How to Minimize Your Risks Investing in Stablecoins

The main idea of a stablecoin is to hedge your on-chain funds against the volatility of the cryptocurrency market. Stablecoins are pegged to fiat currencies, primarily to the U.S. dollar; and for this reason, their value stays stable in USD terms.

With the growing popularity of decentralized finance (DeFi), stablecoin holders have earned an opportunity to put their stablecoins to work and generate passive income off DeFi’s liquidity pools. Stablecoins are vastly used in the whole of the cryptocurrency market as a measure of dollar to trade genuine cryptocurrencies like ethereum or bitcoin, without having to resort to the fiat dollar.

This has drastically increased the usability of stablecoins in liquidity pools of decentralized exchanges (DEXes) where the value of cryptocurrencies and layer 2 tokens is largely established in USD-pegged stablecoins.

Lending pools on lending DeFi platforms like AAVE have also opened up new opportunities for income for stablecoin holders. There you can stake your stablecoins in a liquidity pool for an interest that varies depending on supply and demand.

If you are holding a cryptocurrency and a stablecoin, you can become a liquidity provider for the relevant trading pool on a decentralized exchange. You will be able to collect your trading fees in the LP tokens of that particular exchange and thus receive an APY on the otherwise idle liquidity locked in your stablecoins. The most prominent harbor of stablecoin liquidity is Ethereum’s Curve Protocol where you can capitalize on opportunities for profit with any stablecoins.

Things to factor in when investing in stablecoin

If you are looking to commit a share of your investment capital to stablecoins, please consider a few factors that will influence the security of your funds. The first parameter is the type of stablecoin. The most reliable ones are fiat-backed and overcollateralized.

The fiat-backed stablecoins are those that you can get for a fiat currency. An example of these stablecoins is Coinbase’s USD Coin (USDC). It functions on the principle of IOU: the issuer owes you the liquidity that you grant them in fiat money. This is a very reliable way to keep your liquidity safe while retaining the opportunity to use your on-chain liquidity on the respective blockchain for profit. One of the best-known overcollateralized stablecoin is Tether (USDT), which is over collateralized by fiat funds, securities, USD, etc

There are also algorithmic stablecoins backed with cryptocurrencies. There are different ways of their backing, for example, MakerDAO and its DAI utilize the mechanism of overbacking where the amount of collateral exceeds the amount of token issuance. It is over collateralized by Ether (ETH) locked in the MakerDAO smart contracts. Such a mechanism must be very reliable.

Most algorithmic stablecoins are algorithmically backed by the blockchain’s native cryptocurrency. This system is used in Terra’s UST stablecoin that is backed by LUNA – Terra’s native cryptocurrency. Its algorithm lets users burn 1 USD worth of LUNA to mint 1 UST and vice versa.

When the price of UST, for example, climbs to 1.01 USD, users can burn LUNA for UST and sell UST for USD with a profit of 0.01 USD per UST. This will increase the supply of UST and increase the LUNA supply to bring the UST price back to $1.

If the UST price falls below $1, for example, to $0.99, the algorithm allows users to buy 1 UST for 0.99 USD and burn it for 1 USD worth of LUNA, similarly getting a profit of 0.01 USD. This will reduce the supply of UST and increase the LUNA supply to bring the UST price back to $1.

However, this might fail to work. And it did fail in the rapid downfall of Terra’s UST to $0.29 and the more than 97% crash in LUNA’s price. The algorithm simply could not cope with the scale of the UST selloff and mint enough LUNA to back its price. And when the UST fell as much as it did, it required such a big additional supply of LUNA to recover its price back to $1 that it caused the price of LUNA to drop as much as it did.

This example shows how risky algorithmic stablecoins can be.

The other parameter to consider in choosing a stablecoin is decentralization. If a stablecoin is centrally issued it is very reliable, but it can get blocked due to legal issues if the governing entity gets into a fiscal jeopardy with regulators. Such a scenario can damage the price of the stablecoin. Besides, the money in the account of a holder must be transparent and legal otherwise it may also be blocked.

But there are also decentralized stablecoins that have no centralized control. They are backed by non-centrally issued cryptocurrencies locked in non-centrally controlled smart contracts. And that makes it practically challenging to devalue the price of such a stablecoin through any legal issues. It suits if investors have assets of ambiguous origin, but it’s worth keeping in mind the Luna story, which is decentralized.

The Tether USDT stablecoin is the most prominent example of a centrally issued stablecoin. In April Tether Holdings Ltd. unveiled more details on its reserves, which confirmed their validity.

So, which stablecoins to go for?

In order to hedge your funds securely against cryptocurrencies’ volatility, it will be best to put your liquidity into several stablecoins on various blockchains. For example, the BUSD stablecoin can allow you to generate an APY on the largest DEX on Binance Smart Chain – Pancakeswap – while USDC and USDT can allow you to make use of demand for stablecoin liquidity on the Ethereum blockchain.

I would also advise going for non-centrally-issued stablecoins, for example, DAI, and try to abstain from investing large portions of your capital into stablecoins that lack proper backing.

And if you are dealing with chunky sums of money, it will be best for you to do your own research before committing your funds to one or another stablecoin rather than buy them rashly. Having a good understanding of how a stablecoin’s price is regulated will already allow you to have a notion of how securely your funds are stored and not be worried about their safety.

Dmitry Mishunin, the founder and CEO of a a DeFi security and analytics company HashEx