Crypto trading: how to choose the right stablecoin?

The stablecoins, are, as their name suggests, “stable” cryptocurrencies whose price is indexed to that of other assets which are most often fiat currencies (dollars, euros, pounds sterling, etc.) or commodities (gold, etc.). They can be used by investors for a variety of reasons and not all work the same way. We will see in this article why it can be interesting (but risky) to own one, and How? ‘Or’ What make your choice among the dozens of tokens available on the market.

Why use stablecoins?

With a total market capitalization of over US$160 billion, stablecoins are an integral part of the cryptocurrency universe. They combine the advantage of fiat currencies in terms of stability and those of the blockchain in terms of transfer and storage. They have thus largely contributed to the advent of DeFi. Here is a list of the main reasons for their success:

  • To avoid volatility by keeping cryptocurrency : stablecoins serve as safe investment against the price volatility of other cryptocurrencies. With stablecoins, investors protect themselves against price movements while holding onto cryptocurrency. Exchanges can thus take place directly on the blockchain, whether centrally or not. For stablecoins with a large capitalization, the market is more liquid than fiat currencies.
  • Exposure to foreign currencies: stablecoins allow everyone to gain exposure to currencies that are difficult to access from certain countries. This is possible without amount limits and with reduced fees compared to traditional banks.
  • Pay and/or send funds: stablecoins can be used to pay or transfer funds internationally without the constraints associated with traditional banks (fees, delays, etc.).
  • Avoid taxes: in France, you must declare each exchange of cryptocurrency against a fiat currency (euros or other) to taxes. Stablecoins allow the French to take advantage of the stability of fiat currencies without having this concern.
  • Generate passive income superior to traditional banks: While a livret A yields 1% annually, the returns offered for stacking stablecoins can go up to several tens of %.
Yield on USDT – source: Coinmarketcap

If all stablecoins aim to have a value that tracks that of an underlying asset, the way to achieve this may be different. There is currently 3 major operating models which we will detail below.

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Centralized and collateralized stablecoins

This is the simplest, most widespread and oldest mode of operation. It includes the market leaders with USDT, USDC and BUSD.

For each token issued, the issuing company must hold the equivalent in underlying asset. For example, Circle must have $1 in the bank for every USDC in circulation.

Similarly, Paxos holds in Brink’s vaults one ounce of gold for each available PAXG.

In fact, most issuing companies do not own 100% of the underlying asset himself. The images below present the reserves of the 2 largest stablecoins. While part of the value is made up of cash dollars, the rest is provided by government bonds and other financial products.

Theter reserves for USDT
Tether reserves for USDT (source: tether.io)
Circle Reserves for USDC
Circle reserves for USDC – source: circle.com

On the other hand, the visibility on reserves issuing companies is not not the same for all stablecoins. Some companies show great transparency with regular audits carried out by external companies. Others maintain a certain opacity on their accounts. For example Tether (number 1 in terms of volume) has already been condemned for having lied about its reserves between 2016 and 2019.

To reassure users, it is often possible for them to go exchange their stablecoins directly with the issuing company against the underlying asset at a ratio of 1 to 1. However conditions differ depending on the companies. If we still take number 1 as an example, it is possible to exchange USDT for USD on the Tether site but only after paying a fee of $150 and for a minimum amount of $100,000! Suffice to say that if the USDT were to lose its peg (parity with the dollar) on other exchanges as it has done rapidly in recent days, it would hurt a large part of the users.

We will retain the following points for this model of stablecoins:

Advantages

  • As the issuing company owns the underlying asset, this ensures the continuity of value of the stablecoin.
  • Can be issued by regulated companies which provides some confidence.

Disadvantages

  • Very sensitive to censorship because centralized. It is enough for the financial authorities to block the funds of the issuing company so that users can no longer exchange their tokens for the underlying asset.
  • depends on honesty of the issuing company as to its reserves.

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Decentralized and over-collateralized stablecoins

These stablecoins are collateralized by other cryptocurrencies. The most used are the DAI and the MIM, pegged to the US dollar.

There is no central entity that manages this model, everything happens on the blockchain using smart contracts. This makes the data accessible to everyone. The transparency is therefore total.

To ensure that their tokens will always be worth $1, these stablecoins are overcollateralized to prevent volatility courses of the cryptos which serve as a reserve. For example for DAI, the protocol requires 153% collateral. For 1 DAI issued, MakerDAO has $1.53 of cryptocurrency in reserve (some stablecoins go up to 500%). We can see the distribution of DAI reserves on the graph below:

Collateral of the DAI
DAI collateral (source: daistats.com)

If the value of the collateral falls below a certain level, the protocol sells it automatically to be able to ensure the value of its stablecoins.

Here are the takeaways for this stablecoin model:

Advantages

  • On-chain data verifiable by everyone.
  • Decentralized.

Inconvenience

  • Remains sensitive to sudden changes in the price of cryptocurrencies serving as the underlying

Algorithmic decentralized stablecoins

In this model of stablecoin there is no collateral. It’s a algorithm playing the role of “central bank” which ensures the value of the token. Here too everything happens on the blockchain using smart contracts.

Most often, the protocol uses 2 cryptocurrencies: one is the stablecoin, while the other is used to absorb variations in the price of the stablecoin. A mechanism of mint and of burn linking the 2 cryptos incentivizes users to makearbitration by making small profits as soon as the value of the stablecoin moves away from that of the asset it must follow. When the price of the stablecoin is too low, the protocol burns down, thus reducing the supply in relation to the demand, which causes its price to rise and vice versa.

Unfortunately this model is sensitive to massive sales movements of the 2 protocol tokens. This can create a “death spiral” driving the price of the stablecoin towards 0.

This is what happened recently with UST and LUNA. Several other projects had already had identical ends such as BASIS and IRON.

Advantages

  • Total transparency because everything is on the blockchain and can be viewed by everyone.
  • Fully decentralized.

Inconvenience

  • Requires mass adoption to be truly stable.

Which stablecoin to choose?

You will understand the choice is far from simpleespecially since some stablecoins are interdependent and mix modes of operation.

Thus the DAI, which is intended to be decentralized, is based at 48% on the USDC which is centralized. FRAX uses over-collateralization at 88% and an algorithm for the remaining 12%. The MIM, which is not algorithmic, was 40% over-collateralized by the UST, which is…

With over 80 stablecoins listed on coingecko, the market is vast. All present significant risks that should be understood and measured before acquiring them. Also, before turning to a centralized stablecoin or not, it is important tostudy how it worksits history, available liquidity, trading conditions… A good way to limiting the risks can be to spread your stablecoin portfolio over several of them.

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