Stablecoins and their risks

What is a stablecoin? What are the different types of stablecoins and what risks do they carry?

Key Takeaways 

• Stablecoins are digital assets whose value is pegged to that of a real world asset, e.g. fiat currencies or gold.

• USD-pegged stablecoins have gained popularity in the crypto space as a base (digital) currency and as a store of values between investments. 

• A tradeoff called ‘the stablecoin trilemma’ must be faced by any stablecoin since it can’t be, at the same time: decentralised, capital efficient and stable. 

• Stablecoins come with risks and a monetary loss when investing in them must never be excluded. 

Introduction

Some call them "the best of both worlds", and some call them "the trader's safe haven". While both statements do have some truth to them, there is much more to be said about stablecoins.

The cryptocurrency space has seen an exponential expansion in recent history. In tandem with this growth came the rise of the stablecoin market, which acts as the go-to mechanism for users to access the cryptocurrency supply. Indeed, beneath the hundreds of millions of dollars exchanging hands in daily crypto trading are often coins such as USD Coin (USDC) , Tether (USDT) and Dai (Maker DAO) , which constitute the top three coins in the stablecoin market. In their native form, stablecoins give credibility to a rising and essential use-case for blockchain technology as a means to apply monetary policies within a growing ecosystem

Before investing in any asset, be it a stablecoin or something else, it is your responsibility to educate yourself about it. Only this way can you truly mitigate risk and reap all the associated benefits.

What is a stablecoin?

The idea of a stablecoin isn’t exactly new when seen in light of current central banking standards, and various models have come out over the years in an attempt to offer similar value-propositions. The most basic purpose of a stablecoin is to maintain price stability in relation to another cryptocurrency such as Bitcoin, Ethereum or Litecoin. In many cases, the purpose of a stablecoin like USDC is to maintain a one-to-one (1:1) valuation with the US Dollar. In layman terms, this means that one USDC equals one Dollar.

Why do we need stablecoins?

A fiat-pegged stablecoin acts as a bridge between the old and new money models, retaining the supposed security of fiat currencies while allowing users to access cryptocurrency markets and blockchain services more easily. Stablecoins also allow a consumer - who might fear highly volatile markets - to dip their toes into the space with relative safety and security, given the 1:1 ratio guarantee.

The use-cases for stablecoins

1. Remittances
2. Commerce and payment processing for daily use
3. Salaries, expenses & other recurring payments
4. Derivatives trading
5. Store of value for long-term hedging

A stablecoin is a blockchain-native solution whose purpose is to preserve crypto valuations in traditional fiat currencies like the US Dollar and the Euro (with projects like EURt and Parallel ). So, it isn’t surprising that the sub-sector has grown to over $130 billion in market capitalisation at the time of this writing.

Understanding stablecoins

Bitcoin remains the most popular cryptocurrency in existence and there’s no reason to doubt that this will change any time soon. With a current market capitalisation of around $540 billion, Bitcoin alone makes up for around 40% of the entire crypto market. 

As Bitcoin veterans would tell you, even intraday price swings can be wild. In fact, it might not be uncommon to see Bitcoin moving in excess of 10% in either direction within the span of a few hours. While the same can now be said for traditional assets such as crude oil, which went into negative territory for the first time in history during the Covid outbreak, this kind of short-term volatility speaks to a need for a stable asset with which to measure Bitcoin’s movements. Basically, a matured currency should eventually act as a medium of monetary exchange, as well as a means to store monetary value – which by definition should remain relatively stable over longer time horizons.

Since stablecoins are built to mimic fiat currencies within the cryptocurrency system, the ideal crypto token would maintain its purchasing power and encourage spending the tokens just like its fiat-counterparts. Otherwise, people would save or hodl the currency as they often do with Bitcoin.

Reasons for price stability

The main reasons for price stability of fiat currencies are the reserves that back them and the timely market actions taken to ensure that this stays the same, by authorities like central banks. While it’s debatable which hard assets back fiat currencies, given that fiat has transitioned from a “gold standard” to a “US Dollar standard”, fiat currencies like the US Dollar are pegged to a basket of underlying assets such as forex reserves and hard assets like gold, which act as collateral and keep the price from having wild swings. Of course, they also have the full backing of the American economy and US authorities.

