The Pros and Cons of Stablecoins: Why You Need To Know How They Work

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Stablecoins are under the microscope right now following the total collapse of Luna and UST, the once-stablecoin of the Terra ecosystem.

The sudden depegging of UST and violent subsequent selloff of the Luna token recently ‘rekt’ thousands of investors who had put their trust in the protocol despite (or perhaps because of) its algorithmic nature. 

This black swan event caused a shakeout of the wider crypto market because of the size of Terra’s failure (tens of billions), and has forced us all to re-evaluate our use of stablecoins and which ones we can fully trust.

It has happened before that stablecoin drama caused a drawdown in the general crypto market. Several years ago when a younger and more novel Tether (USDT) was facing legal battles with the Securities and Exchange Commission (SEC), it also shook the confidence of the market.

This was because, at the time, the market cap of USDT was a significant share of the total liquidity trading in and out of the likes of Bitcoin and Ethereum back in 2017/18 when the overall crypto market cap was only a fraction of what it is today.

Cryptocurrency keeps evolving with each passing year as new innovations that were once met with speculation and distrust eventually become trusted by the market. Tether has earned trust over a number of years after surviving the earliest regulatory opposition to its existence and has allowed newer stablecoins to exist and innovate further.

Today there are many other stablecoin options out there such as USD Coin (USDC), Binance USD (BUSD), MakerDAO (DAI), Paxos Standard (PAX), and Gemini Dollar (GUSD) that provide alternatives to USDT. 

In this article we look at the pros and cons of stablecoins, why they are needed, and what the risks are of utilizing them.

What is a Stablecoin?

A stablecoin is a cryptocurrency that maintains a fixed value because it is backed by reserves of other assets such as fiat currencies, securities, gold or precious metals, property, or any other assets as collateral.

There are four main types of stablecoins: 

  • Fiat-Collateralized: Fiat-backed stablecoins are backed by real-world currencies such as US Dollars or British Pounds at a 1:1 ratio.
  • Commodity-Backed: Backed by precious commodities like gold, platinum, or real estate.
  • Crypto-Backed: Backed by other cryptocurrencies which are kept as a reserve to ensure price stability in the event of price fluctuations. Smart contracts can also be coded to ensure no trust is needed in third parties.
  • Algorithmic: These involve adjustments in the algorithm for controlling the supply and demand of stablecoins, usually in the form of two tokens: one a stablecoin and the other a cryptocurrency that backs the stablecoin.

Cryptocurrencies are decentralized and not controlled by centralized entities such as governments or regulatory bodies. They operate on supply-and-demand principles in a free market and can be volatile in nature. 

Simply put, stablecoins allow investors and traders to ‘cash out’ of risky investments into another crypto coin that will not fluctuate wildly in value during times of market volatility.

Pros of Stablecoins

There are several reasons and numerous benefits to using stablecoins. In general, they are simply faster, cheaper, transparent, borderless, and programmable compared to fiat currencies. Some more benefits are listed below.

  1. Stablecoins allow a quicker and easier way for investors to enter the crypto market by bridging fiat into stablecoins, which act like fiat currencies on exchanges.
  1. Stablecoins are more efficient than fiat because they have the digital properties of other crypto tokens and can be moved around quicker and more efficiently than fiat money.
  1. Stablecoins can be held as capital in non-custodial wallets such as Metamask, thus removing the need for third parties to intermediate.
  1. Stablecoins allow for quicker, immediate peer-to-peer payments abroad that are semi-anonymous with much lower fees than fiat currencies.
  1. Stablecoins can be used for holding, trading, borrowing, and lending abroad. When fiat-related regulatory processes are involved, even better.
  1. Stablecoins can be staked to earn a higher yield than traditional finance in DeFi applications. When adding liquidity to protocols, they also minimize the risk of impermanent loss due to their price stability.
  1. Blockchain data and tracking allows for a more transparent view of the market, giving investors more information on liquidity flows and thus greater decision-making power.
  1. Many sectors of the economy and the unbanked population are benefiting from the use of stablecoins in remittance, escrow, payroll, settlement, and alternative banking that is self-custodial, cutting out intermediaries.

Cons of Stablecoins

Stablecoins used to be more controversial in the earlier days of crypto but have garnered more regulatory approval in recent years, minimizing many of the negative aspects.

  1. Stablecoins usually require trust in a third party to ensure the coins are backed by the stated assets, which also means external audits are needed to ensure assets are accounted for.
  1. There are lower yields on stablecoins in DeFi applications than on regular cryptos, however, these yields are still significantly higher than the interest rates offered by traditional banks.
  1. Stablecoins utilized in DeFi applications are subject to the usual risks involved with unregulated cryptocurrency projects. The TerraLuna disaster was a perfect example of an extreme worst-case scenario for an algorithmic stablecoin.
  1. Trial and error. Due to the relative infancy of stablecoins and the experimental nature of new technologies within crypto, there is still a risk when getting involved with newer projects or protocols.
  1. Regulatory scrutiny. As the stablecoin market keeps growing and adding billions of dollars in value to the crypto market, it will generate increased interest from authorities. This can also be seen as a positive.

Conclusion

Stablecoins and their rapid proliferation across all blockchain protocols have brought more flexibility and adoption to the cryptocurrency industry. They are now embedded in the fabric of the market and are here to stay. 

The onus remains on the individual investor to do your own research (DYOR) when deciding which stablecoin to hold. Find out who created it, whether it’s a trusted centralized business or a decentralized protocol managed by smart contracts. All the options are open to you when it comes to the safer management of risk in the crypto market.

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