Following the collapse of TerraUSD (now USTC), some crypto users have become increasingly uncertain about the stability of stablecoins. Even the US Treasury cited risks to the collective financial stability of stablecoins, while the Federal Reserve discussed the uncertainty of how some stablecoins are backed.
Generally, stablecoins exist in numerous forms – from being backed by fiat currencies to using an algorithm to maintain stability. Before discussing the top five stablecoins by market cap, this article takes you through the definition of a stablecoin and how it works. Besides, it discusses the centralized vs. decentralized stablecoin models.
What is a Stablecoin?
A stablecoin is a digital currency whose value is tied to another asset, like a commodity or fiat currency, to stabilize its price. It achieves stability by maintaining a peg of 1:1 to a reserve asset or an algorithm. This way, stablecoins bridge the world of digital currencies and fiat as their prices are stable and, to a large extent, reliable.
Digital currencies, such as Bitcoin, Ether, and Ripple, present multiple benefits, such as eliminating intermediaries from financial transactions and opening their use in cross-border settlements. However, one major downside is that the prices of cryptocurrencies are highly volatile.
Though volatility is good for traders, it makes cryptocurrencies inconvenient as a payment method. People using them to pay for goods and services don’t want to become a laughing stock for buying two pizzas with 10,000 Bitcoin.
Fun Fact: Two large pepperoni pizzas were 10,000 Bitcoins in 2010! 🍕🍕— CoinGecko (@coingecko) May 22, 2022
On the other hand, most merchants hate making losses when crypto prices decline after being paid.
This unpredictability contrasts with the largely stable prices of fiat currencies, like US dollars, and commodities like Gold and Silver. While the values of fiat currencies and commodities change steadily with time, their daily swings are somewhat more stable than digital assets, which increase and drop in value recurrently.
Apart from using stablecoins to overcome the volatility problem prevalent in crypto markets, you can also use them to:
- Trade or save crypto – Assuming you are a crypto trader who invested in a certain asset and has increased in value. After reaching your target, you need to take profits as you calculate your next move. You can convert your profits to stablecoins instead of cashing them out into fiat and save on withdrawal costs.
- Earn interest – Decentralized applications (dApps) like Compound allow stablecoin holders to lock their assets in liquidity pools and generate yield. Besides, holders can also earn interest by lending their holdings on DeFi lending platforms, like Aave.
Cross-border settlements – Stablecoins are associated with fast processing and cost-effective transaction fees, making them ideal for cross-border payments.
Top Five Stablecoins by Market Cap
Essentially, the best stablecoins must allow regular reserve audits and have a high trading volume to act as a liquid exchange medium. These two elements offer a foundation on which users can trust in the stability of the stablecoin, knowing well that it’s backed by verifiable proof of assets and can be easily exchanged for other coins. From Tether to FRAX, these are the top five stablecoins by market cap.
USDT is the world’s first and biggest stablecoin by market cap. It was first launched as RealCoin in July 2014, rebranded as Tether in November 2014, and started trading on BitFinex exchange in February 2015. USDT was developed to solve two primary issues with existing digital currencies: high volatility and convertibility between fiat money and digital assets. Tether issued a stablecoin fully backed 1:1 by US dollar reserves held at financial institutions to solve these issues.
USDT is one of the earliest digital currencies and one of the first successful stablecoins. USDT was initially launched on the Bitcoin network and later spread to Ethereum, Bitcoin Omni, Liquid Protocol, Polygon, TRON, EOS, Bitcoin Cash, and others.
Apart from being technologically groundbreaking, USDT was backed by some of the popular names in the crypto space, including Bitcoin Foundation director Brock Pierce. Nevertheless, as soon as it succeeded, suspicion and controversy followed, which is anticipated considering the degree of attention it received as the first stablecoin. Luckily, it has got past most of these controversies and maintained its position in driving the future of money.