In some cases, as with the current crisis, central bankers jump in to manage the demand and supply of the currency in order to maintain price stability. This is often done with several tools such as interest rate changes and increasing the global money supply. Since most cryptocurrencies such as Bitcoin are set to succeed on the sweat of their own brow, they lack fiat currency features. However, stablecoins act as the de-facto blockchain-based solution backed by direct fiat and other assets, which act as collateral.

Notably, cryptocurrencies like Bitcoin were never meant to function as fiat currencies or stablecoins given the underlying fundamental differences in technology, limited supply and immutable underlying code. This opens the door to something as close to a free market as one might ever hope for.

What are the different types of stablecoins?

Stablecoins are vital to the burgeoning digital economy and bridge the gap between various cryptocurrencies, as well as traditional fiats. There are three different types of stablecoins.

Fiat-Collateralised Stablecoins

This type of stablecoin keeps fiat currency reserves like the US dollar, to be used as collateral in order to issue a number of tokens. Other forms of collateral could include precious metals such as gold, silver and other commodities like oil. However, most fiat-collateralised US Dollar stablecoins use dollar reserves.

Stored by third-party custodians, they are regularly audited by central banks for compliance to regulations. Tether (USDT), USDC and BUSD are popular stablecoins, each having the value equivalent of a single US dollar and backed by dollar deposits. These stablecoins are generally backed by USD cash and short-dated U.S. treasuries. 

Crypto-Collateralised Stablecoins

This type of stablecoin is backed by other cryptocurrencies. However, since the reserve cryptocurrency could be prone to high volatility, such stablecoins are “over-collateralized”. This means that a big portion of the issued supply is maintained as a reserve in order to distribute a lower number of stablecoins, which in turn allows the issuers to maintain price stability.

For instance, $2,000 worth of ETH may be held as reserves for issuing $1,000 worth of crypto-backed stablecoins, which allows for up to 50% of swings in reserve currency (Ether). The frequency of audits also adds to price stability, as investors are able to keep their minds at ease that processes are running smoothly. MakerDAO’s Ethereum-based DAI uses such a system, wherein the stablecoin ‘DAI’ is pegged against the US Dollar and allows for a basket of crypto-assets as a reserve.

Commodity-Collateralised Stablecoins

Commodity-backed stablecoins are collateralised using physical assets like precious metals, oil, and real estate. The most popular commodity to be collateralized is gold; Tether Gold (XAUT) and Paxos Gold (PAXG) are two of the most liquid gold-backed stablecoins. However, it is important to remember that these commodities can, and are more likely to, fluctuate in price and therefore have the potential to lose value. 

Commodity-backed stablecoins facilitate investments in assets that may otherwise be out of reach locally. For instance, in many regions, obtaining a gold bar and finding a secure storage location is complex and expensive. As a result, holding physical commodities like gold and silver isn’t always a realistic proposition.

Algorithmic Stablecoins

These stablecoins use algorithmic mechanisms to retain price stability, and are not backed by any assets. Seigniorage-style coins utilise an algorithmic approach to expand and contract the money supply, similar to how a central bank prints and destroys money. Similar to other stablecoin competitors, the main objective is to maintain price stability as close to $1 USD as possible. 

There are three types of algorithmic stablecoins. Each type utilises a different algorithm to maintain its value.

1. Rebase algorithmic stablecoins usually manipulate the base supply to maintain its peg. The protocol will add (mint) or remove (burn) coins from circulation depending on the stablecoin’s price deviation from $1 USD. Minting will occur when the price is above  $1 USD, whereas burning will occur when the price is less than $1 USD.
2. Seigniorage algorithmic stablecoins utilise the multi-coins system. Here, a specific stablecoin is set to be stable and at least one other coin is designed to facilitate such stability. The Seigniorage model usually applies a combination of protocol-based mint-and-burn mechanisms with free market mechanisms, which attempt to drive market behaviour towards trading non-stablecoins and thereby, urging stablecoin price according to the price peg.
3. Fractional algorithmic stablecoins are a combination of the previous two. This type of stablecoin is presented to maintain the value through being partially backed by collateral (e.g. fiat currency) and having an algorithm that modifies the stablecoin supply as needed.

The Stablecoin trilemma

Every stablecoin has to balance three main goals. As mentioned before, the main target and purpose of a stablecoin is to hold a stable value pegged to the value of another asset, such as a fiat currency. However, in most stablecoin designs, the goal to achieve high price stability comes with a tradeoff in either the decentralisation of the system or its capital efficiency.

