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Stablecoins are an attempt to create a cryptocurrency token with a stable price—their stability commonly achieved by pegging the token to an asset such as gold or fiat. By being backed by more traditional investments, the market has greater confidence in their price. For this reason, stablecoins are often the go-to option for both institutional and retail users of cryptocurrencies. The crypto ecosystem is ever-evolving. With this blog article, we'll learn all about stablecoins and its lifecycle in detail. Understanding stablecoins lifecycle helps stakeholders appreciate the value stablecoins bring to the digital economy and the broader financial world.
A stablecoin is a type of cryptocurrency designed to maintain a stable value by pegging its price to an external reference, such as a fiat currency (like the U.S. dollar), a commodity (such as gold), or a financial instrument. The primary goal of stablecoins is to offer the benefits of digital currencies such as security, privacy, and decentralized control, while minimizing the price volatility. Unlike cryptocurrencies like Bitcoin and Ethereum, they are collateralized with a peg to fiat currency, offering a stable exchange rate. Both stablecoins and algorithmic cryptocurrencies are recorded and can be traded on the blockchain. They pursue price stability by maintaining reserve assets as collateral or through algorithmic formulas that control supply.
Price fluctuation makes Bitcoin too volatile for daily use. We need a digital asset that is decentralized but doesn't change in value. The market needed an asset that can be used as a store of monetary value for entering and exiting (on and off ramps) decentralized finance ecosystems. The asset also needs to act as a medium of exchange — its value should remain stable over time. Ideally, a digital asset should have low inflation to maintain its purchasing power. Stablecoins achieve stability by pegging themselves to a less volatile asset such as gold or fiat currency. It represents real money, which makes for its price stability.
Mainstream users consider traditional cryptocurrencies, which lack both long-term and short-term stability, to be extremely risky. Adopting cryptocurrencies as a direct replacement for conventional fiat currency requires stability. A volatile currency can compromise the purchasing power of a holder. Stablecoins are a digital currency where you don't have to worry about volatility or instability of crypto prices. Here are some key benefits of stablecoins:
Cryptocurrencies like Bitcoin are notorious for their volatility. For instance, Bitcoin rose to a then-all-time high of $64,000 in early 2021, then fell below $30,000 by that summer. After rising back to $68,000 by November 2021, it dropped to about $35,000 in January 2022. In contrast, fiat-backed stablecoins are seen as more acceptable because their market prices don't fluctuate as frequently.
Stablecoins offer an efficient solution for settling international payments. Cross-border transactions with stablecoins are faster, cheaper, and more efficient than traditional methods. For example, Tether was used in transferring millions of dollars across the China-Russia border. Major banks like South Korea’s Shinhan Bank and Africa’s Standard Bank Group are leveraging stablecoins for international remittances.
Stablecoins can anchor crypto trading and protect investors during volatile markets. Traders can convert volatile crypto assets to stablecoins to preserve value and then re-enter the market without converting to fiat currency.
Launched in 2014, BitUSD was the first stablecoin, issued on the BitShare blockchain. It was backed by BitShares’ core token, BTS, and other cryptos locked in a smart contract.
Launched in 2014, Tether became one of the most popular stablecoins. Each USDT token is backed by one US dollar held in reserve, stabilizing its price. USDT has grown significantly, with its supply reaching almost 10 million during the 2017 Bitcoin bull run.
Initially developed to use the Bitcoin blockchain, Tether now uses multiple protocols, including Ethereum, Algorand, Bitcoin Cash, EOS, Tron, and OMG. This diversification helps maintain its security and stability.
The issuance of a stablecoin, known as "minting," is a straightforward process. The depositor exchanges fiat currency with the issuer at a fixed rate (typically 1:1), and the stablecoin is transferred to the depositor's digital wallet. The reverse process, exchanging stablecoin back to fiat currency, is called "burning." Stablecoins typically do not generate interest, but they can be transferred to decentralized finance (DeFi) protocols, where users can earn interest based on their risk.
The stability mechanism is crucial in the issuance process. Most stablecoins publish a white paper detailing their pegging currency and underlying mechanisms. Generally, stablecoins fall into two categories: public reserve-backed and algorithmic-backed. Uncollateralized stablecoins, which use algorithms to stabilize value without backing assets, are not covered due to their small market cap.
For public reserve-backed stablecoins (e.g., Tether), high-quality liquid assets (HQLA) like treasury bills, commercial paper, and certificates of deposit serve as major collateral. Algorithmic stablecoins (e.g., Terra USD) are backed by other cryptocurrencies like Ethereum and Bitcoin.
Stablecoins are designed to maintain a stable value by pegging themselves to less volatile assets or using other mechanisms to ensure stability. There are four primary types of stablecoins, each with different methods of achieving and maintaining their stability:
These stablecoins are backed by a reserve of fiat currencies, such as the U.S. dollar, euro, or yen. They are the most straightforward and common type of stablecoin.
Mechanism: Each stablecoin is backed by an equivalent amount of fiat currency held in reserve by a central entity. For example, 1 USD-backed stablecoin is backed by 1 U.S. dollar in a bank account.
Examples: Tether (USDT), USD Coin (USDC), TrueUSD (TUSD).
Benefits: Simple structure, high level of trust due to tangible asset backing.
Disadvantages: Centralized nature, counterparty risk, requires regular audits and transparency.
These stablecoins are backed by other cryptocurrencies rather than fiat currencies.
Mechanism: To account for the volatility of the underlying cryptocurrencies, these stablecoins are often over-collateralized. For example, to issue $1 worth of a stablecoin, more than $1 worth of cryptocurrency is held as collateral.
Examples: MakerDAO’s Dai (DAI).
Benefits: Decentralized, does not require a trusted central authority.
