Despite the name, cryptocurrencies don’t tend to make for a good currency. They’re volatile, not always liquid, difficult to use and can suffer from terrible transaction throughputs.
Take the benchmark cryptoasset Bitcoin, which can only process around seven transactions per second.
Why? Because a block of transactions can only handle so many, and each block is only mined every 10 minutes, leading to wait times that can stretch into hours!
As for volatility, how could a gas pump advertise in bitcoin prices when the assets can fluctuate 10% in a day? That would require a full-time team member to adjust the billboard every 30 minutes.
Not all blockchain networks are as terribly inefficient as bitcoin, and to its credit, bitcoin is generally regarded as an asset or commodity, not a medium of exchange.
In the years that followed bitcoin’s rise to power, hundreds of competitors came to the fore.
Some, such as Solana and Cosmos, can handle tens of thousands of transactions per second.
But this does nothing to fix crypto’s other inherent shortcomings. In fact, their speed often comes at the sacrifice of price stability and network reliability.
This is where stablecoins come in.
How do stablecoins work?
Stablecoins are a class of cryptoasset pegged to the price of another asset, usually the US dollar, but there are gold-pegged, euro-pegged, even Mexican peso-pegged stablecoins too.
The benefits are obvious- you can engage in decentralised finance (DeFi) without worrying about volatile price fluctuations, but also without having to go through a dreaded financial institution (this is crypto, after all).
In order to maintain this peg, there has to be some sort of underlying protocol, and there are two ways a stablecoin’s peg is maintained: Algorithmically or collateralised.
Algorithmic stablecoins
Algorithmic stablecoins sustain their peg through supply and demand with a sister token via a process called arbitrage.
Theoretically speaking, when an algorithmic stablecoin loses its peg, arbitrage traders can step in to sell their stablecoins for a sister token, thus limiting supply and driving the price back to peg.
When the supply gets too small and the stablecoin goes above peg, arbitrage traders can sell their sister tokens to increase the stablecoin’s supply, thus driving the price back to peg.
If this sounds like unsustainable nonsense, it’s because it is.
Terra USD was an algorithmic stablecoin and LUNA was its sister token. Their collapse in May 2022 caused the two-trillion-dollar market rout that the cryptocurrency sector has yet failed to recover from.
Since Terra’s collapse, algorithmic stablecoins have all but gone the way of the dodo.
Collateralised stablecoins
Collateralised stablecoins, on the other hand, are more popular than ever.
Tether (USDT), the OG stablecoin since 2015, is the most-traded cryptocurrency in the world, often clocking in over US$100bn in trading volumes in a day.
Of the five most-traded cryptocurrencies, three are collateralised stablecoins- Tether (USDT), Binance USD (BUSD) and USD Coin (USDC).
Bitcoin and Ethereum make up the other two slots.
Collateralised stablecoins *theoretically* work because they are backed 1:1 or higher by the real-world asset they are meant to be pegged to.
USDT, for instance, *is* backed by cold hard Washingtons.
Why all of these asterisk’s? Because the actual amount of collateral backing USDT has been the source of controversy of too deep a level to get into here.
Broadly speaking, Tether was playing fast and loose with the nature of the collateral backing USDT, with much of this so-called collateral being short-term, unsecured debt.
This could have been a disaster. What would happen is everyone decided to redeem their USDT, but there wasn’t enough liquidity to support a bank run?
Who knows… e-riots maybe?
New York Attorney General Letitia James fined Tether and sister company Bitfinex US$18.5mln for failing to disclose its reserves and ordered mandatory reporting standards.
Tether has since reduced its reliance on commercial paper and published regular attestation reports.
Tether’s rocky road aside, stablecoins have clearly proved their utility, and reporting standards have greatly improved.
So why are they persistently controversial?
Centralised securities?
In February 2023, stablecoin issuer Paxos was instructed to cease minting BUSD, the dollar-pegged cryptocurrency developed for premier cryptocurrency exchange Binance, by the New York Department of Financial Services (NYDFS).
The order came after the Securities and Exchange Commission (SEC) announced legal action against Paxos for issuing what it deemed unregistered securities in the form of various stablecoins, including BUSD.
The move was surprising, if not totally unexpected, given how hawkish US regulators were on the crypto markets at the time.
According to the SEC, BUSD constituted an unregistered security under US law and should be treated as such.
Paxos “categorically disagreed” with this, while Binance head Changpeng ‘CZ’ Zhao warned that the enforcement “will have profound impacts on the crypto industry”.
Regardless, at the time of writing, BUSD has ceased minting in the US and there are fears that the regulators will take the fight to Tether next.
Stablecoins are maligned by some corners of the crypto community too, primarily because of their centralised nature.
Collateralised stablecoins necessitate a central issuing authority, and they often partner with major financial institutions such as BNY Mellon (NYSE:BK) (in Circle’s case) to provide custodial services.
One day, a truly algorithmic stablecoin could come to the fore, but given the continued fallout of Terra USD, that might be a long time in the making.