As of September 8, 2022, USDT was the third-largest crypto after Bitcoin and Ether and the biggest stablecoin with a market cap of approximately $67 billion. It recorded a daily trading volume of almost $50 billion. The fact that USDT has been around for almost eight years and has survived multiple legal battles, seems to give investors the confidence to use it. This is probably why it is the most widely used stablecoin.
How is Tether Backed?
Despite USDT being the biggest stablecoin by market cap, it has experienced several controversies, especially regarding liquidity and whether its reserves are sufficient to back the number of coins in circulation.
According to the Tether website, USDT is fully backed and transparent. The website claims that each USDT coin is pegged at 1:1 with fiat money and backed 100$ by Tether reserves. For more details, check Tether’s daily reserve publications.
In May 2022, USDT’s value briefly declined to $0.96 following the collapse of UST. However, its value quickly recovered to above $0.99, and its custodian assured investors that it would continue honouring redemption requests, which hit 2 billion coins on May 12 at a 1:1 with the US dollar.
USD Coin (USDC)
As its name suggests, USDC is a stablecoin whose value is pegged to the US dollar on a 1:1. As of September 8, 2022, USDC was the fourth biggest crypto with a market cap of approximately $52 billion. It also recorded a daily trading volume of $50 billion.
Founded in 2018 by Centre, a joint consortium of Circle and Coinbase, USDC was launched as a regulated stablecoin that operates on the blockchain. It offers liquidity to cryptocurrency markets and is available on numerous blockchains, like Ethereum, Algorand, BNB Smart Chain, Solana, Polygon, and Tron. Essentially, USDC is an ERC20 utility token – a standard for developing smart contracts on Ethereum.
How is USDC Backed?
USDC is fully backed by US dollars and dollar-denominated assets, such as US Treasury securities. Centre holds USDC’s reserve assets in multiple accounts of licensed US banks. To uphold a peg of 1:1 with the US dollar, for each USDC coin in circulation, $1 is held in collateral.
Centre closely works with auditors and government regulators to provide a transparent and clear account of its reserves. You can check monthly reports of its reserve balances, including the number of circulating coins and their equivalent value in US dollars. The international auditing firm, Grant Thornton, is responsible for releasing USDC’s substantiation reports. These reports help cultivate investor trust in USDC, revealing the actual amounts of assets backing the token.
When you purchase 1 USDC from Circle, Centre mints a new USDC; when you sell 1 USDC, the coin is burned or removed from circulation. Several companies, products, and services currently support the USDC standard, including web3 wallets, crypto marketplaces, DeFi protocols, payment services, and savings and lending platforms.
Binance USD (BUSD)
BUSD is the third largest stablecoin by market cap, established by Paxos Standard and Binance. Paxos leverages blockchain to provide stablecoin-as-a-service products to companies. BUSD is regulated by the New York State Department of Financial Services. Technically speaking, BUSD is a fiat-collateralized stablecoin that upholds a peg of 1:1 with US dollars. Paxos holds an equal amount of US dollars as the circulating supply of BUSD in FDIC-insured financial institutions.
BUSD provides three primary transaction aspects: accessibility, flexibility, and speed. As of September 8, 2022, BUSD had a market cap of approximately $20 billion and a daily trading volume of $5 billion.
How Does BUSD Maintain Its Peg?
The method of maintaining BUSD’s peg is similar to that of USDT and USDC. Every BUSD is exchanged for $1 from the reserves. When you send your BUSD to Paxos, they burn the tokens and send you their fiat alternative. Essentially, this mechanism maintains the circulating coins and reserves at a constant peg of 1:1.
When the BUSD price drops below $1 per BUSD, investors buy BUSD in large amounts and convert them to fiat money via Paxos. An increase in BUSD demand logically pushes the coin price back to $1, reinstating its peg.
Apart from ensuring that BUSD is 100% collateralized, Paxos is accountable for minting and burning BUSD tokens. The company can also freeze wallets and withdraw funds related to illegal activities. BUSD tokens have an inbuilt function known as SetLawEnforcementRole, which reveals the stablecoin regulation.
