Basics of Stable Coins

USDC is the second-largest stablecoin at $42 billion in market cap, depegged from the U.S. dollar as contagion from the collapse of Silicon Valley Bank spreads. The USDC/USD trading pair dropped as low as 82 cents on a few crypto exchanges. It recovered to about 1 dollar as of Tuesday.

USDC, or USD Coin, is a stablecoin that is pegged to the US dollar on a 1:1 basis, meaning that for every USDC token in circulation, there is an equivalent US dollar held in reserve. This stablecoin was created by Circle, a fintech company, in collaboration with Coinbase, one of the largest cryptocurrency exchanges in the world.

USDC is meant to maintain a 1-to-1 peg with the U.S. dollar, but worries about the impact of Silicon Valley Bank’s failure drove it down from $1 on Friday. An undisclosed portion of USDC’s cash reserves are parked at the now-failed bank, leading to concern that money backing the stablecoin is now stuck. Stablecoins such as USDC are a key part of the crypto industry’s foundation, and when they stray far from $1 (or whatever fiat asset they’re pegged to) that suggests concern about their financial footing.

Creating a coin that tracks another commodity’s price or value requires a pegging mechanism. There are multiple ways to do this; most rely on another asset acting as collateral. Some methods have proved more successful than others, but there is still no such thing as a guaranteed peg!

Fiat-backed stablecoins maintain a reserve of fiat currency, such as USD or GBP, to back each token. This means that users can convert from fiat into a stablecoin and back at a fixed rate. If the price of the token deviates from the underlying fiat currency, arbitrageurs can step in and bring the price back to the pegged rate.

Crypto-backed stablecoins work similarly, but instead of fiat currency, they use cryptocurrencies as collateral. However, due to the high volatility of cryptocurrencies, these stablecoins often over-collateralize their reserves to protect against sudden price changes.

Algorithmic stablecoins take a different approach, where no reserves back the tokens. Instead, algorithms and smart contracts manage the token supply to maintain a stable price. While this model is less common, it removes the need for reserves and provides a unique way to stabilize the token’s value.

Fractional stablecoins are stablecoins that are backed by a fraction of the value of the underlying asset, rather than the full value. This allows for more flexible and efficient use of reserves, but it also increases the risk of volatility. FRAX, the stablecoin of Frax Finance, claims to be the world’s first fractionally backed stablecoin, with parts of its supply backed by collateral and parts of the supply algorithmic.

Stablecoins are ideal for day-to-day payments, which is a significant strength. Due to high volatility, most cryptocurrencies haven’t achieved widespread use for payment processing. In contrast, stablecoins offer stability and are an ideal payment option for businesses, shops, and individuals.

Stablecoins are blockchain-based, which provides many benefits. You can send stablecoins to anyone worldwide who has a compatible crypto wallet, which is easy and quick to create. Double-spending and false transactions are nearly impossible, offering peace of mind for users.

Stablecoins can be used by investors and traders to hedge their portfolios. By allocating a certain percentage of their portfolio to stablecoins, investors can reduce overall risk. During a market downturn, traders can sell crypto for stablecoins and repurchase them at a lower price (shorting). Stablecoins allow for convenient entry and exit positions without needing to take money off-chain, ensuring ease of use and convenience.

Stablecoins’ capacity to maintain their peg is not an absolute guarantee. While some prominent projects have demonstrated a favorable track record, there have been instances of unstable performance by a considerable number of other ventures.

A deficiency of transparency still persists in the stablecoin realm. Not all stablecoins furnish complete public audits and several offer only periodic attestations.

Fiat-backed stablecoins tend to be more centralized in comparison to other cryptocurrencies. These types of stablecoins entail a centralized authority to hold the collateral and may also be subject to external financial regulation.

Cryptocurrency-backed and algorithmic stablecoins rely heavily on their community to function. It’s common for crypto-based projects to incorporate open governance mechanisms, which allow users to have a say in the development and operations of the project.

The US White House has called for Congress to hasten its efforts to regulate cryptocurrencies, and in December 2022, Senator Pat Toomey proposed the Stablecoin TRUST Act, which seeks to establish a federal regulatory framework for payment in stablecoins.

Under this bill, depository institutions, state-based money-transmitting businesses, national trust banks, and other entities with a new federal license could act as stablecoin issuers. In the UK, plans have been laid out to make the country a global hub for crypto asset technology, with a focus on regulating stablecoins as a means of payment.

The European Union is also set to regulate stablecoins through the Markets in Crypto Assets (MiCA) framework, which will have significant implications for stablecoin issuers across Europe.

Stablecoins are digital currencies designed to maintain a stable value, typically pegged to a fiat currency such as the USD. There are different types of stablecoins, including fiat-backed, crypto-backed, algorithmic, and fractional stablecoins, each with unique features and characteristics. Stablecoins offer advantages such as stability for day-to-day payments, ease of use, and convenient entry and exit positions for investors and traders. However, stablecoins are not immune to drawbacks such as potential instability, lack of transparency, and centralized authority in fiat-backed stablecoins. Currently, there is no global or US-wide regulation governing stablecoins, although recent proposals seek to establish a federal regulatory framework for payment in stablecoins in the US and the EU.