How Stablecoins Merge Traditional and Decentralized Finance

Stablecoins, a term referring to cryptocurrencies that are pegged to fiat currencies, such as the U.S. dollar, first came to the scene in 2014. Tether (USDT), originally called realcoin, was launched as the first stablecoin that year. At the time, it was a very unique product, designed to bring the stability of the dollar (and other government-backed currencies) to the cryptocurrency ecosystem.

Today, there are three main types of stablecoins: fiat-backed coins, crypto-backed coins and algorithmic coins. Fiat-backed stablecoins are cryptocurrencies that are collateralized 1:1 with a specific fiat currency. Crypto-backed stablecoins are backed with a specific cryptocurrency, while algorithmic stablecoins are stablecoins that rely on a complex algorithm or algorithms to match the price of the cryptocurrency to that of a specific fiat currency.

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What are the use cases for stablecoins?

Stablecoins first gained popularity on crypto exchanges that did not offer fiat trading pairs. Most cryptocurrencies are quite volatile, and because of their volatile nature, many traders and investors needed a trading vehicle that provided stability and avoided this volatility. Because stablecoins are cryptocurrencies, they are able to be transferred between exchanges quite easily. This increases liquidity in the crypto economy and also allows traders to take advantage of cross-exchange arbitrage opportunities they might see. There are many popular stablecoins, such as tether, the gemini dollar (GUSD), USD coin (USDC), etc. In fact, there are two stablecoins in the top 10 cryptocurrencies by market cap – tether and USD coin.

Another popular use case for stablecoins is lending and borrowing - particularly in the decentralized finance (DeFi) economy. Traders and investors will often borrow against a crypto position, or allow their coins to be lent out to other borrowers in exchange for the opportunity to generate yield.

Stablecoins provide a lot of the plumbing in the crypto ecosystem. Because there is demand for stablecoins, there is usually an above-average rate for borrowing and lending them. Investors are able to earn interest with stablecoins by depositing into various lending pools. Smart contracts – the code that runs crypto lending pools – are acting as traditional banks in this scenario, where savers are providing the liquidity to borrowers. Unlike traditional finance (TradFi), most liquidity pools provide instant liquidity. This concept is referred to as DeFi, and it is growing in popularity.

While stablecoins are designed to be “stable,” it’s important to understand the risks they involve. Each type of stablecoin has different risks, and advisors and investors must understand each one separately.

• Fiat-backed: These are centralized coins. This means the issuer must hold fiat currency. Investors must demand proof of reserves with frequent audits. Examples: USDT, GUSD, USDC.
• Crypto-backed: These are much more volatile than fiat-backed stablecoins. Proof of reserves is required, along with constant monitoring of the crypto used to back the stablecoin. Example: DAI.
• Algorithmic-backed: Investors must research the code used to create the algorithmic function used to create stability. Example: AMPL, terraUST (UST).

Opportunities with stablecoins

Stablecoins provide a unique opportunity for advisors and investors. While they are designed to be stable and not volatile, they cannot and should not be used as a replacement for cash. And although it would be great to send bank reserves to a stablecoin position in order to generate an attractive rate of interest (especially during periods of inflation), it’s important to remember that these products are still new and unproven.

However, stablecoins do offer an attractive yield, allow for borrowing and lending, create tremendous liquidity in the crypto ecosystem and provide an uncorrelated (to other cryptocurrencies) asset that can be used for trading or as part of a diversified crypto portfolio.

Bridging TradFi and DeFi

In my opinion, the birth of stablecoins created the bridge that will connect the traditional financial markets to the wild world of crypto markets. I am more excited about the future of DeFi than I was about Bitcoin in 2012. As this new DeFi world evolves, advisors must be educated on the risks and opportunities this innovation will create. Navigating the next few years of the TradFi/DeFi ecosystem merging could provide opportunities unlike anything we’ve seen.