Crypto trading: how to choose the right stablecoin?

The stable coins, are, as their name suggests, “stable” cryptocurrencies whose price is indexed to that of other assets these are usually fiat currencies (dollars, euros, pound sterling, etc.) or commodities (gold, etc.). They can be used by investors for a variety of reasons and not all work in 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 stable coins?

With a total market cap 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 that of the blockchain in terms of transfer and storage† So they have largely contributed to the arrival from DeFi. Here is a list of the main reasons for their success:

  • To avoid volatility by holding cryptocurrency : stablecoins serve as safe investment against the price volatility of other cryptocurrencies. With stablecoins, investors protect themselves from price movements while holding cryptocurrency. Exchanges can therefore take place directly on the blockchain, whether or not centrally. For large capitalization stablecoins, the market is more liquid than fiat currencies
  • Foreign currency exposure: Stablecoins allow anyone to gain exposure to currencies that are difficult to access from certain countries. This is possible without limits and at a lower cost compared to traditional banks.
  • Pay and/or send money: stablecoins can be used to pay or transfer money internationally without the restrictions associated with traditional banks (fees, delays, etc.).
  • Avoid taxes: in France, you must declare any exchange of cryptocurrency against a fiat currency (Euro or other) with taxes. Stablecoins allow the French to take advantage of the stability of fiat currencies without having to worry.
  • Generate passive income superior to traditional banks: While a booklet A yields 1% annually, the returns offered for stacking stablecoins can reach several tens of %.
Returns on USDT – source: Coinmarketcap

I fall stable coins if you want to have a value that follows that of an underlying asset, the way to achieve this may be different. There is currently 3 key business models which we will describe below.

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Centralized and Collateralized Stablecoins

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

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

Likewise, in Brink’s vaults, Paxos keeps one ounce of gold for every available PAXG.

In fact, most issuing companies do not own 100% of the underlying asset himself. The images below show the reserves of the 2 largest stablecoins. While some of the value is in 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 make it look great transparency with regular audits performed by external companies. Others hold a certain opacity on their accounts. For example, Tether (number 1 by volume) has already been convicted of lying about its reserves between 2016 and 2019.

To reassure users, they can go often trade their stablecoins directly with the issuing company against the underlying in a ratio of 1 to 1. However circumstances differ depending on the companies. Still taking 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 it to say that if the USDT were to lose its peg (parity to the dollar) on other exchanges, as it has rapidly done in recent days, it would hurt a good portion of users.

We keep the following points for this model of stablecoins:

Advantages:

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

Cons

  • All 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 with regard to its reserves.

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Decentralized and Overcollateralized Stablecoins

These stablecoins are backed by other cryptocurrencies. The most commonly 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. So the transparency is total.

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

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

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

Here are the takeaways for this stablecoin model:

Advantages:

  • On-chain data verifiable for everyone.
  • decentralized.

Discomfort

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

Algorithmic Decentralized Stablecoins

In this model of stablecoin there is: no collateral† It is a algorithm playing the role of “central bank” that guarantees the value of the token. Here, too, everything happens on the blockchain with the help of smart contracts.

Typically, the protocol uses 2 cryptocurrencies: one is the stablecoin, while the other is used to accommodate variations in the stablecoin’s price. a mechanism of coin and from burn linking the 2 cryptos incentivizes users to createarbitration by making small profits once the value of the stablecoin deviates from that of the asset it is supposed to track. When the price of the stablecoin is too low, the protocol burns down, decreasing supply relative to demand, driving the price up and vice versa.

Unfortunately this model sensitive to massive sales movements of the 2 protocol tokens. This can create a “death spiral” that drives the stablecoin’s price to 0.

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

Advantages:

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

Discomfort

  • Requires mass adoption to be truly stable.

Which stablecoin to choose?

You will understand that the choice is: far from easyespecially since some stablecoins are interdependent and have different modes of operation.

For example, the DAI, which is intended to be decentralized, is based on 48% of the USDC that is centralized. FRAX uses 88% overcollateralization and an algorithm for the remaining 12%. The MIM, which is not algorithmic, was 40% overfunded by the UST, which…

With more than 80 stablecoins listed on coingecko, the market is huge† All present significant risks that must be understood and measured before they are acquired. Before turning to a centralized stablecoin or not, it is also important to:study how it worksits history, available liquidity, trading conditions… A good way to limiting the risks can be to spread your stablecoin portfolio across several of them

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