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Stablecoins are
cryptocurrencies A cryptocurrency, crypto-currency, or crypto is a digital currency designed to work as a medium of exchange through a computer network that is not reliant on any central authority, such as a government or bank A bank is a financial i ...
where the price is supposed to be pegged to a reference asset, which is either
fiat money Fiat money (from la, fiat, "let it be done") is a type of currency that is not backed by any commodity such as gold or silver. It is typically designated by the issuing government to be legal tender. Throughout history, fiat money was sometime ...
, exchange-traded commodities (such as
precious metal Precious metals are rare, naturally occurring metallic chemical elements of high economic value. Chemically, the precious metals tend to be less reactive than most elements (see noble metal). They are usually ductile and have a high lustre. ...
s or industrial metals), or another cryptocurrency. In theory, the peg would make stablecoins "stable" and not subject to changes in value; however, in practice, stablecoins have been proven time and time again to lack stability, and many stablecoins have plummeted in value as the
ponzi scheme A Ponzi scheme (, ) is a form of fraud that lures investors and pays profits to earlier investors with funds from more recent investors. Named after Italian businessman Charles Ponzi, the scheme leads victims to believe that profits are comin ...
they are tied to crashes.


Background

Stablecoins have a number of purported purposes. They can theoretically be used for payments, and are in theory more likely to retain their value than cryptocurrencies such as
Bitcoin Bitcoin ( abbreviation: BTC; sign: ₿) is a decentralized digital currency that can be transferred on the peer-to-peer bitcoin network. Bitcoin transactions are verified by network nodes through cryptography and recorded in a public distr ...
and
altcoin A cryptocurrency, crypto-currency, or crypto is a digital currency designed to work as a medium of exchange through a computer network that is not reliant on any central authority, such as a government or bank, to uphold or maintain it. It is ...
s, which are highly volatile. Of course, in practice, many stablecoins have also failed to retain their value, plummeting to zero along other altcoins. Stablecoins are typically non-interest bearing, and therefore do not provide any benefits to the holder.


Reserve-backed stablecoins

Reserve-backed cryptocurrencies are coins that are stabilized by assets. Furthermore, such coins, assuming they are managed in
good faith In human interactions, good faith ( la, bona fides) is a sincere intention to be fair, open, and honest, regardless of the outcome of the interaction. Some Latin phrases have lost their literal meaning over centuries, but that is not the case ...
, and have a mechanism for redeeming the asset(s) backing them, are unlikely to drop below the value of the underlying physical asset, due to
arbitrage In economics and finance, arbitrage (, ) is the practice of taking advantage of a difference in prices in two or more markets; striking a combination of matching deals to capitalise on the difference, the profit being the difference between the ...
. However, in practice, few stablecoins actually meet these assumptions. Backed stablecoins are subject to the same volatility and risk associated with the backing asset. If the backed stablecoin is backed in a decentralized manner, then they are relatively safe from predation, but if there is a central vault, they may be robbed, or suffer loss of confidence.


Fiat backed

The value of stablecoins of this type is based on the value of the backing currency, which is held by a third-party–regulated financial entity. In this setting, the trust in the custodian of the backing asset is crucial for the stability of price of the stablecoin. Fiat-backed stablecoins can be traded on exchanges and are redeemable from the issuer. The cost of maintaining the stability of the stablecoin is equivalent to the cost of maintaining the backing reserve and the cost of legal compliance, maintaining licenses, auditors and the business infrastructure required by the regulator. Cryptocurrencies backed by fiat currency are the most common and were the first type of stablecoins on the market. Their characteristics are: * Their value is pegged to one or more currencies (most commonly the
US dollar The United States dollar (symbol: $; code: USD; also abbreviated US$ or U.S. Dollar, to distinguish it from other dollar-denominated currencies; referred to as the dollar, U.S. dollar, American dollar, or colloquially buck) is the official ...
, the
euro The euro ( symbol: €; code: EUR) is the official currency of 19 out of the member states of the European Union (EU). This group of states is known as the eurozone or, officially, the euro area, and includes about 340 million citizens . ...
, and the
Swiss franc The Swiss franc is the currency and legal tender of Switzerland and Liechtenstein. It is also legal tender in the Italian exclave of Campione d'Italia which is surrounded by Swiss territory. The Swiss National Bank (SNB) issues banknotes and the f ...
) in a fixed ratio; * The tether is realized off-
chain A chain is a serial assembly of connected pieces, called links, typically made of metal, with an overall character similar to that of a rope in that it is flexible and curved in compression but linear, rigid, and load-bearing in tension. A c ...
, through banks or other types of regulated financial institutions which serve as depositaries of the currency used to back the stablecoin; * The amount of the currency used for backing of the stablecoin has to reflect the circulating supply of the stablecoin. Examples: TrueUSD (TUSD), USD Tether (USDT),
USD Coin USD Coin (USDC) is a digital stablecoin pegged to the United States dollar. USD Coin is managed by a consortium called Centre, which was founded by Circle and includes members from the cryptocurrency exchange Coinbase and Bitcoin mining company ...
.


