reserves prove insufficient to handle redemptions. No stablecoin has proven itself completely resilient to breaking its peg.
Fractional Reserve Risks
Fiat-backed stablecoins don‘t guarantee they hold 100% reserves. Instead, they employ fractional reserves meaning they only hold a "fraction" of the reserves needed to back all coins. This is similar to how banks only hold a fraction of deposits on hand.
If demand for redemptions spikes, fractional reserve stablecoins won‘t have enough reserves leading to the peg breaking. Tether admits only holding enough to handle normal daily redemptions. Yet in a crisis, redemptions could overwhelm reserves.
Limited Legal Protections
Unlike bank deposits, stablecoin holdings don‘t enjoy the same government protections. Stablecoins currently fall outside FDIC insurance and SIPC protection. If a stablecoin issuer fails, users can‘t rely on deposit insurance to recover funds.
Some stablecoin issuers like Circle carry private insurance policies to cover losses. But insurance doesn‘t guarantee you can immediately access your stablecoins if the issuer has problems. Buying stablecoins isn‘t the same as holding dollars in a real bank account.
Competitor State-Issued CBDCs
Finally, the biggest long-term threat may be competition from government-issued Central Bank Digital Currencies (CBDCs). China has already started trials of its Digital Yuan. The Fed and other central banks are considering creating CBDCs.
CBDCs would become the dominant digital payment system backed by the full faith of governments. Stablecoins may end up disintermediated or restricted if CBDCs take over digital payments. Holding privately-issued stablecoins is not the same thing as owning directly issued central bank money.
Diving Deep on Major Stablecoins – Benefits and Unique Risks
Let‘s examine some of the top stablecoins and the unique benefits they bring as well as their potential weaknesses:
Tether (USDT)
Market Cap: $70 Billion
Pros
- Most liquid and widely-available stablecoin with support on every exchange.
- Established network effects and first mover advantage.
Cons
- Subject to lengthy investigations over reserve transparency. Still many open questions on backing.
- Highly centralized and controlled by a single private company.
- Based out of Hong Kong so subject to Chinese regulations. Already banned USDT transfers to China in 2021.
Controversies
Tether has been embroiled in controversy over its backing and reserves. Critics argued Tether operated a fractional reserve, issuing more USDT than it had reserves to back.
These suspicions were confirmed in 2021 when the NYAG investigation forced Tether to admit it held riskier assets like corporate paper instead of all cash to back USDT issuance. Tether paid an $18 million fine and agreed to submit reports on its reserves.
However, Tether remains far less transparent than a real bank. It provides an overall reserve breakdown without specifics on holders of its commercial paper. Tether claims to hold over $70 billion in reserves against USDT now, but doubts linger.
USD Coin (USDC)
Market Cap: $50 Billion
Pros
- Issued by Circle which is a US company subject to higher regulatory standards.
- Attested monthly by Grant Thornton LLP to ensure 1:1 backing.
- Backed by US Treasuries.
Cons
- Still relies on private attestations rather than full audits.
- Major outage in 2024 showed technology stability risks remain.
Trends
USDC has seen rapid growth with its market cap rising 500% in 2021. It overtook other stablecoins to become the second largest behind Tether. Circle plans to go public to add more transparency.
However, USDC suffered an outage in 2024 halting transfers for several hours. While it maintained its peg, the tech failure shows stability risks persist.
Binance USD (BUSD)
Market Cap: $15 Billion
Pros
- Issued by Paxos based in the US.
- Monthly attestations by Withum auditors.
- Backed by US Treasuries.
Cons
- Owned by Binance which is under global regulatory scrutiny. Binance banned from operating in ontario.
- Attestations still less transparency than full audits.
Trends
Like USDC, BUSD has seen rapid adoption especially on its issuers‘ platform Binance. It barely existed in 2020 but now sits firmly as a top 5 stablecoin.
However, there are concerns around Binance influencing control and direction of the stablecoin. Binance itself is banned from operating in jurisdictions like Ontario over regulatory issues.
DAI Stablecoin
Market Cap: $8 Billion
Pros
- Decentralized stablecoin using crypto collateral and algorithms.
- Transparent collateral reserves programmatically managed.
Cons
- Historical issues maintaining the peg during volatility.
- Requires overcollateralization so inefficient usage of capital.
- Risk of liquidations and volatility from Ethereum-based collateral.
Trends
DAI aims to be a decentralized alternative to centralized corporate stablecoins like USDT. It maintains its peg through both collateral and holders voting to adjust interest rate incentives.
However, DAI lost its dollar peg during March 2020‘s volatility. Its stability mechanisms proved insufficient. DAI faces scaling challenges if it reaches mass adoption.
TerraUSD (UST) – Failed Algorithmic Stablecoin
Pre-Collapse Market Cap: $18 Billion
Pros
- Algorithmic stablecoin promising to maintain peg without collateral.
- Strong community support and adoption before death spiral.
Cons
- Lost peg and collapsed in May 2022 resulting in $40 billion+ losses.
- No collateral means no way to maintain peg when it breaks.
- Algorithmic stabilization is an unproven concept.
Analysis
TerraUSD (UST) was the largest algorithmic stablecoin before it suffered a devastating collapse in May 2022. UST lost its 1:1 dollar peg which began a death spiral of falling prices.
Without any collateral reserves, Terra could not defend the peg once the market lost confidence. The Luna Foundation used its Bitcoin reserves to try stabilizing UST, but ultimately failed.
The Terra collapse shows the inherent weaknesses with algorithmic stablecoins. If adoption stalls or demand drops, there are no reserves or backing to maintain the peg. Mathematical models alone cannot sustain a stablecoin.
Conclusion – Evaluating Stablecoin Promises and Perils
Stablecoins present an important cryptocurrency innovation – digital coins with price stability. However, the risks span from fractional reserves to technology failures to regulations.
When analyzing stablecoins, investors should ask:
- Is the stablecoin fully audited to prove backing?
- What is the collateral? Is it sufficiently insured?
- Can the stablecoin maintain its peg under market stress?
- Are legal protections like FDIC insurance available?
Billions poured into stablecoins seeking shelter from crypto volatility. But speculative activity paired with opacity raises red flags. Proceed with caution and do your own research when trusting any "stable" coin.