Recent turmoil in the banking industry after both Silicon Valley Bank (SVB) and Silvergate collapsed also caused several stablecoins to depeg, or lose their tie, to the U.S. dollar. USD Coin (USDC), particularly, was affected after its issuer, Circle, revealed that over $3 billion in its reserves was held at SVB. Over the weekend, the value of USDC dropped as low as 87 cents. As of this update, USDC has regained its peg to the dollar but the events have brought renewed focus – and questions – about this category of cryptocurrency.
A stablecoin is a term used to describe a category of cryptocurrencies that are pegged to the value of a fiat currency, such as the U.S. dollar, to maintain a steady value in the volatile world of cryptocurrencies. In other words, a stablecoin pegged to the U.S. dollar is designed to maintain a price of $1.
There are a few different types of stablecoins, including algorithmic stablecoins, cryptocurrency-backed stablecoins and fiat-backed stablecoins. A fiat-backed stablecoin simply means a government-issued currency like the U.S. dollar backs the stablecoin itself. In this article, we’ll focus on fiat-backed stablecoins and how they are meant to work, as well as why they sometimes don't.
What are stablecoins?
Stablecoins are cryptocurrencies whose value is pegged to the value of a fiat currency. They provide a way to store value within the cryptocurrency market without worrying about the fluctuations of cryptocurrencies like bitcoin (BTC). One use case for stablecoins is the ease of liquidating more volatile crypto assets into a more stable cryptocurrency to sidestep a correction or crypto crash. Instead of converting those cryptocurrencies to fiat currency, you can liquidate your digital assets into stablecoins and keep it easily accessible to re-buy into the same or other cryptocurrencies when you feel the time is right.
What are fiat-backed stablecoins?
Stablecoins are generally categorized into four different types: fiat-backed, commodity-backed, cryptocurrency-backed and algorithmic stablecoins.
The most popular types of stablecoins are "fiat-backed" meaning they are digital assets that have financial reserves in fiat currency held by a regulated institution like a traditional bank. In short, compared to its three other counterparts, fiat-backed stablecoins are truly backed by real-world currencies. These coins can be used to purchase goods and services online, just like any other cryptocurrency.
Unlike other cryptocurrencies, a stablecoin's value is tied to the price of the underlying asset, and not supply and demand. For example, 1 tether (USDT) should always be worth $1, though market conditions can make it fluctuate (we'll get more into this below). This makes them a more reliable form of currency for payments than other forms of cryptocurrency.
To purchase fiat-backed stablecoins, investors need to exchange their fiat currencies or other cryptocurrencies for them. When they want to sell their coins, they can exchange them for the corresponding fiat currency or use them to purchase other cryptocurrencies. Unlike other cryptocurrencies, fiat-backed coins do not require miners and are not decentralized. Instead, they use centralized servers and rely on third parties to manage their transactions.
Why causes stablecoins to depeg?
While the entire point of stablecoins is to maintain a stable value, sometimes they deviate from their peg, usually by tiny fractions of a cent. This is usually due to market conditions around liquidity and supply and demand that generally rectify quickly without intervention from the issuing companies.
In the case of USD Coin and Circle, the news that $3.3 billion of the company's reserves was held by a now-defunct bank caused worry among holders of the coin. Circle's guarantee that it held reserves equal to the amount of USDC in circulation was put in doubt, and people began to unload the stablecoin at a discount to leave their positions, fearing the worst and a UST-like meltdown.
The other contributing factor was that while USDC can be used 24/7 on chain, "issuance and redemption is constrained by the working hours of the U.S. banking system," as Circle CEO Jeremy Allaire explained in a post following the depeg. Since this event, Alliare has stated they are remedying this issue with a new partner to allow automatic minting.
Finally, following U.S. regulators' guarantee that all funds would be insured, USDC began its climb back to its $1 peg, which it has regained as of this update.
For a case of a stablecoin that did not fare as well after depegging, read CoinDesk's explainer on the rise and fall of Terra.
Popular fiat-backed stablecoins
Tether (USDT) has the largest market capitalization among fiat-backed stablecoins, meaning it is the most liquid. Additionally, it is used on almost all crypto exchanges worldwide.
According to Tether, USDT is backed by assets in its reserve. It also publishes a quarterly attestation showing the percentages of its reserve by asset class.
Regarding fiat-backed assets, USDC reserves are kept in the custody of leading U.S. financial institutions. USDC provides transparency allowing financial institutions to maintain their fiat reserves. Additionally, USDC's partners must report their U.S. dollar holdings regularly.
Binance USD (BUSD) is a stablecoin pegged to the U.S. dollar developed in partnership between Binance and Paxos. It adheres to the regulatory framework of the New York state Department of Financial Services (NYDFS) and is backed by reserves held either in fiat cash and/or U.S. Treasury bills. Paxos issued BUSD on the Ethereum blockchain until February 2022, following regulatory action from the New York Department of Financial Services (NYDFS) which ordered a halt to any new minting of BUSD by Paxos. Binance continues to offer a wrapped BUSD token (BEP-20) on BNB Chain.
EUROS (EURS) is a digital token pegged to the euro developed by STASIS. It is the world's largest euro-backed stablecoin, but is still small compared to U.S. stablecoin counterparts. Its reserves are in accounts of partner institutions and STASIS promises a "unrivaled level of reserve transparency" on their website.