Commodity-backed

The main characteristics of commodity-backed stablecoins are: * Their value is fixed to one or more commodities and redeemable for such (more or less) on demand; * There is a promise to pay, by unregulated individuals,
agorist Agorism is a social philosophy that advocates creating a society in which all relations between people are voluntary exchanges by means of counter-economics, engaging with aspects of nonviolent revolution. It was first proposed by American lib ...
firms, or even regulated financial institutions; * The amount of commodity used to back the stablecoin has to reflect the circulating supply of the stablecoin. Holders of commodity-backed stablecoins can redeem their stablecoins at the conversion rate to take possession of real assets. The cost of maintaining the stability of the stablecoin is the cost of storing and protecting the commodity backing.


Cryptocurrency-backed

Cryptocurrency-backed stablecoins are issued with cryptocurrencies as collateral, which is conceptually similar to fiat-backed stablecoins. However, the significant difference between the two designs is that while fiat collateralization typically happens off the
blockchain A blockchain is a type of distributed ledger technology (DLT) that consists of growing lists of records, called ''blocks'', that are securely linked together using cryptography. Each block contains a cryptographic hash of the previous block, a ...
, the cryptocurrency or crypto asset used to back this type of stablecoins is done on the blockchain, using
smart contract A smart contract is a computer program or a transaction protocol that is intended to automatically execute, control or document events and actions according to the terms of a contract or an agreement. The objectives of smart contracts are the re ...
s in a more decentralized fashion. In many cases, these work by allowing users to take out a loan against a
smart contract A smart contract is a computer program or a transaction protocol that is intended to automatically execute, control or document events and actions according to the terms of a contract or an agreement. The objectives of smart contracts are the re ...
via locking up collateral, making it more worthwhile to pay off their debt should the stablecoin ever decrease in value. To prevent sudden crashes, a user who takes out a loan may be liquidated by the smart contract should their collateral decrease too close to the value of their withdrawal. Significant features of crypto-backed stablecoins are: * The value of the stablecoin is collateralized by another cryptocurrency or a cryptocurrency portfolio; * The peg is executed on-chain via smart contracts; * The supply of the stablecoins is regulated on-chain, using smart contracts; * The price stability is achieved through introduction of supplementary instruments and incentives, not just the collateral. The technical implementation of this type of stablecoins is more complex and varied than that of the fiat-collateralized kind which introduces a greater risks of exploits due to bugs in the smart contract code. With the tethering done on-chain, it is not subject to third-party regulation creating a decentralized solution. The potentially problematic aspect of this type of stablecoins is the change in value of the collateral and the reliance on supplementary instruments. The complexity and non-direct backing of the stablecoin may deter usage, as it may be difficult to comprehend how the price is actually ensured. Due to the nature of the highly volatile and convergent cryptocurrency market, a very large collateral must also be maintained to ensure the stability. Live stablecoins projects of this type are Havven (the pair: nUSD stablecoin and HAV the collateral-backed nUSD), DAI (pair: CDP Collateralized Debt Position and MKR governance token used to control the supply) and others. There is also Wrapped Bitcoin (WBTC), see BitGo.


Seigniorage-style/algorithmic stablecoins (not backed)

