Since its inception, cryptocurrencies have been considered volatile assets for many reasons. Suddenly, stablecoins appeared and everything seemed to normalize. After all, stability is one of the main conditions for potential investors and, in general, an important feature for any person. But at the beginning of March 2023, something happened that absolutely all players of the crypto market were wary of: the authority of stablecoins faltered along with the course of one of their most famous representatives — the USDC digital dollar. Why did this happen and is any stability of cryptocurrencies really a fiction? Let’s find out together with BeFund experts.
What are stablecoins?
We are already used to some groups of cryptocurrencies being called something special. For example, everything that appeared after Bitcoin and is its alternative is called altcoin. Similarly with stablecoins, it is not difficult to guess that the word “stable” should indicate an unshakable rate or a high degree of resistance to external negative factors. In fact, this is how it is, or at least it should be according to the intention of the creators of the “unshakable” cryptocurrency. And in many ways the idea turned out to be really revolutionary.
You can see for yourself that the exchange rates of any cryptocurrencies are extremely unstable: rapid rises can be replaced by a significant fall, after which it jumps up again and so on. It was almost impossible to observe a straight line of the course graph before the appearance of stablecoins. In statistics, there is even a special term for such variability – volatility. This phenomenon has always plagued all stock brokers, and with the advent of crypto exchanges, it has become a real pain for those who want to make money on cryptocurrency. They are assisted by IT specialists who invent ways to monitor the course and analyze its fluctuations. For example, BeFund developers offer for free use a special Telegram bot that monitors rates and notifies about its changes.
At the same time, there are other assets that are considered stable enough: some fiat currencies or, for example, gold. Therefore, the decision to create a special cryptocurrency tied to some stable asset with the creation of a corresponding reserve that guarantees an unchanged exchange rate became logical.
And here there is an important misunderstanding related to the very concept of cryptocurrency — an asset that uses its own distributed databases, that is, its own blockchain. Under such conditions, binding to something else is impossible and unnecessary. Therefore, none of the stablecoins has its own blockchain, but develops in the so-called ecosystem, which is deployed on an already ready, suitable platform. Now we understand that in fact stablecoins, despite the name, are tokens issued on the basis of smart contracts, which means that they are somehow dependent on the blockchain in which they are placed. Not all users of cryptocurrencies delve into this question, but everyone needs to understand the true nature of stablecoins.
This is, as it were, the whole brilliant idea and its vivid example Tether is a cryptocurrency token that, according to its creator, is 80% backed by USD reserves. This allows you to always exchange ₮ 1 for $1, which is a 1:1 ratio. After 2016, cryptocurrencies began to appear en masse, which declared their connection to gold, oil, other currencies and assets and proudly called themselves stablecoins.
Advantages and disadvantages of stablecoins
If the advantages are clear from the very idea of creating stablecoins, the general public does not know enough about the disadvantages. However, additional benefits arise from the already mentioned ecosystem of each individual stablecoin and the smart contracts used for its minting. For example, the DAI stablecoin on Ethtreum has a CDP (Collateralized Debt Position) smart contract that prohibits issuing more tokens than the available fiat reserves allow. The Tether smart contract provides the ability to legally block transactions if there is any danger or complaint. USDC is based on ERC-20, which is one of the most widely used standards for Ethereum in the world. But in any case, any smart contract provides the greatest transparency of the process.
The first drawback is ideological, which is contrary to the nature of cryptocurrencies and blockchain in general. In order to maintain a stable course, a binding to centralized mechanisms is used, which goes against the concept of decentralization. The currency of any country in the world is a product of a centralized system; gold bars stored in a centralized bank vault – no explanation needed here.
The second problem is also connected with real money, more precisely with the American dollar. As you know, the dollar is a product of a complex financial system based on US debt bonds and the activities of the Federal Reserve. Thus, in order to tie your cryptocurrency to dollars, you must first purchase them, which means playing by the rules of the banking system. PayPal, which wanted to waive any transaction fees, once faced a similar conflict. But over time, the payment system failed, and the same is true for USD-pegged stablecoins. In order to ensure a stable exchange rate, coin creators need to constantly invest the dollars received for cryptocurrency into US debt bonds and try to keep the system running at the expense of the interest received.