This creates the so-called ‘stablecoin trilemma’. 

Capital efficiency describes how much value is needed to create one unit of the issued stablecoin. High capital efficiency is needed to scale the demand and, thus, the supply of the stablecoin. If, for instance, more capital than $1 is needed to create one unit of a USD-pegged stablecoin, the stablecoin design would be described as capital-inefficient. If less than a dollar is needed, the system can be considered capital-efficient to enable growth. The growth can also help to stabilise the system, making capital efficiency a strongly demanded characteristic. 

Decentralisation is the third dimension of the trilemma and plays a crucial role in any token and protocol design. Stablecoins have become an important and integral part of DeFi and the wider Web3 ecosystem. Thus, decentralisation of the governance and the systems of stablecoin issuers helps to mitigate centralised single points of failure and risks. Stablecoin issuers aim to follow the properties of the base layer, meaning they aim for censorship resistance and transparency and to be permissionless through decentralisation.

The nature of a trilemma is that under no condition all three goals can be achieved at the same time. The picture above explains this trade-off:

• A stablecoin wanting to maintain its peg and be fully decentralised needs to be overcollateralized (e.g. DAI), that is, capital inefficient. 

• A capital efficient stablecoin not needing to be overcollateralized cannot be fully decentralised, as it needs a centralised issuer and custodian (e.g. Tether or Circle). 

• A fully decentralised and also capital efficient stablecoin must have an algorithmic stabilisation mechanism. History shows that this comes at the expenses of price stability.   
  

What risks do stablecoins carry?

In comparison to other cryptocurrencies, stablecoins are indeed low-risk. Still, it's important to note that every stablecoin bears some of the typical crypto risks, along with stablecoin-specific risks. 

The latter varies from stablecoin to stablecoin, but is generally divided into these categories:

• Tech risk
• Centralisation risk
• Counterparty risk
• Market/economic risk
• Systemic risk
• Regulatory risk

But before jumping into all of that, here are some pointers on what to keep in mind before investing in any stablecoin of your choice:

• Proper management and auditing of centralised/decentralised reserve - Completely decentralised coins with synthetic real-world assets can be safe and auditable. Be sure to examine what the case is for the coin you are considering, because this is vital in case of any potential involvement of regulators.

• Diversified reserves - A stablecoin with a tangible real-world assets reserve backing provides much more safety and stability than other crypto assets. If the reserve backing the stablecoin is also diversified and low in volatility, the stablecoin itself becomes safer.

• Technical due diligence - Blockchain and smart contract failures do happen. It's important to know how big is the technical risk of the stablecoin you are considering.

Tech Risk

Crypto-collateralised and algorithmic stablecoins are regulated by smart contracts. 

Smart contracts undergo a thorough review process called an audit. Nonetheless, it could be the case that bugs or logical errors are present. If properly exploited, these protocol flaws could result in a loss of partial or total value of a stablecoin. 

A classical example is USP, the stablecoin of the Platypus Finance stablecoin. Platypus Finance is a single-sided Automatic Market Maker (AMM) for stablecoins, built on the Avalanche network, that is designed to optimise capital efficiency. Its stablecoin, UPS, could be minted using the liquidity provided to the protocol (in the form of other stablecoins, e.g. USDC, USDT) as collateral. 

The hacker exploited a vulnerability in the smart contract whereby deposited funds could be withdrawn while they were being utilised as collateral for a debt position in PlatypusTreasure, as the solvency check will succeed in all circumstances. 

In practice, the attacker entered the protocol with USDC, used this to mint USP (in other words, using USDC as collateral), managed to withdraw the deposited USDC and eventually liquidated (meaning, burnt) the USP position by redeeming funds from the protocol. With that, the attacker drained the Platypus pools, which led to a depeg of USP (along with a heavy loss for Platypus liquidity providers). 

Centralisation Risk

These are risks linked to the fact that stablecoin holding accounts/wallets can be embezzled, blocked, or accessed by unauthorized third parties. Centralisation risks are the same monetary issues that fiat-currencies face when a central authority has the power to print money without oversight. This can potentially lead to hyperinflation.