Seigniorage Seigniorage , also spelled seignorage or seigneurage (from the Old French ''seigneuriage'', "right of the lord (''seigneur'') to mint money"), is the difference between the value of money and the cost to produce and distribute it. The term can be ...
-style coins, also known as algorithmic stablecoins, utilize
algorithms In mathematics and computer science, an algorithm () is a finite sequence of rigorous instructions, typically used to solve a class of specific problems or to perform a computation. Algorithms are used as specifications for performing c ...
to control the stablecoin's money supply, similar to a central bank's approach to printing and destroying currency. Seigniorage-based stablecoins are a less popular form of stablecoin. Significant features of seigniorage-style stablecoins are: * Adjustments are made on-chain, * No collateral is needed to mint coins, * Value is controlled by supply and demand through algorithms, stabilizing price. Basis was one example of a seigniorage-style coin.
TerraUSD Terra is a blockchain protocol and payment platform used for algorithmic stablecoins. The project was created in 2018 by Terraform Labs, a startup co-founded by Do Kwon and Daniel Shin. It is most known for its Terra stablecoin and the associa ...
(UST), created by
Do Kwon Kwon Do-Hyung (), more commonly known as Do Kwon, is the South Korean co-founder and CEO of Singapore-based Terraform Labs, the parent company of crashed stablecoin TerraUSD and cryptocurrency Luna. TerraUSD and Luna collapsed in May 2022, wipi ...
, was meant to maintain a 1:1 peg with the
United States dollar The United States dollar ( symbol: $; code: USD; also abbreviated US$ or U.S. Dollar, to distinguish it from other dollar-denominated currencies; referred to as the dollar, U.S. dollar, American dollar, or colloquially buck) is the officia ...
. Instead of being backed by dollars, UST was designed to keep its peg through a complex system connected with another Terra network token, Terra (LUNA). In May 2022 UST broke its peg with its price plunging to 10 cents, while LUNA fell to "virtually zero", down from an all-time high of $119.51. The collapse wiped out almost $45 billion of
market capitalization Market capitalization, sometimes referred to as market cap, is the total value of a publicly traded company's outstanding common shares owned by stockholders. Market capitalization is equal to the market price per common share multiplied by t ...
over the course of a week. On 13 June 2022, Tron's algorithmic stablecoin, USDD, lost its peg to the US Dollar.


Possible advantages

The
Bank of International Settlements The Bank for International Settlements (BIS) is an international financial institution owned by central banks that "fosters international monetary and financial cooperation and serves as a bank for central banks". The BIS carries out its work thr ...
lists the possible merits of the subject as enhancement of anti-money laundering efforts, operational resilience, customer data protection, financial inclusion, tax compliance, and cybersecurity.


Risks and criticisms


Lack of regulation

Nellie Liang Jean Nellie Liang (born 1958) is an economist who currently serves as President Joe Biden's Under Secretary of the Treasury for Domestic Finance. Education Liang graduated from the University of Notre Dame with a B.A. in economics in 1979. ...
,
Under Secretary of the Treasury for Domestic Finance The Under Secretary of the Treasury for Domestic Finance is a high-ranking position within United States Department of the Treasury that reports to, advises, and assists the Secretary of the Treasury and the Deputy Secretary of the Treasury. The u ...
reported to the
Senate banking committee The United States Senate Committee on Banking, Housing, and Urban Affairs (formerly the Committee on Banking and Currency), also known as the Senate Banking Committee, has jurisdiction over matters related to banks and banking, price controls, ...
that the rapid growth of the stablecoin market capitalization and its potential for financial services innovation require urgent congressional regulation.


Lack of transparency

Tether A tether is a cord, fixture, or flexible attachment that characteristically anchors something movable to something fixed; it also maybe used to connect two movable objects, such as an item being towed by its tow. Applications for tethers includ ...
is currently the world's largest
market capitalization Market capitalization, sometimes referred to as market cap, is the total value of a publicly traded company's outstanding common shares owned by stockholders. Market capitalization is equal to the market price per common share multiplied by t ...
stablecoin. It has been accused of failing to produce audits for reserves used to collateralize the quantity of minted USDT stablecoin. Tether has since issued assurance reports on USDT backing, although some speculation persists.


De-pegging

Contrary to their name, stablecoins have historically lacked stability and can be prone to failure due to volatility and upkeep required in many cases. To the investor, they lack any concrete benefit over simply holding the fiat currency (or other goods) that the stablecoin is pegged to; therefore, once the peg is put in jeopardy, the stablecoin can quickly crash. Stablecoins such as TerraUSD, USDD, DEI and others crashed to zero in 2022 alone.


Other concerns

Griffin and Shams' research attributed the creation of unbacked USDT to the rise in Bitcoin's price in 2017. Following that, research indicated little to no evidence that Tether USD minting events influenced Bitcoin values unless they were publicized to the public by Whale Alert.


Failed and abandoned stablecoin projects

The stablecoin project Basis, which had received over $100 million in
venture capital Venture capital (often abbreviated as VC) is a form of private equity financing that is provided by venture capital firms or funds to startups, early-stage, and emerging companies that have been deemed to have high growth potential or which ha ...
funding, shut down in December 2018, citing concerns about US regulation. Diem (formerly Libra) was abandoned by Facebook/Meta and later purchased by Silvergate Capital.


References

{{Cryptocurrencies, state=expanded Cryptocurrencies