What are stablecoins?

How Stablecoins Work

Stablecoins allow users to benefit from digital currencies, such as security, privacy, low fees, and transparency, while minimizing the problem of volatility.

Stable tokens maintain a fixed value by being pegged to more stable assets, most often fiat currency.

The company issuing the stablecoin holds a reserve where the funds ensuring the token's stability are kept. Thus, each stablecoin is backed by a real asset. The reserve funds serve as collateral, and in theory, the stablecoin owner can exchange it for the asset it is backed by.

Types of Stablecoins

There are 3 main types of stablecoins:

• Fiat-backed Stablecoins. Examples: Tether (USDT), USD Coin (USDC), Binance USD (BUSD). These coins are backed by reserves of fiat currency held by a legal entity in bank accounts, allowing, if necessary, to exchange all issued coins for real money.

• Crypto-backed Stablecoins. Example – DAI. In this case, other cryptocurrencies are used for backing. Since the cryptocurrency rate is subject to significant fluctuations, over-collateralization is often applied to such stablecoins: for each token with a face value of $1, cryptocurrency worth at least $1.5 is reserved.

• Algorithmic Stablecoins. Example – Terra (UST). Here, maintaining the peg to the dollar is ensured by a special algorithm that automatically issues or burns tokens, regulating the balance of supply and demand.

Most Popular Stablecoins

USDT (Tether) – a stablecoin or digital analog of the US dollar, developed on the Omni Layer platform by Tether Limited in June 2014. The token is pegged to the US dollar at a 1:1 ratio (during strong market volatility, the ratio may change, for example: 0.92 to 1). The main idea of the coin is to present the world with an asset that has all the advantages of cryptocurrency (decentralization, privacy, minimal fees) and the stability of fiat currencies. At the same time, the issuing company Tether strives to comply with the legislation and meet the KYC and AML rules in the jurisdictions where it is available. 

USD Coin (USDC) – an ERC20 standard token created by Circle and CoinBase (after the merger of the companies - Centre Consortium) in October 2018. Circle also owns Circle Invest, a service helping beginners who decide to invest in cryptocurrency. The token is pegged to the US dollar at a 1:1 ratio. The basis of this token, like its colleagues, does not include any innovative technologies, but experts are confident that its rate is much more stable than that of other stablecoins, as the project is supported by major corporate partners: Bitmain (a well-known manufacturer of mining equipment), Goldman Sachs (the world's largest investment bank), Baidu (the leader in search systems in China), IDG Capital (one of the leaders in venture capital investments). 

DAI – is a decentralized stablecoin issued on the Ethereum blockchain and managed by a system of smart contracts of the MakerDAO protocol. It is distinguished by being backed not by fiat currency but by cryptocurrency assets, predominantly Ethereum (ETH), allowing DAI to maintain its peg to the US dollar ($1). To maintain price stability, DAI uses a collateral system: each issued DAI is backed by excess collateral value in cryptocurrency, usually exceeding its face value. If the collateral price falls and becomes too low, a liquidation mechanism is triggered, allowing the system to maintain stability.

Pros and Cons of Stablecoins

Pros:

• Accessibility. Today, stablecoins can be purchased on any platform;

• Liquidity. Stable coins are easily bought and sold; 

• Fast Transactions and Low Fees. Stablecoin transfers often occur faster and are cheaper than traditional bank transfers, especially for international transactions;

• For those who profit from exchange rate differences, an obvious advantage is that stablecoins regularly lose their peg to the base asset

As for the cons, one major issue stands out: the stablecoin issuer can freeze them, and you will lose your funds. In December 2023, Tether announced an update to its wallet blocking policy. From this point on, the company began blocking access to USDT for wallets listed on the US Sanctions List (SDN), which is maintained by the Office of Foreign Assets Control (OFAC). Tether claims this is necessary to comply with international anti-money laundering (AML) and counter-terrorism financing (CFT) standards.

It is unknown what other sanctions will be applied to wallets in the future, so it is not recommended to store large amounts in stablecoins on a permanent basis; it is better to diversify your portfolio.

Arbitrage on Stablecoins

Arbitrage opportunities often arise due to slight discrepancies in the exchange rate between USDC and USDT. For example, in 2023, after rumors about potential issues with USDC, the exchange rate of this stablecoin, pegged to the dollar, temporarily dropped by 1%. Traders took advantage of the situation, conducting transactions of up to $300,000 to buy USDC at a price of $0.93 and then sell it on Binance at $0.937. Such an operation allowed extracting profit due to the minimal but regular difference in the exchange rate.

Additionally, large orders, or so-called "walls," of around $50-100 million with a difference of about 0.7% were observed in the market. This indicated the presence of large players who were likely trying to maintain or adjust the USDC exchange rate to their advantage. Some traders also used more complex strategies, such as buying at a price of $0.9 with the expectation of the exchange rate rising to $0.99. Using automated bots, such as ArbitrageScanner, traders quickly responded to changes, thus minimizing risks and increasing profits.