Stablecoins are the foundation of liquidity in the cryptocurrency market. Perhaps this is the most popular asset class for all market participants, from market makers to beginners.
Today, there are over 120 assets in this class that use different solutions and algorithms to store value. Some, for example, USDT, succeed quite successfully, while others depreciate, as happened with the notorious Terra LUNA.
What are stablecoins and why you can’t do without them
Stablecoins include tokens whose value is tied to other, mainly traditional, assets. Coins pegged to fiat currencies have gained the most popularity. They are considered one of the core primitives of DeFi and the foundation for centralized and decentralized trading platforms.
At the moment, the total capitalization of stablecoins exceeds $120 billion, and the veteran of the USDT segment is one of the three most capitalized cryptocurrencies and a leader in trading volumes.
These assets perform several very important functions:
- Payments and settlements.
- Providing liquidity.
- Blockchain lending.
- Earnings in DeFi.
In addition, stablecoins are used as safe haven assets during periods of market decline. It is important that among stablecoins there are many multi-chain assets. If the user needs to use the capabilities of the Tron network, it is enough to exchange USDT-ERC20 for TRC20 and calmly continue to work with the same USDT.
The key technical characteristics of stablecoins include:
- Security.
- The procedure for issuing and redeeming tokens.
- Price saving mechanism.
Depending on the characteristics of these processes, two large groups of assets are distinguished: centralized and decentralized. Both types of coins are available on many trading platforms, including http://letsexchange.io.
Basic mechanisms for preserving the value of decentralized stablecoins
Centralized stablecoins are more understandable to the mass user. There is an issuing company that stores real-life assets in its accounts or depositories, and there are tokens in circulation on the blockchain in an amount equivalent to the amount of the pledge.
However, this binding mechanism is not ideal. Coins are controlled by issuers, and issuers are controlled by regulators. Once the company starts having problems, it will affect all coin users. Also, many questions arise about the opacity of reserves.
The idea of a model devoid of these shortcomings was in the air. Moreover, there were already enough technical capabilities to implement it. Ultimately, the mechanism using smart contracts to maintain a link to the underlying asset and the transparency of the blockchain was implemented in several versions.
CDP
CDP (collateralized debt position) provides the ability to issue stablecoins against cryptocurrency. Typically, the collateral significantly exceeds the loan amount and can reach 150%. If the price of the underlying asset falls to the set minimum, the debt position is automatically closed. The collateral will be sold to cover losses.
This is an already proven and relatively safe mechanism. Its main drawback is the need for over-provision, which significantly reduces the efficiency of capital use. Also, when the market collapses, there is a massive liquidation of loans and many positions are closed with losses.
Seigniorage
In this model, collateral is also used to mint tokens, but arbitrageurs maintain the peg. This mechanism worked effectively in a growing market and was considered quite promising until the market began to fall. Due to the lack of automatic liquidation in the event of a collapse in the value of the collateral, the coins depreciate to zero. A clear example of this scenario was the collapse of Terra (UST).
Elastic supply model (rebase)
This algorithm preserves the value of an asset by automatically releasing and burning tokens according to changes in supply and demand. At the same time, the amounts on the user’s balance also change, and this is clearly inconvenient.
There are even more exotic models of store of value. However, the dominant position still remains with the CDP and seigniorage models.
Each model may have its own implementation features in each specific project. Therefore, when choosing stablecoins for an investment portfolio, you also cannot do without your own research. An investor should understand the mechanisms of stability, safety, and security of an asset in crisis situations.