An example of centralisation risk is the ability of Circle (the issuer of USDC) to block certain wallets if required by its policy. The USDC “Blacklist Policy” states that, when an address is “blacklisted,” it can “no longer receive USDC, and all of the USDC controlled by that address is blocked and cannot be transferred on-chain.” 

Circle’s USDC has, for instance, blacklisted all Ethereum addresses owned by Tornado Cash (a protocol which helps obscure the trail of a crypto transaction in order to hide the original source), listed in the US Treasury Department’s sanction against the protocol. Thus, any USDC currently held in a Tornado Cash address are now frozen indefinitely.

Counterparty risk

Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions. 

To date, the market and the media have been primarily focused on one element of counterparty risk  for stablecoins —  whether there actually is one US dollar sitting in the issuer’s bank account for each stablecoin in circulation (meaning, a 1:1 peg). 

Many stablecoin issuers have failed to demonstrate that they can honour full 1:1 redemptions. While the 1:1 peg and the associated regulatory oversight necessary to address this risk are key elements for the stability of a stablecoin, there are other elements of counterparty risk that have been almost entirely ignored (or perhaps forgotten) by the market and the media:

• the counterparty risk of the bank holding the US dollars (e.g. Silicon Valley Bank and USDC);
• the counterparty risk of the stablecoin issuer;

These should also be considered carefully when investing in a (fiat or commodity collateralised) stablecoin. 

Market/economic risk

Stablecoins owe their success and popularity to their presence in the DeFi space, specifically as collateral and principal on multiple DeFi platforms. 

They display, or at least should display, low volatility, and thanks to their wide adoption and availability on almost every crypto exchange, these stablecoins enjoy a low market risk. 

Recent events however suggest that this is not always the case. 

Take UST, the algorithmic stablecoin backed by the LUNA token. Its flawed design (UST stability was entirely supported by a single cryptocurrency) resulted in its spectacular collapse, where investors and holders lost approximately $18 billion from UST alone, plus the losses associated with the LUNA token collapse. 

USDT and USDC have also experienced heavy depegging events. The most recent one was for USDC and linked to the failure of Silicon Valley Bank, one of the custody banks for USDC reserves. While USDC eventually came back to parity with the USD, investors might have lost money in panic-selling below peg, or being liquidated on leveraged positions that relied on USDC as collateral. 

Last, agEUR, a EUR-pegged stablecoin, lost its peg after it was revealed that part of its collateral reserves were locked into the Euler protocol at the time of its hack. Around 40% of agEUR backing reserves are now missing - but slowly being returned by the Euler attacker. 

The market risks of stablecoin are clearly there and need to be accounted for when investing into these types of digital assets. 

Systemic risk

Systemic risk is the possibility that an event at the company level could trigger severe instability, or even collapse an entire industry or economy. Systemic risk was a major contributor to the financial crisis of 2008. Companies considered to be a systemic risk are often called "too big to fail."

To put stablecoins in the context of systemic risk, one just needs to keep in mind that for example Binance, the largest crypto exchange, quotes all its major crypto not against USD, but against stablecoins like USDT, USDC and BUSD. These three stablecoins together have a market capitalization of around $120 billion. It is easy to see the impact that a collapse of one of these stablecoins would have on the crypto industry. 

With regard to the financial markets as a whole, stablecoins are still not considered as “too big to fail”. Their unregulated growth could however pose a risk to the system, for example if a massive wave of redemptions would force Tether (USDT issuer) to sell part of its reserve. These are kept in cash and short term bonds and the liquidation of billions of dollars worth of US bonds would definitely create a temporary shock in the bond market. 

Regulatory Risk

Regulatory risk is the risk that a change in laws and regulations will materially impact a security, business, sector, or market. A change in laws or regulations made by the government or a regulatory body can increase the costs of operating a business, reduce the attractiveness of an investment, or change the competitive landscape in a given business sector. In extreme cases, such changes can destroy a stablecoin issuer’s business model.

Conclusion

Stablecoins, as all other crypto currencies, come with risks. We hope that with this article, we were able to make you more aware of the potential risks you could face when investing in stablecoins. 

Remember: every investment comes with a risk, so it is up to you to find an asset that is worth investing in and meets your risk preferences.

At SwissBorg we do our best to give you plenty of options to grow your wealth, but also to educate you on how to invest in crypto the smart way. So, make sure to check out our app, which is equipped with the best investment tools, and the SwissBorg Academy, where we regularly publish educational content.