Stablecoins: A reliable investment option in DeFi
Are you looking for a safe investment option that can give you the benefits of cryptocurrency without being too risky? If you are, then you’re not alone! It’s important to find assets that won’t be affected by sudden changes in the market. That’s where stablecoins come in!
Stablecoins are particular types of cryptocurrencies that help to solve the problem of cryptocurrency values going up and down too rapidly. So, they are a reliable investment option for DeFi investors like you, whether you are a beginner, an experienced investor, or just planning to become one.
To help you understand stablecoins better, let’s take a closer look at what they are and their different types.
What are stablecoins?
Stablecoins are digital assets that aim to maintain a stable value to a particular asset, such as the US dollar, euro, or gold. The most popular coins are USDT, USDC, DAI, BUSD, and TUSD. The mechanism that stablecoins use to maintain a stable value of a particular asset by tying their value to the underlying asset’s price is also known as a “peg.” The main goal of stablecoins (and one of their main problems) is to maintain the peg. Unlike other cryptocurrencies, stablecoins aim to minimize market volatility, which makes them attractive and safe for investors and traders. But why are they so popular?
First, these coins maintain a stable price, allowing investors and traders to store and exchange money without fear of significant price fluctuations. These tokens are also helpful to pay for goods and services like you would with regular fiat money.
Second, these tokens offer high liquidity and a stable price, making them easily convertible into other cryptocurrencies or fiat.
However, “stablecoin” is a collective term encompassing various types of these tokens; some are “less” stable than others. Let’s take a closer look at the main types of stablecoins.
What are the types of stablecoins?
Stablecoins are a vital component of the decentralized finance (DeFi) ecosystem. Different stablecoins are available in the market, each with unique characteristics and mechanisms for maintaining price stability. Below are the four main types of stablecoins:
Fiat-backed stablecoins
Fiat-backed stablecoins are pegged to a specific fiat currency, usually the USD or EUR, at a ratio of 1:1. At first glance, fiat-backed stablecoins are similar to paper money, but they are not actual fiat currencies.
For example, if you deposit $5,000 in a US bank and hold 5,000 USDT in a crypto exchange, and the bank goes bankrupt, the FDIC insurance will pay you back your $5,000. On the other hand, if the crypto exchange goes bankrupt, nobody guarantees the return of your 5,000 USDT. Some crypto exchanges can use the benefits of the FDIC or similar insurances on fiat deposits, depending on how and where they are set up. However, crypto deposits, even in stablecoins, generally remain uninsured.
The most popular tokens in this category are USDT, USDC, BUSD, TUSD, and EURT. The names of these tokens usually indicate the currencies they are pegged to.
Additionally, each stablecoin in this group has an issuer responsible for ensuring the peg and free conversion of the token into fiat and vice versa. For example, Circle is an issuer of USDC, and you can easily convert USDC into USD without any additional fees at Coinbase exchange, which is associated with Circle. By the way, the tokens from this group are usually over-collateralized by fiat reserves, which means that the value of the cash-equivalent assets held as collateral (the assets that back a stablecoin to maintain its stability) is greater than the value of the stablecoins issued, generally by at least 30%-40%.
Fiat-backed stablecoins are the most popular and least risky among all groups of these tokens.
Crypto-backed stablecoins
Crypto-backed stablecoins are backed by other cryptocurrencies, usually BTC and ETH. However, there are also cases with collateral in coins other than these. Meanwhile, collateral in other, more risky cryptocurrencies is a tricky thing. The backing of the stablecoin disappears if the collateral cryptocurrency significantly drops in value.
In the case of crypto-backed stablecoins, the mechanism of over-colatellateralization is used. DAI, issued by MakerDAO, and MAI, issued by QiDAO, are the most famous tokens in this category. The risk level of these coins significantly depends on the level of risk and volatility associated with the cryptocurrencies used as collateral.
Commodity-backed stablecoins
Commodity-backed stablecoins are tokens backed by certain commodities, such as gold, oil, and real estate.
This type of token includes XAUT and PAXG, both backed by gold and are the most liquid stablecoins in this group. There is also a USDR token, the world’s first stablecoin collateralized by tokenized real estate.
The risk of these tokens is directly proportional to the price volatility of the underlying commodities. However, an additional custodial risk is introduced here. It is more challenging to verify that a certain quantity of gold or real estate is in possession of a stablecoin issuer than it is to verify that a certain quantity of BTC or ETH is deposited in a wallet holding the collateral.
Algorithmic stablecoins
Algorithmic stablecoins are not backed by assets but are designed to remain pegged to a stable currency. Algorithmic stablecoins usually use a combination of two tokens – a stablecoin and a supporting cryptocurrency – with the algorithm managing the correlation between them. Mathematical algorithms regulate their price by tracking changes in supply and demand in the market. If there is a high demand but a low supply of an asset, its price increases, and vice versa.
However, the absence of concrete collateral raises the risk of price fluctuations. A prime example is the TerraUSD catastrophe, which caused a significant price drop in UST’s supporting cryptocurrency LUNA, resulting in many investors losing a significant amount of money due to stablecoin’s price drop. FRAX and MIM are the most prominent examples of algorithmic stablecoins.
