Understanding Stablecoins – The Big Guide

Last updated on 28th March 2021

Stablecoins are cryptocurrencies whose prices are stable because their value is connected to fiat currency, gold, or another stable external asset.

In fact, the main difference between Bitcoin and stablecoins lies in stability.

BTC, ETH, and other high-value cryptocurrencies have a host of benefits, of which a key one is the absence of a mediator in sending payments. Anyone can make payments in cryptos. However, one of the most fundamental drawbacks is that their prices can fluctuate wildly.

Moreover, they are not easy to predict. Ordinary people can face challenges in using them because they generally want to know the value of their money at any given time. Often, their security and even their livelihood depends on it.

In contrast to cryptocurrency’s unpredictability, fiat currencies like the Euro and the U.S. dollars and commodities like oil or gold have stable prices. The value of currencies like the Euro and Swiss franc can change gradually with time, but cryptos demonstrate far more dramatic shifts, with value jumping up and down as often as daily.

What Keeps Stablecoins Stable?

Stablecoins are heralded as the perfect combination of safety, stability, and transparency, uniting the best features of fiat and crypto in one. They attempt to counter price fluctuations by connecting the value of cryptocurrencies to fiat money and other stable assets.

Generally, the person or establishment behind the stablecoin will secure it by setting up a reserve to store the asset backing the stablecoin. You might back up 1000 units of a stablecoin by depositing 1000 dollars in a traditional bank. That’s how real world assets and stablecoin are tied together. The funds in the reserve are stablecoin “collateral”. In theory, a user can redeem one stablecoin unit for one unit of the underlying asset.

There are different kinds of stablecoins. One more complicated type is where other cryptocurrencies rather than fiat serve as collateral. However, these have been developed to track mainstream assets as well.

How are Stablecoins Regulated?

The value of stablecoins is pegged to commodities and fiat in limited ways, which banks are using. Banks are working on expansion of operations to generate experience in cybersecurity, anti-money laundering measures, and other greatly challenging areas. This experience can be used by exchanges and entities as a compliance model.

The US Office of the Comptroller of the Currency (OCC) issued a statement in January 2021, saying banks could adopt blockchain networks. The OCC is a key bank regulator. They drew a comparison between risks and activities involving operations with stablecoin to those involving use of digital certificates to identity banks and their clients on long-standing platforms for electronic transactions guaranteeing cash holdings back these transactions. The regulator also stated that banks were obligated to follow current regulations on risk protection, including cybersecurity and money laundering.

Their decision to allow the blockchain was not related to Bitcoin directly, because it’s not linked to an asset like stablecoins are. Despite that, Bitcoin prices reached record levels in the wake of OCC’s announcement. According to the acting Comptroller, it removes all legal doubts as to banks’ authority to link to blockchains as validator nodes. Bank customers are showing increasing demand for lower costs and higher speed, interoperability, and efficiency. The ability to make payments in stablecoin is highly coveted.

More Complex Controls Needed

Stablecoins’ wider adoption is motivating banks to create more complex controls considering the nature of this cryptocurrency. Digital assets store transaction records and coin ownership on an electronic, cryptographically protected database. Bitcoin and stablecoins have many identical design features. This helps traditional financial institutions develop the fintech capacity to serve crypto companies, which are unregulated. Banks are developing infrastructure to solve issues like AML and KYC successfully. Security remains the main issue.

One challenge relates to the fact that banks need to back stablecoin value by holding cash reserves. Stablecoins rely on a multitude of interconnected actions for transactions that will be hard to audit given that the audit subject won’t necessarily have full control over the transaction data on the numerous platforms required for end user accounts, digital assets, and currencies used by counterparties. According to Bloomberg, banks will probably use this opportunity to create controls for a vaster market. The cryptocurrency market topped $1 trillion in February 2021.

