The Role of Stablecoins in a Decentralized Ecosystem

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Banks. As much as people may hate them, everyone to some degree needs them. However, not everyone has access to a bank account around the world or a safe place to store their hard-earned money. Even if they do find a bank, once your money is in there, it technically is not yours anymore, as banks have the liberty to lend out your money for embarrassingly low-interest rates, freeze your accounts if they notice anything suspicious, and have high fees for almost anything. For these reasons and more, the world of decentralized finance (DeFi) is emerging and likely to disrupt the entire financial system in the decades to come.

DeFi is defined as “financial technology based on secure distributed ledgers”, these distributed ledgers ensure that there are no central authorities that can control the way you interact with money, financial products, or financial services. Further, DeFi eliminates the fees that banks charge for using their services, your money is stored in a secure digital wallet that belongs to you, and there are no ‘Know Your Customer” (KYC) protocols to adhere to. But the real value of using DeFi as opposed to traditional banking can only be understood once the role of Stablecoins in a decentralized ecosystem is made clear. Let me explain.

What Are StableCoins?

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Stablecoins are cryptocurrencies that are designed to be immune to the volatility of traditional cryptocurrencies. It is important to note that there are different types of stablecoins, that preserve their value via different protocols.

For example, fiat-collateralized stablecoins derive their value from being pegged to other asset classes of value such as the U.S. Dollar, precious metals like gold, or any other financial instruments like crude oil, and are used primarily as a medium of exchange from one cryptocurrency to another. Examples include Tether (USDT) and the United States Dollar Coin (USDC) which are both backed by U.S. dollar reserves.

Crypto-collateralized stablecoins preserve their value by holding a reserve of other cryptocurrencies, however, due to the volatile nature of cryptocurrencies, the value held usually must exceed the value of the stablecoins that are issued. Examples include Wrapped Bitcoin (WBTC) which is backed by Bitcoin issued on the Ethereum blockchain, and MakerDAO’s DAI token, which is backed by Ethereum and other cryptocurrencies.

The last type is known as Algorithmic Stablecoins, which control their supply and value through the use of computer programs running a preset formula designed to keep the supply at the right amount to maintain its price. These are similar to central banks like the U.S. Federal reserve which can print money at will without needing the currency to be backed by anything. The issue with this type of stablecoin is that during times of large volatility in the market the value can plunge significantly and unpeg from the U.S Dollar which is exactly what happened with TerraUSD (UST) this week. For context, UST had a market cap of roughly $18B, making it one of the largest stablecoins in the space, but due to its recent drop of over 60%, everyone saw what that did to Terra’s native cryptocurrency Luna, which is now down 99.7% over the span of 24 hours.

With all the headlines over the past year of stablecoins wrecking havoc in the crypto space with doubts about USDT and now UST, they clearly play a much larger role than simply being a medium of exchange for fiat and cryptocurrencies.

Now that we’re clear on what stablecoins are let’s look deeper into the actual role of stablecoins in the decentralized realm of the crypto ecosystem.

Stablecoins in DeFi

Let’s be honest, the real reason people have any interest in DeFi is for the absurd annual percentage yields (APY) you can get on some of your staked cryptocurrency. However, with traditional cryptocurrencies, the interest earned over the course of the year can be negated due to a large price drop in the currency. That’s where stablecoins come in. With stablecoins, you can earn equally high APYs on them without the risk of price volatility for the most part.

One example is with USDC, a fiat-collateralized stablecoin pegged to the U.S. dollar. It is fully reliable and can earn you up to 15% APY on some DeFi protocols — which trumps any central bank in the modern era.

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Stablecoins can also be utilized in yield farming, the process of locking your money into a large fund known as a liquidity pool that is associated with a specific pair of cryptocurrencies that the fund is comprised of, which in turn pays you a percentage of the liquidity you provided daily.

Traditional yield farming is fairly risky in that price volatility can lead to impermanent loss, which occurs when the price of your deposited assets changes drastically compared to when you first deposited them. However, the riskier the liquidity pair, typically the higher the interest rates paid out, so for some, it is a risk worth taking. Stablecoin yield farming, however, offsets this risk almost entirely due to the lack of price action and although you may get lower rates, at least you can sleep easy at night.

Lastly, stablecoins enable investors to take profits out of cryptocurrencies without paying capital gains tax or going through the tedious process of converting back to fiat every time. This allows investors to park their profits in a stable cryptocurrency that can now be used to provide liquidity to liquidity pools for yield farming, or simply to be staked or lent out for insane APYs, to earn even more money on their profits. This sums up the beauty of stablecoins in a decentralized ecosystem.

Conclusion

Stablecoins are often left out of the discussion when it comes to making a lot of money with cryptocurrencies because they aren't as exciting as a low market cap coin that can potentially 100x over the course of a few months, however, they play a tremendously important role in the entire space as you now know. Therefore, understanding the specific nuances between different stablecoins and their roles in a decentralized ecosystem is something that will serve you well in your journey with cryptocurrencies and the wonderful world of decentralized finance.

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