What Makes A Stablecoin Unstable?
According to Coinbase, a stablecoin is a digital currency that is pegged to a “stable” reserve asset like the U.S. dollar or gold.
The purpose of a stablecoin is to track a currency, mostly the US dollar. The promise is that whenever you want to exchange your stablecoin for fiat (local currency), you get one dollar for each stablecoin you are holding. Emphasis on ‘whenever’. But what if the stablecoin issuer does not actually have what it takes to keep that promise? What happens to your money? And what can you do to be sure your money is safe?
The stability that stablecoins brings is attractive, and it is a large part of the reason that Decentralised Finance is blooming so rapidly. But what if the stability is a mirage? What if the guarantee of giving you a dollar for your stablecoin does not hold? That’s like saying you have money in the bank, only to get your account balance and see nothing. Or to see money there but not be able to use it.
There are really four ways that issuers keep their coin pegged to the dollar: they can back it with real dollars in the bank or commercial papers, they can back it with other cryptocurrencies, they can back it with a commodity, or they use an algorithm to keep it stable. Let’s take a look.
Traditionally Collateralized Stablecoins
These stablecoins are backed by dollars in the bank, commercial papers, bonds, or a mixture of them. The most popular of this kind include Gemini (GUSD), Tether (USDT), USDCoin (USDC) and BinanceUSD (BUSD)
These are stablecoins that are backed by other stablecoins. An example is DAI, backed by Ethereum.
These stablecoins are backed by commodities such as gold, silver and real estate. The most functional include Tether Gold (XAUT) and Pax-Gold (PAXG).
Being algorithmic means that the stability of a stablecoin is regulated by programming that keeps it balanced against the forces of the market. Terra for instance uses an algorithm to balance UST their stablecoin against Luna, the Terra blockchain’s staking token. Other algorithmic stablecoins are RAI, FEI and FRAX.
Should you be worried about your stablecoin going to zero?
Going to zero should be something that can happen only to other coins but never to a stablecoin, right? That’s supposed to be the point. But the backing of a stablecoin fluctuates, some more than others. In fact, in June 2021 the Iron Titanium token, an algorithmic stablecoin that was partially collateralized, fell from $60 to near zero in the space of a day leaving many investors including Billionaire investor Mark Cuban in the mud. Some commodity-backed coins try to hedge against this by being backed by a mixture of precious metals, just as the fiat-backed ones use a mixture of bonds and dollars, which usually trade in opposite directions.
Beyond fluctuations, and far more importantly, is the question, are these coins truly backed as their issuers claim? We have made a special stable coin review here in the past.
No stablecoin has made news for this as much as Tether. The favourite phrase of the issuers of USDT, the most used stablecoin, seems to be “We are the most transparent stablecoin issuer”. When investigations got hot, Tether’s lawyer admitted that only 74% of their coins were collateralized. Tether in 2018 published a “verification” of its cash reserve at Deltec Bank & Trust Ltd. of the Bahamas, saying Tether was fully backed by cash. The very next day, however, that money began moving from Tether’s accounts to Bitfinex’s, and when asked about it, Tether refused to comment on why money moves from Tether’s account to Bitfinex’s. When asked about this by The Verge they said, “Tether and Bitfinex are two different businesses and groups with two different objectives”.
Err… really? The Paradise Papers leaks showed that the operators of Bitfinex exchange were the same as those who control the USDT. That is not even half of the story with more of the dive here. So much for being “the most transparent stablecoin issuer”. And it’s not just Tether.
Circle, the 2nd biggest stablecoin issuer (USDC) also claimed that their coins were backed 1:1 by the dollar, until July 2021 when they released a report that their coins were only 61% backed by cash-related assets, with the rest being in other forms less liquid than the dollar, and which get you stuck if a lot of people wanted to sell their USDC at once. Circle promised to begin holding collateral in cash and short-term treasuries which are easier to sell, beginning September.
Who’s complaining? It’s not like there have been issues in trying to buy or sell USDT and USDC.
Right now, there isn’t. Most people holding USDT now are not in a panic to sell. Plus, Tether has been stress-tested, in March 2020 and in 2021 and each time traders needed to park their money in USDT, Tether came through. USDT’s price remained stable.
What if a lot more people get concerned about their USDT not being backed and try to bail out? What if one of these coming regulations, and surely is coming, by the tone of the SEC hits Tether and many people try to sell off all at once? Let’s hope for the better.
Regulations Affecting Stablecoin Stability
The US government has an overwhelming influence on stablecoins since most of the stablecoins track the US dollar. In November 2021 a report on stablecoins was produced by the U.S. President’s Working Group, demanding that stablecoins only be issued by institutions bestowed with the power to issue the dollar. If this is implemented it puts the power to issue stablecoins in the hands of the banks, and not just the banks, but the really big banks, who already control the monopoly of money that has caused financial crises in the past.
Whatever the US Congress decides to do will obviously affect everyone in the world who uses dollar-pegged stablecoins like USDC and USDT. If Tether goes to zero, it might be good news for more transparent and law-backed stablecoins like Gemini and USDC, but experts in the short-term borrowing markets say it could affect stability in wider markets if it happens together with commercial papers’ and other sell-offs.
Stablecoins have great value and huge benefits for the future and would need a healthy and not too stringent regulation to thrive successfully.
Whichever stablecoins you choose to use, you want to be sure they can stand when regulations and market forces come banging at their door.