Stablecoins are called the “holy grail of crypto”. Over $60 billion worth of stablecoins is traded each day!
But the fact of the matter is, that the most popular stablecoin, Tether, hasn’t really been the most transparent currency in crypto. In fact, there is a growing possibility that Tether might crash spectacularly one of these days.
This has been going on for quite a while.
It makes you wonder…
..are stablecoins safe for storing funds?
Not exactly. But we work with what we’ve got. Because what’s the alternative?
Bitcoin is too volatile to use as a trading pair. National currencies are still not fully supported by most exchanges.
The safest bet would be to go with regulated fiat-backed stablecoins like USD Coin and Gemini Dollar. But crypto-backed stablecoins are better when you take everything else into account.
What are stablecoins?
Stablecoins, simply put, are cryptocurrencies that have stable value. They are usually backed by an underlying asset, and are pegged to a certain price. The price is usually 1 USD.
Two main categores of stablecoin exist: collateralized and non-collateralized.
Non-collateralized stablecoin
Also known as algorithmic stablecoin, this type of token is not backed by an underlying asset. Instead, it has a mechanism that functions similarly to a central bank.
As a central bank mints banknotes to preserve national currency value, a non-collateralized stablecoin executes a similar process for the same reason.
But instead of physically minting coins, the algorithm digitally mints them if the demand is higher than the supply.
But if the supply is higher than demand, it issues shares of “futures coins” to users.
Basically, the next time demand becomes higher than supply again, the system will mint new coins and those same users that received those shares will be entitled to future coins.
This is analogous to banks giving out loans.
You might not know this, but majority of the loans given out by banks are money that they hold. Yep. They have that authority. It’s called fractional reserve.
They basically give you money they don’t have and force you to pay interest.
Collateralized stablecoin
This type of stablecoin scheme requires an underlying asset to be used as collateral in exchange for a token.
Collateral can be national currencies, precious metals, other cryptocurrencies, commodities, etc.
Fiat-backed stablecoins are the most abundant in the cryptosphere. The most popular one is Tether, which is backed by USD, and hence, pegged at 1 USD per coin.
But now, Tether has other separate stablecoin platforms for gold and other fiat currencies like the Chinese Yuan.
Other precious metals-backed stablecoins include Digix and Kinesis.
Some stablecoin platforms have multiple collateral. A prominent example would be MakerDAO.
MakerDAO’s stablecoin, Multi-collateral DAI supports multiple assets including cryptocurrencies, fiat currencies, precious metals, etc.
Risks of stablecoins
Risks of algorithmic stablecoins
The riskiest part about algorithmic stablecoins is that it is backed by nothing but an algorithm that tries to balance itself out. Now, in economics there is no such thing as “free lunch”.
If the price of the stablecoin keeps falling due to waning demand, it might withstand it for a time by minting more. But if it goes on for too long, users will lose confidence that the system will be able to balance out.
This will trigger a sellout death spiral.
If that happens, the stablecoins become worthless. What would it take for this to happen?
Well, that’s another high-risk factor of algorithmic stablecoins. It’s extremely difficult to analyze how much downward pressure the system can take.
Unknown variables like that does not inspire confidence in a stablecoin. I’d personally stay away from non-collateralized stablecoins.
Risks of fiat-backed stablecoins
First of all, fiat-backed stablecoins are centralized, which go against everything the crypto community stand for.
This also implies that some downsides of national currencies are present in this type of stablecoin, including devaluation caused by inflation.
There are two types of fiat-backed stablecoins, regulated and unregulated.
And the most prominent of them all, which is Tether, is not regulated. Obviously, this poses some risk. Having no oversight over their asset means the Tether company could lie about how much US dollar they have as collateral.
They’ve hidden this for so long until sometime early last year, when they disclosed that only 74% of Tether is backed by USD.
Yet it is still one of the most traded currencies in the crypto market. In fact, Tether is the only stablecoin with a trading volume that far exceeds its market cap.
And I’m not sure how much this is gonna change anytime soon. Tether just makes it so convenient to trade in crypto markets.
It allows you to not have to convert back to your fiat money, which most exchanges do not support.
Regulated stablecoins like the Gemini Dollar (GUSD) and USD Coin (USDC) are backed by 100% USD. Therefore, they are not as risky.
Their disadvantage is that they cannot bypass currency controls. For instance, US sanctions against Iran disables Tether from servicing the Middle Eastern country.
So much for banking the unbanked, right?
Risk of precious metals-backed stablecoins
Gold or silver-backed stablecoins usually function as digital representations of physical gold or silver. These precious metals are secured in vaults and can be claimed via tokens, if need be.
Now does that mean precious metals-backed stablecoins are safe? Not entirely.
Governments can still seize them.
Why would they? Well. In the event that crypto technology becomes too powerful, the states would likely want to snuff it out by any means necessary.
The custodian of the gold or silver will have no choice but to surrender their vaults. This is an extreme scenario but it’s not too far-fetched either.
Risk of crypto-backed stablecoins
The most popular crypto-backed stablecoin platform is MakerDAO, with DAI as its stablecoin. Before, DAI used to be backed by Ether only, but now supports other assets like precious metals and fiat currencies.
But let’s just focus on the crypto assets for now.
The biggest risk of crypto-backed stablecoins is the volatility of their underlying assets. For instance, back in November 2018 Ether lost almost half its value in a few days time.
Thankfully, the MakerDAO system was robust enough to handle downward pressure. DAI was able to survive. Had it happened under an hour, I wouldn’t be sure if people would be able to put more Ether in the system in time to keep it afloat.
So the risk is still there!
The safest stablecoin
So all in all, are stablecoins safe? No, but other than the algorithmic model, they are adequate for now.
Basically, the risk level of an asset-backed stablecoin boils down to its underlying asset. This model is more decentralized but not really the safest.
If I have to choose, I’d say the safest would have to be the regulated fiat-backed stablecoins like the Gemini Dollar and Coinbase’s USD Coin. What else can I say?
Since we’re talking about safety here, regulated fiat stablecoins are the best bet. They are being regularly audited and are backed by something that is relatively stable for the time being (USD).
I wouldn’t say they are the best as a currency, but they are the least likely to crash and burn spectacularly in the near future.
But I still think MakerDAO is the best stablecoin platform in the world. Now, this is just my opinion. Obviously the market disagrees with me, seeing as Tether is the most widely adopted among all stablecoins.
But DAI’s system is more decentralized and honestly quite brilliant. It would take an entire blog post to illustrate how cleverly the mechanism is maintaining its stability. I plan to write about it soon.
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