DeFi Financial Commodity Series: Stablecoin

The cryptocurrency market is a market that is highly volatile and open for business 24/7. Because of this, many short-term traders don’t go to sleep with their hands full of BTC or ETH, as they’d be worried that the market could be turned upside down when they wake up. These traders will usually need a safe haven where the prices are more stable, like USDT or USDC. The prices for USDT and USDC are both pegged to the US dollar, making it more stable. This offers an option for traders to convert their cryptocurrency to USDT or USDC while they rest before the next trading day. Additionally, in the cryptocurrency market, exchanging between cryptocurrency assets is easy, but exchanging between cryptocurrency and fiat currency is more costly. This makes stablecoins, which are issued as cryptocurrency, a good middle ground, and one that is growing at a very fast pace. Nowadays, many users receiving payments in cryptocurrency prefer to be paid in stablecoins over BTC or ETH. This is because the value of payments in BTC or ETH can fluctuate by more than 5% upon receipt.

Because of the reasons mentioned above, stablecoins are a financial product that all cryptocurrency users will come into contact with. Presently, stablecoins can be categorized as either pegged to fiat currency or cryptocurrency. Let us discuss these concepts further.

  1. Stablecoins supported by fiat currency, for example: USDT and USDC Whether it is the USDT issued by Tether or the USDC issued by Coinbase, both tokens work on the same assumption. They assume that for every one stablecoin issued on the blockchain, one US Dollar will be deposited in the corresponding bank account. This ensures a 1:1 ratio between the stablecoin and the US Dollar. Stablecoin USDT had been repeatedly criticized for not having enough US Dollar to support it. To counteract this, Tether released a third-party assurance report on March 30, 2020 to confirm that they indeed have enough US Dollar to support USDT on the blockchain.

One may say that an assurance report is not the same as an audit, as an assurance report only verifies that the numbers presented are correct whereas an audit can thoroughly investigate underlying risks. However, to date, no stablecoin issued has successfully passed an audit. At least Tether’s assurance report, which they will commission every quarter, has provided a certain level of transparency.

In today’s cryptocurrency market, stablecoins pegged to fiat currencies are popular due to their stability. Many users also prefer performing transactions using these stablecoins.

  1. Stablecoins supported by cryptocurrencies, for example: DAI DAI, which also aims to keep its value at a 1:1 ratio with the US dollar, does not peg itself to fiat currency. Instead, it is backed by underlying collaterals on smart contracts issued on the Ethereum blockchain. Whenever a DAI is issued under a smart contract, there must be a cryptocurrency issued as a collateral. The value of this cryptocurrency should be worth more than the value of DAI issued. If the value of the collateral cryptocurrency declines beyond a certain percentage, the smart contracts can automatically liquidate the loan, thereby ensuring the stability of DAI prices. Unlike stablecoins pegged to fiat currencies, the act of minting, transfering, and burning DAI tokens are not controlled by a certain group or individual. Users therefore don’t have to wonder whether the equivalent amount of stablecoin in fiat currency has been deposited. They know that every time a DAI is issued, there is a corresponding collateral as a guarantee.

Due to rapid changes in the market, there may be losses caused by difficulty in executing smart contracts when prices collapse too quickly. This is a situation that Maker Foundation foresaw. When they started issuing DAIs, they also started issuing another cryptocurrency called MKR. The purpose of MKR is to compensate users if and when there are unforeseeable losses in the DAI’s price. For example: when there was a short-term collapse of Ether in March 2020, the DAI incurred a loss of $4 million USD. However it was compensated by issuing more MKRs.

Although there is a lack of trading pairs for DAI on many exchanges, in terms of all available decentralized stablecoins in the market, DAI undoubtedly plays a very major role.

Stablecoins have already become an indispensable part of today’s cryptocurrency market. In the beginning it was created as a risk management tool for traders, but its current applications have already surpassed its original intention. Before you start investing in DeFi, make sure to gain a deeper understanding of the safe haven that stablecoins can be. We expect that they will definitely become an important part of your investment tools.

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