Any DeFi investor needs to understand the different types of stablecoins available in the market. However, it is also crucial to be aware of the risks associated with these tokens if you want to invest in stablecoins and keep your money. The following section will discuss some of these risks and problems.
What are the risks of stablecoins?
One of the main problems with these tokens is de-pegging, which is when a stablecoin loses its peg to the underlying asset. For example, if you had 1,000 USDT pegged to the US dollar at a 1:1 ratio, woke up, and found out that USDT was worth $0.90, you would still have 1,000 USDT but could only exchange them for $900. De-pegging can occur for several reasons, including lack of liquidity, fraud, technical failures, and regulation changes.
- Lack of liquidity. Lack of liquidity is a common reason for de-pegging across all types of stablecoins. A lack of liquidity can occur if there are not enough buyers or sellers to maintain the peg. Similarly, in the case of stablecoins backed by fiat, other cryptocurrencies, or commodities, a lack of liquidity can occur if the value of the reserves drops for some reason. For instance, in March 2023, when Silicon Valley Bank, a major US bank, went bankrupt, one of its clients – Circle, which issues USDC, was affected. So, USDC temporarily lost its peg.
- Fraud. Another reason for de-pegging is fraud. Unfortunately, stablecoins, like other cryptocurrencies, are not insured against the possibility of price manipulation by attackers using “whale trading” or “pump and dump” schemes. Manipulation and fraud caused one of the largest stablecoins collapses in the history of the crypto market – the UST collapse.
- Technical failures. Technical failures are the reason for de-pegging, too. However, it applies more to algorithmic stablecoins, which rely on the flawless operation of the algorithm and smart contracts. But de-peg will be there when the stabilization algorithm has technical problems.
- Regulation changes. Changes in the regulation of stablecoins are our last reason. If a particular country that has a lot of stablecoins users bans the use of stablecoins, then the popularity and the demand for these tokens will fall, as will their value.
It’s worth noting that some stablecoins are more resistant to de-pegging than others, depending on their underlying principles and mechanisms. While risks exist, these coins can also provide opportunities for profit in the DeFi market. The following section will explore how to invest in stablecoins and mitigate their associated risks.
Maximize your earnings from stablecoins!
So, how can you earn money on stablecoins? Let’s explore some strategies.
- DeFi lending. Lend your stablecoins at interest through a lending protocol. While the profit from this may be minimal, it is a relatively low-risk strategy. Popular DeFi lending platforms include Aave, Compound, and Venus.
- Liquidity mining. Deposit your stablecoins on an Automated Market Maker (AMM) platform and receive rewards in the native token of that platform for providing liquidity. Alternatively, you can provide liquidity through a yield aggregator and receive rewards in the stablecoins you invest. Popular liquidity mining platforms and yield aggregators include PancakeSwap, Sushiswap, UniSwap, Beefy, AutoFarm, and Acryptos.
While using stablecoins protects you from price fluctuations, there is always a risk that your stablecoins may lose their peg, and that’s why you need to consider a hedging strategy.
Hedging against stablecoins’ de-pegging risk
Suppose you are interested in investing in the USDC-DAI liquidity pool through a yield aggregator. Depositing the tokens you own directly in this liquidity pool carries a risk of losing money if one or both of these coins de-pegs. Instead you can borrow USDC and DAI, using as collateral some other cryptocurrencies that you want to hold long term (for example, BTC or ETH), and then deposit the borrowed tokens into the USDC-DAI liquidity pool on the yield aggregator. If de-pegging occurs, you can return the borrowed tokens without incurring significant losses, thus minimizing the impact of the de-pegging problem.
However, it’s essential to remember that this strategy has advantages and disadvantages. On the one hand, you can earn rewards by depositing tokens into the liquidity pool through a yield aggregator, and you minimize your exposure in case of stablecoin de-peg. On the other hand, you sacrifice a part of the yield, as you will have to pay interest for borrowing the stablecoins. Additionally, there is a risk associated with your collateral, as it can be stolen or blocked from withdrawal.
Stablecoins offer numerous opportunities for earning money in DeFi. By employing these strategies, you can maximize your earnings while minimizing the associated risks.
Risks and rewards of stablecoins in DeFi
Stablecoins have become an essential tool in DeFi, providing investors with stable and secure assets that can be used for trading, investing, and making online payments. However, it’s vital to note that these coins are not entirely risk-free. Unreliable stablecoins can lead to significant losses for investors.
Investors should research and only invest in reliable and reputable stablecoins with a transparent collateralization system to avoid the risks. Some examples of reliable coins are USDC, DAI, and Tether.
Despite the risks, stablecoins offer several advantages to DeFi investors. For example, investors can use stablecoins to earn interest through lending or liquidity provision. Additionally, they can be used as a hedge against market volatility.
Always remember to do your research before making any investment decisions in DeFi and act according to your DeFi risk management strategy. Stay tuned for our new articles. We wish your stablecoins always remain pegged and stable.
Invest Wisely!