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As its name suggests, a stablecoin is a type of digital cryptocurrency that is developed to maintain a fixed or stable value. As highly volatile assets, cryptocurrencies can be difficult to use everyday transactions. A vital role of any currency is its ability to act as a medium of exchange and a storage of monetary value. For example, if you plan to purchase apples three days from now using Ethereum, the number of apples you will be able to purchase could swing widely in that three-day span. If you know that you need to purchase a set amount of apples in the near future, it will be more practical for you to purchase them using fiat currency like U.S. dollars because the dollar holds a stable value over extended periods of time. Customers are likely to be hesitant to use a currency if they have no way of knowing what their purchasing power will be in the near future.
Stablecoins provide value to their users by providing them with a low-volatility cryptocurrency that holds a stable purchasing power level for extended amounts of time. This feature allows customers to use stablecoins as a better medium of exchange. Stablecoins are linked to underlying assets that help peg their price to more stable assets such as the U.S. dollar. It is important to note that unlike cryptocurrencies like Bitcoin, the vast majority of stablecoins derive their value from reserve assets that may be redeemed for the stablecoin. These reserve assets can consist of a wide array of assets such as fiat currencies, crypto and commodities.
Stablecoins can be split into two groups: centralized stablecoins that hold their collateral off-chain and decentralized stablecoins that hold their stablecoin reserves on-chain.
How Stablecoins Make Money
The business models and revenue streams of stablecoin companies vary depending on whether they are a centralized stablecoin or a decentralized one.
Centralized stablecoins are stablecoins that hold their reserve assets off-chain. These reserve assets are controlled by a central authority or financial institution. It is important to note that a stablecoin backed by a large amount of non-crypto assets is likely to be an off-chain centralized stablecoin. Examples of these stablecoins include Tether, USDC, Paxos Standard and the Gemini dollar.
Centralized stablecoins bring in revenue in a variety of ways. One of the most prominent ways stablecoin companies make money is through short-term lending and investing. These companies take a portion of the reserve assets and lend them out to others to earn interest, counting on the unlikelihood that a large number of stablecoin holders would redeem their collateral at once. This method mirrors how a bank operates by lending out the money customers place in savings accounts. An example would be when Tether loaned $1 billion to Celsius Network in October 2021. Alex Mashinsky, the CEO of Celsius Network, confirmed that the network would pay Tether an interest rate of 5% to 6% per year. Therefore, this deal will generate Tether between $50 to $60 million dollars per year.
Another example of centralized stablecoin companies participating in lending and investing is Circle. Circle is the company that developed USDC in collaboration with Coinbase Global Inc. (NASDAQ: COIN). In July 2021, Circle acknowledged that 61% of USDC reserves were in cash or cash equivalents while the rest was invested in a variety of assets such as Certificates of Deposit, corporate bonds, municipal bonds, U.S. Treasuries and commercial paper.
Centralized stablecoins also bring in revenue through charging issuance and redemption fees. You incur fees when you create stablecoins by handing over collateral or if you redeem your stablecoins for the original collateral. These fees tend to be relatively small, with Tether charging a 0.1% redemption fee. However, Tether does have a minimum withdrawal fee of $1,000 dollars to discourage low-volume redemptions.
Decentralized stablecoins are stablecoins that hold their reserve assets on-chain using other cryptocurrencies and smart contracts. This process helps solve the transparency issues that centralized stablecoin providers face. These stablecoins use smart contracts to eliminate the need for a third party. Decentralized stablecoins often issue an additional cryptocurrency along with the pegged stable cryptocurrency that serves different purposes such as governance and revenue sharing. For example, the MKR token of MakerDao is the more volatile governance token while the DAI token is the pegged stablecoin.
The MakerDao’s MKR token also provides rights to interest on collateral. The interest, which is known as the stability fee, is paid in MKR tokens, which are then subsequently burned. Burning decreases the supply of MKR and should lead to an increase in price. Many decentralized stablecoin projects issue cryptocurrencies as payment and incentives to the founding team. The decentralized autonomous organizations (DAOs) behind the decentralized stablecoins can then vote to issue more of these tokens to reward groups or individuals who perform vital roles for the project.
Are Stablecoins Worth Investing In?
Stablecoins can serve as an excellent investment and provide a wide array of investment opportunities. However, it is important to note that stablecoins have faced recent controversies regarding their collateral. It is important to do your due diligence for all investments, including stablecoins.
How to Make Money On Stablecoins
You can earn money in a variety of ways by investing in stablecoins. Note that just holding stablecoins will not earn money since the value is pegged to stay at the same value. You can earn interest on your stablecoins by lending them out on various protocols. For example, in March 2022, lending your DAI tokens on Compound pays an annual percentage yield (APY) of 2.56% while lending USDC pays an APY of 2.03%. These APYs can be much higher, however, if you stake stablecoins through a lending aggregator, where users can earn over 5% APY.
Should You Use Stablecoins?
Stablecoins can be especially helpful if you are looking to borrow money on decentralized lending protocols such as Compound and Aave. They are a vital part of the decentralized finance (DeFi) ecosystem. On these protocols, users provide collateral to borrow funds. The users must over-collateralize or, in other words, provide more value in collateral than the asset that is borrowed. If the value of the collateral drops compared to the asset that is borrowed, the user is liquidated and loses the collateral. Stablecoins are useful when used as collateral on these borrowing and lending protocols because they carry less of a risk of liquidation.
How are Stablecoins Funded?
Stablecoins are funded by their users. A stablecoin is created when a user chooses to lock up collateral to mint a stablecoin.
Stablecoin Outlook for 2022 and Beyond
The vast majority of stablecoins should stay at the same value in 2022. However, stablecoins carry the risk of a bank run if the stablecoin lacks the proper backing. Some stablecoins have recently faced controversies regarding if they truly possess the amount of collateral that they claim.
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