Much can be said about the problem of stability of cryptocurrencies tied to goods. But it is better to immediately move on to the examples that the whole world has been watching since the spring of 2022. Thus, due to world sanctions, Russian oil depreciated almost three times in one year; natural gas – five times. Once powerful assets now bring only losses. And this can happen to any tangible asset for a thousand different reasons. Therefore, even the most stable product today can become unnecessary tomorrow for only one reason – because it is a material product.
Thus, at the time of writing this article, 4 main types of stablecoins are known:
- Fiat – backed by the currencies of different countries;
- Commodity — ensured by the availability of various goods on exchanges;
- Cryptocurrencies — secured by other cryptocurrencies;
- Algorithmic — not backed by anything, but based on software algorithms that adjust the rate by managing the total number of coins.
The first two types are fully centralized, the third is partially centralized, and the last is fully centralized, but extremely controversial and complex.
Why did the USDC exchange rate change and is this possible in the future?
The situation surrounding USDC has terrified many owners of this stablecoin and caused panic among other similar coins. But in reality, the events of March should not be perceived as a fiasco, but rather as an instructive lesson. The fact remains: the rate of USDC issued on the Ethereum platform dropped to $0.9 due to the loss of the peg to the USD, which made this coin stable. However, this happened due to other negative factors that befell the 18th largest US bank Silicon Valley Bank, and not the other way around.
After the leak of information about the bank’s liquidity problems and the previous collapse of another American bank, Silvergate, investors began to actively withdraw funds from Silicon Valley Bank, which owns the lion’s share of assets to stabilize the USDC rate. It should be understood that all the necessary dollars are not lying on the shelves of the warehouse: 77% of their volume is in short-term loans for 1-4 months. Another 8% of the assets were really “buried” by Silvergate, so in the balance we have only 15% of real funds to support the USDC exchange rate. Thus, breaking the peg to the USD became the only possible step to save from an instant default. And it worked.
In just a few days, Silicon Valley Bank recovered from the powerful blow and stablecoin dependence was restored. This was facilitated by the support of powerful financial organizations that in the first 24 hours provided bank assistance for almost $2.5 billion, including Coinbase, 0x3356, Jump Trading, FalconX and others. Many supporters of USDC continued to buy tokens even in the most acute moment of the crisis, because they believed in stability even more than their own eyes.
Despite everything, trust in other stablecoins has been shaken. Algorithmic DAI suffered the greatest reputational risks, as it is 48% dependent on USDC. The owners of Tether stated at the very beginning that they have no relationship with Silicon Valley Bank or Silvergate and that their cryptocurrency will remain stable under all conditions.
Although the USDC lesson is important, it cannot be called new. Less than a year before the mentioned events, in May 2022, in less than 5 days, another stablecoin, Terra USD (UST), collapsed, for the functioning of the ecosystem of which the cryptocurrency LUNA was traded. The reasons were similar: the unexpected loss of the peg to the dollar caused a rapid drop in price to $0.62 on the first day and $0.23 on the next. Despite the efforts of the owners from Terraform Labs, it was not possible to “revive” the token and cryptocurrency. Then, in a wave of panic, the Tether rate also fell to $0.94 for a while, but quickly recovered.
Conclusions
The idea of securing the exchange rate of a cryptocurrency at the expense of another stable asset is great, but in this case, many questions arise about the asset itself. If humanity had something that could remain unchanged and useful regardless of time and circumstances, stablecoins could fully meet the purpose of their creation. But in our material world there is nothing like that, so we have to choose from the most stable unstable assets. At the same time, stablecoins show much less volatility than conventional cryptocurrencies, and therefore deserve attention and trust. The BeFund team reminds you this material should not be considered financial advice, so if you have any questions about stablecoins or blockchain projects in general, we will be happy to discuss them in a live chat. Let’s arrange a call via email — [email protected].