Tripled Demand

Stablecoin is far less speculative than more traditional cryptos like Bitcoin and Ethereum, which is why it represents a very small part of digital currencies. However, demand for it has been escalating over the past two years. Institutional investor demand has resulting in a tenfold increase in this period and tripling in the past year. Banks like Goldman Sachs and JPMorgan may be citing digital asset risks, but they are also making big investments in digital currency projects.

Monitoring digital assets requires regulatory overlap navigation and new expertise. For instance, the Federal Deposit Insurance Corporation does not endorse any direct digital asset insurance at this time. Under the US Stablecoin Tethering and Bank Licensing Enforcement Act, commonly referred to as the Stable Act, legislators propose stablecoins to be backed by Federal Reserve or FDIC insurance deposits.

The Stable Act would make it illegal for any institution other than a bank to issue stablecoin, moving banks to create compliant platforms as soon as possible.

Recently, the Bahamas Central Bank greenlighted retail use of the Sand Dollar cryptocurrency. They became the first country in the world to do that. This development prompted analysts to predict near-future relocation of the cryptocurrency industry.

A Delicate Balancing Act

In sum, it’s a fine line between regulation and privacy of financial transactions and a painstaking balancing act is required. At the same time, banks need to remain relevant, a fact regulators recognize. Recently, the Federal Deposit Insurance Corporation issued guidelines governing communication between regulated banks and third parties.

They also issued a stablecoin principles statement in December of last year, according to which digital payments have the potential to lower costs, improve efficiency, and foster financial inclusion. These include use of stablecoin as a payment system.

Regulatory measures will help banks increase their influence over financial services where digital currency players are concerned. The OCC action supports stablecoin by focusing on predictability. Their support is limited considering they’re not exposed to volatility, fraud, and theft to the extent that BTC is.

How do Stablecoins Work

Stablecoins have inbuilt price stability. The relevant solutions go far beyond traditional market orders like buy, sell, and stop. Fiat currency backs most of the popular stablecoins 1:1. These stablecoins are defined as off-chain assets because they don’t have another crypto as collateral. The collateral is fiat money that remains in reserve with a central financial institution or issuer. It has to remain proportionate to the circulating stablecoin tokens.

An institution that has 20 million of fiat can distribute 20 million stablecoins, each worth one unit of the fiat. The stablecoins with highest market value in this category include True USD, Tether, Gemini, and Paxos. We’ll discuss them and others in more detail later.

On-Chain Stablecoins

Another group of stablecoins uses other cryptos as collateral. These are known as on-chain stablecoins. Rather than relying on a central issuer, smart contracts are used. If you want to buy an on-chain stablecoin, you get tokens of equal value by locking your crypto funds into a smart contract. To withdraw your initial collateral, you put your stablecoin back into the same contract.

DAI is the best known stablecoin in this group. The creator of DAI, MakerDAO, uses a collateralized debt position to secure assets on the chain as collateral.

Commodity Backed

The third group has coins backed by commodities such as real estate, oil, and precious metals. Gold is the most popular collateral in the last category and backs Paxos Gold as well as Tether Gold. These stablecoins have the highest liquidity of all gold-backed ones. These commodities have more potential to lose value because they’re far more likely than the US dollar or the euro to experience price fluctuation.

Stablecoins backed by commodities make possible investments in assets that otherwise wouldn’t be. For example, getting a bar of gold and finding a location to secure it is difficult and costly in many parts of the world. It’s not realistic to hold physical commodities like gold and silver for this reason.

At the same time, commodity-backed stablecoins make it easier to take ownership of the underlying asset or exchange tokens for cash. For example, Paxos Gold holders can take ownership of the gold or sell their tokens for cash. The weight of the gold bar determines the token redemption. Once redeemed, you can assume ownership of your gold at vaults nationwide.

Algorithmic Stablecoins

This fourth category has coins that use neither cryptocurrency nor fiat money as collateral. However, their prices tend to be stable too. This is because the supply of circulating tokens is managed using smart contracts and specialized algorithms.

These highly advanced algorithms automatically reduce the number of circulating tokens when the price drops below that of the fiat being tracked. Likewise, they will bring more coins in circulation when the market price of the token exceeds the tracked fiat’s price.

