(6 minute read)
You've probably heard the word stablecoin being thrown around lately, but what is it, how is it different than other cryptocurrencies, and why has it been the talk of the town lately? We'll be giving you everything you need to stay up to date on all things crypto. If you're not quite sure what cryptocurrencies are or want a quick refresher, then we recommend you check out our article explaining the basics first: What's Up with This Crypto Thing?
What is a Stablecoin?
A stablecoin is a utility token built upon another coin's blockchain and pegged to a reserve asset (i.e. the U.S. dollar or gold). When a coin is pegged to a reserve asset, the value of one coin should be equal to one asset (Ex. 1 stablecoin = 1 US dollar). Stablecoins are a cryptocurrency without high volatility or high transaction fees, two of the biggest downsides that make digital currency transactions so difficult. A non-volatile cryptocurrency also allows you to safely store your money using crypto technology without having to worry about the price fluctuations that affect other cryptocurrencies. In this way, stablecoins can be viewed as cryptocurrency savings accounts.
Decentralized vs Centralized
Stablecoins can either operate on a decentralized exchange or a centralized exchange. A decentralized exchange (or DEX) is a peer-to-peer trading space where people can trade with one another without having to go through a third party. It might help to think about a decentralized exchange like a farmers market where buyers and sellers of a product can trade directly instead of through a third party, such as a grocery store. Decentralized stablecoins, or stablecoins operating on a decentralized exchange, can be separated into two categories: algorithmic stablecoins and crypto-collateralized stablecoins.
Algorithmic stablecoins use programmed smart contracts that guide the increase or decrease in the coin's supply to align with demand and maintain the coin's peg to its reserve asset. By maintaining equal supply and demand, the value of the coin will be able to maintain its peg. Crypto collateralized stablecoins, on the other hand, maintain their peg by receiving other cryptocurrencies as collateral. When someone wants to buy a set amount of a stablecoin, they may have to provide crypto collateral with a value that is double the value of the stablecoins they received. The ratio of collateral to stablecoin tends to be high in order to prevent price fluctuations of the collateral from affecting the value of the stablecoin.
Centralized exchanges (or CEX) are platforms where users can trade their assets with others, with the party operating the platform serving as the facilitator for all the transactions that occur. You may have heard of a few, such as Coinbase or Binance. Centralized stablecoins, or stablecoins operating on a centralized exchange, are usually fiat collateralized, meaning they are physically backed by the reserve asset they represent. For example, a coin pegged to the dollar will have a dollar in reserves for each coin out in circulation.
If you want to learn more about decentralized versus centralized stablecoins, as well as some examples of different stablecoins, then check out Newsroom's article: Centralized vs Decentralized Stablecoins: How they're different.
Collapse of TerraUSD
Terra was one of the largest algorithmic stablecoins in the world, so how did it fail? On May 9th, the stablecoin became unpegged after a "crypto attack." The attack strategy used was first brought up on Twitter in November of 2021 when Twitter user @FreddieRaynolds pointed out how a wealthy attacker, with around $1 billion of capital, could collapse TerraUSD and make around $30-50 million in profit through it. At the time of hearing about this strategy, the founder of TerraUSD, Do Kwon, shot it down. In a Twitter post, he insisted that the stablecoin would not fail and even went as far as daring billionaires to try it.
Roughly 6 months later, it happened. In the period from May 9th – May 11th, TerraUSD's value had dropped from $1 to $0.30. This downturn continued with the price finally settling at around $0.05 by the end of the week. TerraUSD's collapse shook the crypto market, leading to hundreds of billions of dollars in value being erased within days.
While there is currently no regulation on stablecoins, there are many who are calling for some framework to be put in place to prevent another collapse like this from happening. U.S. Treasury Secretary Janet Yellen has been pushing for stablecoin regulation and, on May 10th, spoke to the Senate Banking Committee regarding the need for a regulatory framework for stablecoins. Though nobody knows exactly when these regulations will roll out or how strict they will be, it is certain that TerraUSD's recent collapse has pushed legislators to speed up the process of its implementation.
Are They Worth It?
So, are stablecoins worth having? That depends on your level of risk and how frequently you trade cryptocurrencies. For someone with more risk tolerance that is constantly using cryptocurrency in transactions some of the pros may outweigh the cons, while someone looking to buy and hold crypto for the long run may not need to get into stablecoins and take on any additional risk. Whether you're a crypto expert, new to the scene, or choosing to avoid investing in crypto entirely, it's helpful to understand what is going on so that you're prepared for whatever the future of crypto may have in store for us.
*For any other questions on cryptocurrencies feel free to reach out to our resident expert, Giancarlo Lamourtte.