Disadvantages: Complexity, over-collateralization requirement, exposure to the volatility of the collateral cryptocurrency.
These stablecoins use algorithms and smart contracts to manage the supply of the stablecoin in circulation to maintain its peg.
Mechanism: The supply of the stablecoin is adjusted automatically based on demand. If the price goes above the peg, new stablecoins are created and sold to bring the price down. If the price falls below the peg, stablecoins are bought back and burned to reduce supply.
Examples: TerraUSD (UST) (note: UST experienced a significant failure in maintaining its peg in 2022), Ampleforth (AMPL).
Benefits: Decentralized, no need for collateral.
Disadvantages: Complexity, algorithmic failure risk, historically unstable as seen with UST.
These stablecoins are backed by physical assets such as gold, oil, or other commodities.
Mechanism: The value of the stablecoin is tied to the value of the physical commodity. For example, a gold-backed stablecoin represents a certain amount of gold held in reserve.
Examples: Tether Gold (XAUT), Paxos Gold (PAXG).
Benefits: Provides exposure to commodities, relatively stable value.
Disadvantages: Centralized nature, storage and audit requirements for physical assets, less liquid compared to fiat-collateralized stablecoins.
Here is a detailed breakdown of the lifecycle of stablecoins:
The lifecycle of a stablecoin begins with the conception and design phase. This stage involves the identification of a market need for a stable cryptocurrency to counteract the volatility seen in assets like Bitcoin. Developers conduct thorough research and feasibility studies to assess market potential and technological requirements. The design phase includes deciding on the type of stablecoin—whether it will be fiat-collateralized, crypto-collateralized, algorithmic, or commodity-collateralized. Technical design involves developing the smart contracts and algorithms necessary to manage supply and ensure the stability of the peg. Legal and regulatory planning is crucial at this stage to ensure compliance with existing financial regulations and to anticipate potential legal challenges.
Once the stablecoin is designed, it moves into the launch and initial adoption phase. This involves the issuance of the stablecoin tokens and securing the necessary collateral. For fiat-collateralized stablecoins, this means setting up reserves of fiat currencies, while for crypto-collateralized stablecoins, it involves locking up cryptocurrency assets. The market introduction typically occurs through Initial Coin Offerings (ICOs) or private sales. Establishing partnerships with cryptocurrency exchanges is vital for listing the stablecoin and ensuring liquidity. Initial marketing efforts focus on attracting early adopters and creating awareness about the stablecoin’s benefits.
In the growth and expansion phase, the stablecoin seeks wider adoption by promoting various use cases such as remittances, trading, payments, and decentralized finance (DeFi) applications. Integrating stablecoin payments with merchants and e-commerce platforms enhances its utility. Building a strong community is essential for expansion. Efforts are made to grow the user base through marketing campaigns, community engagement, and incentive programs. Additionally, creating a robust developer ecosystem encourages the development of applications and services that leverage the stablecoin.
As the stablecoin matures, maintaining market stability becomes paramount. This involves continuously monitoring and adjusting the stablecoin supply to ensure it remains pegged to the reference asset. Regular audits and transparent reporting are crucial to building and maintaining trust among users and investors. Regulatory compliance is a significant aspect of this phase, requiring stablecoin issuers to adapt to evolving regulations and engage with regulators proactively. Implementing robust risk management practices helps address market fluctuations and operational risks, ensuring long-term stability.
The stablecoin market is dynamic, and issuers must navigate various challenges and evolve accordingly. Managing collateral and supply in response to market conditions is a constant task. Technological upgrades are necessary to enhance security, efficiency, and scalability. Increased regulatory scrutiny presents both challenges and opportunities. Stablecoin issuers must comply with new regulations aimed at financial stability, consumer protection, and anti-money laundering. Legal adjustments are often required to align with regulatory feedback and requirements.
In the final stage of the lifecycle, stablecoins may face potential decline or reinvention. Market competition intensifies as new stablecoins and alternative financial solutions emerge. Technological advancements in the blockchain space may disrupt existing models, necessitating adaptation. Some stablecoins may reinvent themselves by evolving their technology, use cases, or regulatory approaches to stay relevant. In cases where challenges persist, an orderly phase-out plan is essential to protect users and investors.
Stablecoins facilitate seamless transactions between traditional and decentralized finance by offering a medium that can interchange with fiat money at a fixed rate and with cryptocurrencies at a floating rate. This dual capability makes stablecoins ideal for adjusting portfolio risk-return profiles, serving as low-risk deposit options pegged to fiat value.
Stablecoins can enhance payment efficiency in tokenized asset transactions, offering a better alternative to fiat money in a DLT world. They act as electronic cash within DeFi ecosystems, providing stability that algorithmic cryptocurrencies lack due to volatility. In tokenized assets, stablecoins improve efficiency by reducing the need for financial intermediaries and combining custodian services.
No, the stability of stablecoins varies with their backing assets. Despite the suggested stability in their name, stablecoins can exhibit significant volatility, as seen with Terra USD in May 2022. It is important to understand that not all stablecoins are equally stable. Regulated, transparent, and public reserve-backed stablecoins tend to offer more stability during volatile periods in the DeFi market. Consolidating design, mechanism, and regulation can enhance stablecoins' role as a bridge between traditional banking and DeFi sectors.
Stablecoins bridge the gap between volatile cryptocurrencies and stable fiat currencies, offering a reliable digital asset that can be used for everyday transactions. Their design to maintain a stable value makes them a crucial component in the adoption and integration of cryptocurrencies into the mainstream financial system. The lifecycle of stablecoins is a dynamic and multifaceted process that involves continuous adaptation to technological advancements, market demands, and regulatory landscapes. Successful stablecoins manage to maintain stability, build trust, and provide valuable use cases while navigating the complexities of the cryptocurrency ecosystem.