How do Stablecoins Make Money?

Stablecoin investors get dividends from coins that are newly issued, which they receive to hold shares of the coin in question. Stablecoins make money thanks to a combination of shares, coins and bonds. When the price of the stablecoin drops, the “bank” sells bonds at a discount, which should give people an incentive to sell their coins.

The bank commits to return the coins at a certain point in the future. Stability of stablecoins is ensured by maintaining free float as well as giving customers an opportunity to pay with them.

The genesis block creates the base shares. All new coins issued go there as dividends. Base coins are issued to holders of base shares separately. This happens when the base coin value exceeds the value of the asset, to which the coin is pegged.

At least theoretically, this dilutes their value and brings it down back to that of the pegged asset. When the value drops below the value of the asset, base bonds are issued. You can buy a base bond when this happens at whatever the current value is at that time. For example, you can buy one of 80 cents and then redeem it for $1.20.

When we talk about issuing new coins, the first new coins issued go to the oldest bond holder. Shareholders get the coins when there are no bond holders.

Are Stablecoins Centralized? Are There Decentralized Stablecoins?

A single entity runs fiat-backed stablecoins, which makes them centralized. You need to trust this organization to have backed up their stablecoins with fiat money. Obviously, you can’t be sure that you can. To ensure transparency, third parties should conduct audits of stablecoins regularly.

Fiat currency is subject to strict regulations, which constrain fiat-backed stablecoins. They also lower the digital asset’s potential efficacy and the efficiency of the conversion process. The stability is not without its disadvantages.

Facebook’s Libra project had to rebrand and drop its multicurrency goal due to regulatory blowback. Initially, they promised a number of global currencies would back the stablecoin to broaden its utility and appeal.

What Does ERC-20 Stablecoin Mean?

Ethereum’s blockchain is based on purchasing, selling, or trading tokens, of which ERC-20 is among the most significant. ERC-20 has been established as the technical standard smart contracts on the ETC blockchain use to implement tokens. Among the cryptocurrencies that use this standard are OmiseGO (OMG), Basic Attention Token (BAT), Maker (MKR), and Augur (REP).

ERC-20 is not unlike Litecoin and Bitcoin. Investors can send and receive ERC-20 tokens, which are blockchain-based. The main difference is that they are issued on ETC’s network rather than running on their own.

The common rules defined by ERC-20 include how users can access token data, how transactions are approved, and how tokens can be transferred as well as information about total token supply. It helps developers predict the functioning of new tokens within the Ethereum network with a high degree of accuracy, making their job easier.

It gives them peace of mind knowing they won’t need to redo every new project whenever a new token is released as long as it follows ERC-20 rules. Compliance is of paramount importance. There’s no other way to make sure the many different tokens issued on Ethereum’s blockchain will be compatible.

Since most developers follow these rules, most of the tokens released through initial coin offerings comply with the ERC-20.

Stablecoin Regulation by SEC

The Securities and Exchange Commission (SEC) issued a statement that no stablecoin that’s directly backed by an asset is a security for practical intents and purpose. While they believe market participants can sell and structure digital assets in a manner that doesn’t violate the requirements of the federal securities laws, the term or label used to denote a person providing or engaging in financial services or activities involving a digital asset or the asset itself may misalign with how that service, activity, or asset is defined under SEC’s laws. To ensure legal compliance, market players are urged to contact SEC FinHub.

FinCEN and Stablecoin

FinCEN (Financial Crimes Enforcement Network) director Kenneth Blanco defines stablecoins as “money transmission services” for all purposes, including to combat money laundering and terrorist financing. Therefore, anyone who receives or sends stablecoins is a money transmitter under the BSA (Bank Secrecy Act).

The rules are universally valid regardless of whether the stablecoin is backed by an algorithm, a commodity, another cryptocurrency, or fiat. Stablecoin administrators must register with FinCEN as money transmitter companies.

