Published Jul 27, 2021
By Qredo Team
Qredo supports a growing list of stablecoins, including Tether, USD Coin and Dai. This post looks at how stablecoins work, and the ways that they’re being used by a growing number of institutional investors and corporate players.
What are stablecoins?
"Simultaneously the most valuable and most boring things to come out of DeFi." — Ethereum founder Vitalik Buterin on stablecoins
Also known as cryptodollars, tokenized fiat, and digital dollars, stablecoins are blockchain-based tokens that have 1:1 parity with a fiat currency, usually the U.S. dollar.
Stablecoins offer a steady anchor in the notoriously choppy waters of the crypto market, allowing value to be stored and transferred on the blockchain without exposure to wild swings in price.
How do stablecoins work?
The most significant feature of stablecoins is their peg, which is how they maintain a stable relationship to the tied asset. Most stablecoins use one of two mechanisms to retain parity: collateral pegs and algorithmic pegs.
Collateralized stablecoins
Popular stablecoin Tether uses the collateralized model. Each Tether is backed by a reserve fund, which holds a mixture of cash, cash equivalents, and commercial paper.
MakerDAO's DAI is another collateralized stablecoin, but backed by a diversified portfolio of crypto collateral. This makes MakerDAO the blockchain-based equivalent of a full-reserve bank.
“Ultimately, decentralized and stable cryptocurrencies pave the way for a modern financial revolution that will remove inefficiencies, reduce risk stemming from centralized parties and change the way we transact.” — MakerDAO Founder Rune Christensen
Algorithmic stablecoins
Algorithmic stablecoins, also called algo-based coins or seigniorage-style coins, are not backed by collateral. Instead, they aim to peg the price of a token using on-chain algorithms that increase or decrease supply according to market conditions.
For example, if too many people sell an algorithmic stablecoin, its price will drop. The stablecoin’s algorithm or “smart contract” will then respond by “retiring” enough coins from circulation so that the price rises again to the mandated peg level.
FEI and Empty Set Dollar (ESD) are two leading algorithmic stablecoin projects.
How do institutional investors use stablecoins?
Stablecoins are powerful tools for sophisticated investors. They can be used as a predictable and convenient passport across the blockchain ecosystem, providing access to both crypto trading opportunities and the growing range of exciting decentralized finance (DeFi) projects.
1. Trading
One of the main uses of stablecoins is to facilitate trading crypto against fiat, via futures, spot or options.
On centralized exchanges, stablecoin pairs — e.g. BTC/DAI or BTC/USDT — offer lower fees than trading directly against fiat. Due to regulatory restrictions, stablecoin pairs are typically more widely available than fiat pairs such as BTC/GBP. As such, they often act as a bridge for those wishing to move their fiat currency in and out of cryptocurrencies (aka “on-ramping” and “off-ramping”).
On decentralized exchanges, stablecoins provide an alternative to fiat, enabling direct trading against global currencies through smart contracts.
Peg arbitrage
As economists know, pegged exchange rate arrangements can be fragile. Pegs often slip on immature crypto trading platforms, and spreads of a few percentage points between the stablecoin and the peg are not uncommon. For nimble traders, this presents a lucrative opportunity. For example, a mean-reverting strategy could be used to bet that a stablecoin will revert to its peg after a bout of volatility. Alternatively, traders might use more complex arbitrage strategies. In this example, a gain of 89% was made in a matter of minutes made through a series of levered arbitrage trades.
2. Lending
Stablecoins are increasingly being deployed in DeFi lending protocols, allowing investors to earn yield by meeting demand for loans and leverage.
Compound is one such decentralized lending protocol running on Ethereum. The Compound contract automatically matches borrowers and lenders (you can see the balance between amounts borrowed and lent here) and adjusts interest rates dynamically based on this demand and supply. Other popular lending dApps include Aave and Alchemix.
Similarly, stablecoins can be lent and borrowed on centralized finance (CeFi) platforms such as Celsius and Nexo, or margin exchanges that supply leverage to crypto market players. Aggregators like LoanScan track interest rates across DeFi protocols and CeFi platforms so holders can shop around for the best deal.
