Security

Stablecoins 101

What are stablecoins and why are they crucial to crypto markets?
Range Team
Range Team
November 22, 2023

Crypto markets are known for their wild swings. Tokens can see massive increases or decreases in their value within a matter of hours. While this volatility might be appealing to speculators, it is a major deterrent for the use of crypto in everyday transactions or long term financial planning. 

Stablecoins are a type of crypto token pegged to the value of another asset, such as fiat currency or gold. This is meant to stabilize the price of the token so that it can be used as a long term store of value or be reliable enough to be a daily means of exchange. 

The use of stablecoins has grown dramatically in the past three years, after the start of the Covid-19 pandemic. The market capitalization of major stablecoins grew more than ninefold between 2020 and 2022, mostly driven by Tether, according to the Bank of International Settlements (BIS). In that time, these tokens became a mainstay of the market, particularly for investors looking to earn yield on their assets.

But the growth quickly came to a halt with the collapse of Terra’s stablecoin in May 2022, TerraUSD, and the subsequent industry fiascos, chief among them FTX. The stablecoin market lost one-quarter of its market cap by the end of the year, according to the BIS.  

The collapse of TerraUSD increased the regulatory scrutiny on stablecoins, which had already at that point caught the attention of authorities around the world. The E.U., U.K. and the U.S.  are still deliberating on stablecoin regulation, whereas Dubai, Japan, Singapore, are among those that have already set up legal frameworks. 

It is important to understand that there are different types of stablecoins and that some come with more risks than others: 

  1. Fiat-backed: These are backed by reserves of fiat currency, such as U.S. Dollars or Euros, which are held in a custodian bank. Examples are USDT, USDC and TUSD. The stablecoin to reserve ratio can be as high as 1:1, meaning that for every stablecoin in circulation, an equivalent amount of fiat currency is in reserve to guarantee its value.
  2. Crypto-backed Stablecoins: These are backed by other cryptocurrencies, which are usually held by smart contracts that can dynamically adjust the reserve of the supporting crypto based on market demand. MakerDAO’s DAI is a key example. 
  3. Commodity-backed: These are pegged to specific physical commodities, such as gold or silver, agricultural products or energy resources. For example, each token of Paxos’s PAXG is backed by about 30 grams of gold stored in London vaults, the firm claims. 
  4. Algorithmic Stablecoins: Unlike the previous types, algorithmic stablecoins do not depend on physical assets or reserves. They employ complex algorithms that control the issuance and burning of stablecoins in order to maintain stability. An example is AMPL. 

One risk that all the above stablecoins have in common is centralization. They are managed by single companies, a fact that has raised concerns about their management and transparency. 

In 2021, the New York Attorney General concluded that USDT had been overstating its reserves and that the USD Tether stablecoin was not fully backed at all times, even though it is supposed to be 100% backed by reserves. The firm that manages USDT later tried to block CoinDesk from obtaining documents related to its reserves.  

Given their increasing systemic importance in the crypto ecosystem, stablecoins need to be well-secured. That’s where Range comes in.