Central Banks and Stablecoin

The popularity and lucrativeness of stablecoins has spurred growth and development of central bank digital currencies (CBDCs). Both the government sector and the private sector are involved in issuing this form of currency.

Against this backdrop, it’s only natural to wonder whether CBDCs and privately issued stablecoins can coexist in the future. Government institutions are presently the only ones who are allowed to issue currency on a national and state level. Stablecoins and CBDCs can coexist only in the context of a business and legislative environment that supports both.

Risks of Stablecoins

Stablecoins are less liquid than traditional cryptocurrencies, which is only to be expected given regulatory impact. Those backed by commodities can be characterized by poor liquidity. There is the risk of the underlying asset’s value plummeting. Stablecoins backed by cryptos have some problems too. Compared to fiat or commodity backed ones, these are much more vulnerable to volatility because they are pegged to other cryptocurrencies. If the pegged asset loses value, so will the stablecoin. It will undergo automatic liquidation into the underlying asset if the price crashes.

The whole purpose of stablecoins was to streamline or protect financial services, but they don’t always fulfill it. This is because local governments can try to limit them. For example, a government might block foreign currency-pegged coins in a country with high inflation as a hedge for the local currency.

Are Stablecoins Safe and Worth Investing In?

There’s some volatility to reckon with when investing in stablecoins, which means the returns anticipated should reflect that. Lending stablecoins is the least risky and simplest way to ensure positive returns. The interest you can expect is approx. 6%. This is a lot better than what a bank will offer, but not good enough for you to use them as speculative assets.

In the long run, investing in stablecoins can be worthwhile. They can protect you from risk as long as you’re able to predict macro trends and bet against them. In an economic crisis, the value of fiat currencies takes a nosedive. If your funds are in Bitcoin, you’ll be protected. Stablecoins were devised as the middle ground with a bit of both worlds. They give you the ability and time to decide where to allocate your funds.

Demand for stablecoins will increase on par with the number of global digital transactions. The number of circulating tokens will increase as well. If you provide or stake liquidity to leverage your stablecoins, you can make money from network transaction fees depending on the underlying applications and blockchain available to you. If there is high demand for your transactions (your stablecoins), you’ll be able to earn more fees.

There are many factors beyond an investor’s control. For example, plummeting oil demand will render a commodity-backed stablecoin of this type worthless. It’s always best to diversify your investments, including when it comes to those in stablecoins.

Stablecoins: Passive Income

To generate a passive income, you buy stablecoins and transfer them to a crypto lending platform. We outline some good ones at the end of this article. The best platforms offer accruing interest and sufficient digital asset coverage. You start earning interest immediately after depositing the coins.

USD Stablecoins

In this section, we discuss the most popular and lucrative stablecoins.

Tether (USDT)

Our list begins with Tether, which converts cash into digital currency to “tether” or anchor the value to that of USD, EUR, the offshore Chinese yuan, and other fiat currencies. Tether reserves back every token. The reserves include cash equivalents, traditional currency, and occasionally other loan receivables and assets to third parties. These can include associated entities. 1 Tether token (USD₮) is always worth 1 USD.

USD Coin (USDC)

USD Coin is the second largest stablecoin after Tether. This newer stablecoin was founded in collaboration of two leading companies in the cryptocurrency ecosystem – Coinbase and Circle. Due to some legal issues Tether was facing in the recent past, USD Coin is considered an even better and more secure alternative by many crypto enthusiasts. Read more about USD Coin.

TrueUSD Stablecoin

TrueUSD was the first regulated stablecoin with full USD backing. It has achieved the highest liquidity and trading volume on exchanges of any stablecoin and has a history of satisfactory liquidity and redeemability.

Binance Dollar Stablecoin (BUSD)

Binance launched a stablecoin backed by USD to provide an alternative to other popular stablecoins that was unique to Binance’s platform. This is BUSD, which you can use in a vast variety of DeFi protocols. It’s a go-to base currency on decentralized BSC.F trading pools.