Unlike USDT, USDC, and BUSD, DAI is a special stablecoin maintained and managed by a decentralized autonomous organization (DAO) - MakerDAO. It’s an ERC20 token issued by smart contracts on Ethereum with a $1. As of September 8, 2022, DAI had a market cap of over $6 billion and a 24-hour trading volume of $0.5 billion.
Apart from buying DAI on exchanges, you can also mint it by taking a loan. The process begins when you open a collateralized debt position (CDP) with Maker and lock ETH or any other accepted asset. Then based on the ratio, you will receive DAI in return as a loan. Some of, or the whole DAI you earn is deposited back when you claim your collateral. Moreover, DAI enables borrowing and lending on the MakerDAO platform.
How Does DAI Maintain Its Value?
DAI maintains a peg of 1:1 with the US dollars by locking monetary values in the Maker Protocol. Therefore, if you own 50 DAI tokens in your account, its value is secured by keeping assets equal to $50 in the protocol. Importantly, the MakerDAO requires borrowers to deposit collateral of 150% of the value they intend to borrow.
Since the assets you lock as collateral are volatile cryptocurrencies, you provide more assets as security than the value of the loan you take. If the collateral declines below 150%, the protocol forcefully liquidates it to maintain the loan and charges you a small fee.
FRAX is a hybrid stablecoin pegged on a 1:1 with the US dollar. It describes itself as the first partially collateralized and partially algorithmic stablecoin. As mentioned, fiat-collateralized stablecoins are secured by fiat collaterals, secured in reserves, and managed by custodians. These stablecoins are exposed to counterparty risks.
On the other hand, algorithmic stablecoins are plagued by volatility, and the recent collapse of UST further exposed their design flaws. FRAX is trying to improve upon such failures and create a stablecoin free of counterparty and design risks.
As of September 8, 2022, FRAX had a total market cap of approximately $1.5 billion and a daily trading volume of almost $6 million.
How Does FRAX Maintain Stability?
FRAX is a fractional reserve algorithmic stablecoin, meaning a portion of the deposited collateral (normally USDC) is kept in reserve for redemption. This ratio varies from 1:1 (full reserve) to 0:1 (no reserve). A FRAX algorithm typically determines the ratio based on FRAX’s market demand.
If there are more sellers than buyers, it means there is more reserve as the algorithm will be absorbing more FRAX tokens from the market to maintain the peg. And if there are more buyers than sellers, it means there is less reserve as the algo will be distributing FRAX tokens from the reserve to the market. Therefore, the algorithm determines whether the market can redeem one FRAX for $1.
If it establishes a yes, it doesn’t need to hold more USDC; if the answer is no, then it must have more USDC in reserves. Again, if the FRAX price drops below $1, the algorithm buys more FRAX tokens to lower the supply and increase demand, pushing the price back to $1. The reverse is also true.
This article has discussed the top five stablecoins by market cap, including USDT, USDC, BUSD, DAI, and FRAX. Stablecoins are ideal for playing it safe when the cryptocurrency space is experiencing wide price swings. These coins claim to maintain a peg of 1:1, meaning they track the prices of their underlying assets. You can mint a centralized stablecoin by locking a similar amount of fiat to a custodian. It’s important to note that centralized stablecoins are prone to liquidity and counterparty risks, such as collateral mismanagement and censorships.
On the other hand, decentralized stablecoins are algorithmic coins not issued by a custodian. They include crypto-collateralized stablecoins, like DAI. Smart contracts are used to manage collateral and issue or burn these coins. As such, decentralized stablecoins are resistant to censorship and counterparty risks. Hence, they are ideal for DeFi use and seem to be characteristics needed for the future of stablecoins.
Josiah is a tech evangelist passionate about helping the world understand Blockchain, Crypto, NFT, DeFi, Tokenization, Fintech, and Web3 concepts. His hobbies are listening to music and playing football. Follow the author on Twitter @TechWriting001