While stablecoins can offer a higher degree of reliability compared to other cryptos, they are certainly not immune to risks.
The vast development of cryptocurrency has created a number of unique innovations, including stablecoins. For many crypto holders out there, stablecoins have presented a solution to maintain the value of digital assets in the long term. In 2020, many investors decided to move millions of their funds to stablecoins, supporting its growth significantly. However, some recent events show that cryptocurrencies are never free of risk, no matter how stable they are.
The Luna Crash is known as one, if not the biggest crypto crash that involves stablecoins. Despite being a stablecoin, the price of TerraUSD dropped to below $1 in early May. Its sister Luna was even worse and lost almost its entire value a few days later. As a result, many traders began to realize that even stablecoins are not immune to volatility risks. So what should we do to avoid such things happening again in the future?
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A stablecoin is basically a cryptocurrency whose value is pegged to a specific asset like gold or other commodities, but most commonly the US dollar. This makes the values of stablecoins more stable than regular cryptocurrencies.
Stablecoins are regarded as the bridge that connects fiat currency and cryptocurrencies. While the price of stablecoins will go up or down following the value of the underlying asset, it's still going to be more stable than other cryptocurrencies that are not pegged to any other asset. So, traders who find Bitcoin and other digital currencies to be too volatile must find stablecoins appealing because of their stable quality. Many traders decided to buy stablecoins for several reasons, such as knowing the exact dollar value of their portfolio or just simply keeping their investment risks low.
The exact mechanism of how stablecoins work actually varies. To date, there are four stablecoins models available on the market:
- Fiat-based stablecoins: The coins are backed 1:1 by fiat currencies like the US dollar. So, if the issuer has $10 million fiat currency, then it can only distribute $10 million stablecoins with each coin worth $1. Some examples of this stablecoin model are Tether (USDT), the Gemini Dollar (GUSD), and Paxos Standard (PAX).
- Crypto-based stablecoins: Also known as on-chain stablecoins, crypto-based stablecoins are backed by other cryptocurrencies as collateral. The process uses smart contracts instead of relying on a central issuer. When you buy a crypto-based stablecoin, you essentially lock your crypto into a smart contract to gain tokens of equal representative value. You can return your stablecoins into the smart contract in order to withdraw your collateral cryptos. DAI is the most prominent example of stablecoins that use this model.
- Asset-based stablecoins: As the name implies, asset-based stablecoins use physical assets or commodities. Gold is the most popular asset to be collateralized in stablecoins because of its stable value, but some stablecoins can also use other assets like oil, metal, and real estate. Some examples of stablecoins that use this model are Tether Gold (XAUT) and Paxos Gold (PAXG).
- Algorithm-based stablecoins: Instead of relying on a specific asset, algorithm-based stablecoins use specialized algorithms and smart contracts to maintain a stable value and control the supply of assets in circulation. An easy example of this model is TerraUSD (UST).
Due to the various mechanisms, there are several risks that you should be aware of when it comes to investing in stablecoins, such as:
Centralization Issues
The concept of centralization is generally against the basic ethos of what blockchain technology is supposed to be about. Originally, blockchain was created to truly decentralize the tech industry so that no single party or authority can control and overpower everyone else. It was supposed to provide transparency and immutability that the modern technology system could not provide. That's actually true for the most part, considering that crypto transactions are decentralized, transparent, and not dominated by a single entity. However, this isn't exactly how stablecoin works.
Off-chain stablecoins and transactions are usually controlled and operated by a single entity. Take USDT for instance. In reality, USDT is controlled by a company called Tether, which controls the supply and distribution of the coins in circulation. Such a lack of decentralization creates a risk for the stablecoin holders because the collapse of Tether also means the collapse of USDT. The best way to minimize the impact is by decentralizing your portfolio and investing in several assets.
Lack of Transparency
A stablecoin can be pegged 1:1 to a fiat currency because people believe that the issuer really has the right amount of fiat currency locked away somewhere safe in order to maintain the price stability of the stablecoin. The catch is that there is no telling that the coin issuer actually has the said amount of fiat currency reserved somewhere because they usually don't publish such information to the public.
If the issuer actually only has, let's say, 80 cents out of $1 stored up in their vault, then the coin isn't actually pegged to $1. As a result, the coin holders could pull out their investment and perhaps crash the value significantly.
Algorithmic Stablecoins Can Fail
At a glance, algorithmic stablecoins sound promising since using an AI-powered algorithm to maintain price stability might prevent errors. Unfortunately, that doesn't mean that it works all the time. To start with, the system might not work during extreme price movements. The Luna Crash undoubtedly represents the incident as the algorithm couldn't handle the massive sell-offs. As a result, the price of the stablecoin plummets drastically.
How to Securely Purchase Stablecoins
Now that you are aware of the risks of trading with stablecoins, it's important to know how to avoid them and make sure that you're investing in the right place. Here are some tips that hopefully could help you get started.
Choose a Stablecoin Carefully
The first step is to decide which stablecoin that you'd like to invest in. Remember that there are several types of stablecoins out there and each one of them is tied to a specific asset or system, so choose the one that suits you the most. Do your research, then calculate the benefits that it offers as well as the underlying risks. Don't forget to consider the stablecoin's potential growth in the long term as well.
Mind the Crypto Exchange
If you just started your trading journey, you'll need to pick a crypto exchange. This is quite a crucial step so make sure to choose wisely. Generally, you can make a choice by using the following methods:
- Pick an exchange that offers the stablecoin you want. This is the option you should take if you already have a preference in which stablecoin you'd like to buy.
- If you're already registered in a crypto exchange and you're okay with whichever stablecoin they provide, you can simply take a look at the list of stablecoins and research them. It is worth noting that some of the large crypto exchanges even have their own stablecoins that you could use, such as USD Coin by Coinbase, the Gemini Dollar by Gemini, and Binance USD by Binance.
Follow the Process
You can start depositing the money that you'll use to buy stablecoins. You can choose to deposit by using one of the payment methods offered by the exchange. Simply connect your wallet or bank account to your trading account and transfer the amount you want. Bear in mind that the processing time may vary depending on the method that you use. For bank transfers, it may take up several business days. Also, note that some methods would charge you additional fees.
Stablecoin purchases usually don't take long, so the coins should be transferred to your account quickly. Once the stablecoins are available in your balance, you're free to use them for any purpose, whether it's for trading, lending, staking, or others.