Gemini Stablecoin (GUSD)

Gemini is also a trusted and secure stablecoin with 1:1 USD backing. It facilitates decentralized exchange transactions because it’s stable in price and readily tradable. You can use it with liquidity pools like automated market makers. Holders are able to generate a passive income by lending and earning interest.

You can use it to buy things from stores that accept Gemini Pay as well as send it across borders. It’s also insured and regulated. The New York Department of Financial Services regulates Gemini.

PAX Stablecoin

Like other stablecoins, PAX is digital, instantaneously transferable, and programmable. It is pegged and backed by to the US dollar 1:1. Paxos Trust Company, the issuer, protects, regulates, and audits it carefully. PAX follows the ERC 20 protocol. It comes with low crypto-asset volatility and multinational transaction fees.

The makers of PAX plan to make it usable for consumer payments in the future, giving people outside the US stable value to protect against volatile currencies.

Basis Stablecoin

Basis showed a lot of promise. Unfortunately, it’s in the process of shutting down.

Reserve Stablecoin

Reserve is an app to purchase, hold, and spend digital dollars. Cross-border transfers are cost-effective and safe. Businesses can also use Reserve to pay international suppliers in a non-volatile currency while keeping their money out of local currency, which is prone to inflation. Reserve is solid and economical on every scale. It’s fully asset backed, decentralized, and supported by top-tier Silicon Valley investors. It is a “fluctuating protocol” currency with the cryptographic right to buy surplus tokens with growth of the network.

IBM Stablecoin

The technology giant partnered with the startup Stronghold and Stellar to start the stablecoin USD Anchor. This coin is backed 1:1 by the US dollar by Prime Trust. The fiat is deposited at FDIC-insured banks. It can’t possibly get any safer than this. The purpose of IBM’s stablecoin is to make settling transactions in all kinds of digital transactional networks possible on the same blockchain networks.

What does this mean? IBM wants to use digital fiat currencies for transactions across numerous blockchains. They want a network that can accommodate multiple different asset classes, such as digital pounds, digital yen, digital dollars, digital euros, and more. All of these will be running on the same network.

DAI Stablecoin

DAI is a decentralized application created from an enhanced loan and repayment process, made possible by smart contracts. If you deposit a cryptocurrency that the makers of DAI accept as collateral, such as ETC, you can get a loan against the value of your deposit and get newly issued DAI. At the moment, ETC’s collateralization ratio is set at 150%. In other words, you can borrow up to 100 units of the coin by depositing $150 worth of ETC.

The smart contracts liquidate the loan automatically if the collateral value drops below this ratio. You can borrow additional DAI if its value increases.

Best Safest Stablecoin: DAI

This is just my opinion, but here’s why I consider DAI the best and safest stablecoins: The amount of DAI in circulation can be controlled by controlling the interest rates for storing and borrowing DAI, the collateralization ratios, and types of accepted collateral. Therefore, its value can be controlled as well. The DAI returned is destroyed automatically when you repay a loan along with all the interest accrued and you can withdraw the collateral. DAI’s USD value is backed by the collateral’s underlying value in USD.

Largest Stablecoins

The largest stablecoins by market capitalization as of March 25 were Tether (USDT) with about $40.3 billion, USD Coin (USDC) with about $10.2 billion, Binance USD with about $3.3 billion, Paxos with about $790 million and True USD (TUSD) with about $324 million. 1 PAX (Paxos Standard) was worth $1,758.49 on March 22. The others are pegged to the USD in a 1:1 ratio.

Euro Stablecoins

One prominent euro stablecoin is EURS, the first digital asset of its kind pegged to the euro. It offers benefits such as blockchain efficiency and transparency combined with the benefits of the most-traded currency in the world. This stable reflects the euro’s value on the blockchain. There are liquidity assurance mechanisms supporting it. The issuer of EURS, STASIS, backs each token 1:1 by euros, which they hold in reserve.

The issuer’s liquidity providers buy securities, which can be exchanged for new EURS. The token is very safe and stable with the support of not only exchanges and liquidity providers, but also payment platforms, custodians, and more. Users can buy EURS on ePayments apart from direct emissions and trade it on HitBTC, Globitex, and Changelly.