3. Yield farming
Driven by the eternal search for yield, pioneering institutions are wading into DeFi to experiment with yield farming. Also known as liquidity mining, this trading strategy takes advantage of the composability of smart contracts to place funds across multiple DeFi protocols in return for greater financial returns.
For example, a trader might deposit stablecoins into Compound. In return, they would receive a crypto asset representing the deposit known as a cToken (for example, cDAI).
This could then be pledged elsewhere in another protocol to earn yet more yield. In addition, Compound rewards lenders with COMP tokens, which might also be lent or staked elsewhere to further maximize returns.
4. Treasury management
While cryptoassets such as bitcoin may still be too volatile for many corporate treasurers to stomach, stablecoins offer blockchain-based payment rails that can fulfil traditional treasury functions, with added flexibility and transparency.
As stablecoins can be sent anywhere in the world as easily as an email (and received soon afterwards), their use can significantly reduce the friction associated with sending international payments through multiple intermediaries. Counterparty risk is also removed as blockchain-based transfers are irreversible by nature. These benefits have been recognized by the United States government which has used stablecoins to provide foreign aid.
In addition, stablecoins also offer corporate treasurers the ability to earn yield on idle assets by accessing the aforementioned earning opportunities such as lending and yield farming.
How do investors buy stablecoins?
There are several easy ways for investors and corporates to buy stablecoins:
On a crypto exchange or OTC broker using fiat currency
Directly from the issuer, such as regulated stablecoin provider Moneyfold
Through crypto banking services like Silvergate and Signature that mint stablecoins on request
Issuing and redeeming stablecoins typically costs very little or nothing at all. Tether charges a 0.1% fee per fiat deposit for USDT, and Circle does not charge issuance or redemption fees for USDC. The same is true on exchanges, where stablecoins can be exchanged with dollars at zero cost (as with USDC on Coinbase), or at low cost (0.09% on Kraken).
What do the regulators say about stablecoins?
“If [stablecoins] are going to be a significant part of the payments universe, which we don’t think crypto assets will be, but stablecoins might be, then we need an appropriate regulatory framework, which frankly we don’t have.”
— Fed chairman Jerome Powell, July 2021
Both industry bodies, and regulators such as the Federal Reserve, are calling for greater stablecoin regulation, and we have already seen several significant milestones:
July, 2021. In a meeting with the Presidential Working Group on Financial Markets (PWG), Treasury secretary Yellen pushed U.S. regulatory agencies to act quickly on stablecoin regulation. Recommendations are expected to be issued in coming months.
December, 2020, The Stablecoin Tethering and Bank Licensing Enforcement (STABLE) Act was proposed by three members of Congress. This would require stablecoin providers to obtain a banking charter and follow the relevant banking regulations in their jurisdiction.
December, 2020. The President’s Working Group on Financial Markets (PWG) released a statement that stablecoins can improve efficiencies in payments and transfers, but that they must meet the same regulatory standards as the rest of the financial system.
July, 2020. The Office of the Comptroller of the Currency (OCC) announced that banks can use stablecoins to settle financial transactions. This laid the foundation for stablecoins to become integrated into institutional financial operations.
The future of stablecoins
Although there remains a lot of skepticism and caution around digital assets in general, stablecoin volume is growing, and they look set to form one of the first stepping stones for institutions to experience this new asset class.
Stablecoins on Qredo
Qredo supports a growing list of stablecoins on Ethereum (ERC-20).
Tether (USDT), the world’s most popular dollar stablecoin from Bitfinex.
USD Coin (USDC), the fully-reserved digital dollar stablecoin from Circle.
Dai (DAI), the decentralized dollar stablecoin issued by MakerDAO.
As the Network grows, more stablecoins will be listed to meet community demand.
Request stablecoin listings and stay up-to-date with Qredo on Twitter and Telegram.
Disclaimer
The content provided in this article is for informational and discussion purposes only. The author is not endorsing any company, project, or token discussed in this article.