Best Places to Buy Stablecoins: Coinbase and Binance

You can convert any fiat currency to Bitcoin through Coinbase or Binance and then to stablecoin for a nominal fee. Then, you can transfer your stablecoin or convert it back to fiat on these platforms. Binance lets you buy BUSD with cash with zero fees. With USD wire transfer, you can buy it in a 1:1 ratio or top up your wallet with Binance with other currencies to exchange to BUSD, if that’s the coin you choose. On Binance, you can convert TUSD, PAX, USDT, and USDC to BUSD without paying any fees. The exchange supports multiple trading pairs to exchange other stablecoins for BUSD.

How Stablecoins can Help Underdeveloped Nations

In countries with high inflation, people can exchange their local currency for stablecoins and keep their savings in USD without the need of a bank account denominated in that currency. They can even earn interest. People in countries like Venezuela, Argentina, Sudan, Zimbabwe, and Turkey should check to see if they are allowed to buy stablecoins in their countries through the respective fintechs.

Are There Stablecoin Debit Cards?

Yes: Coinbase Card, Eidoo, and Circle Visa. Originally, Coinbase Card launched in Europe and the UK, then came to the US. This is a Visa cryptocurrency debit card which is accepted wherever Visa itself is.

Eidoo, an innovative DeFi platform, started issuing a Visa crypto debit card in collaboration with Contis, a member of Visa Europe. Their partnership goes all the way back to the mid-2000. For now, this card is available to users based in Europe and the UK. It makes it possible to hold both fiat and crypto funds, bridging the gap between traditional and decentralized finance.

Eidoo stores the assets in non-custodial accounts, ensuring user autonomy. The card also uses atomic swaps based on smart contracts and stablecoins backed by fiat and issued by Moneyfold Ltd., a UK financial firm, to monitor transactions.

Circle and Visa have entered into a multifaceted agreement, which includes plans to start issuing a corporate crypto card. Circle is involved in the high market value USDC stablecoin. The company aims to enable use of stablecoin for mainstream business and the card is an element of its strategy.

Are There Stablecoins Payback Programs?

A company called Blockchain currently allows their customers to get loans against cryptocurrencies held in their wallet. They get PAX when they lock cryptocurrencies in their wallet. Then, they can send or convert the stablecoins. There is no loan payback deadline. However, the company requires 200% as collateral and offers a minimum loan of $1,000. This means that to get the minimum loan, you must put down an equivalent of $2,000 in cryptos.

Loans can be paid off in PAX, USDC or GUSD. The customer gets their collateral back the same day reception of the stablecoin is confirmed by Blockchain.

How to Store Stablecoins Securely

If you use a traditional exchange to get fiat money into the market, it will cost you more than ten times what you’d expect to pay if you were to move your positions to a stablecoin on an exchange like Binance.

A decentralized exchange will also save time sending cryptos between exchanges to convert back to traditional currencies, which would incur even more fees. An exchange like Binance is a better option even if you can find a traditional exchange with comparable fees.

To store stablecoins securely, it’s best to use only mobile wallets. You have keys like Coinbase wallet or Trust wallet on these. They are far more secure than desktop software. Examples of good software wallets are Guarda and Edge. The former is a combination of desktop and mobile and the latter is only mobile. Nothing is concealed as they are both fully open source.

Best Hardware Wallet for Stablecoins

If you want to store large amounts of stablecoins, Ledger or Trezor will always be the best place. These hardware wallets provide security on an unprecedented scale. On Ledger, keys are stored offline, keeping funds safe from cybercriminals. Even a physical attack against the wallet can be warded off because Ledger uses state of the art chips to guarantee secure access to your stablecoins.

Apart from security, the cutting edge software solution Ledger Live lets you manage a myriad of different stablecoins from the same place. Trezor lets users compare rates, purchase, exchange, transfer, and spend coins in a safe environment.