Are Stablecoins Completely Safe And Which One Should You Use?

Stablecoins have become an important aspect of the cryptocurrency market as far as liquidity is concerned. One can quickly sell their crypto holdings when the market turns bearish in exchange for stablecoins and then buy back when prices bottom out. The rapid rise in stablecoin popularity raises security questions. Are there any risks to holding your money in stablecoin form?

There are currently two different types of stablecoins: Asset-backed stablecoins whose price is pegged to an underlying asset such as a fiat currency and collateralized stablecoins that rely on an incentivized collateral mechanism to maintain their stability. Before we proceed, you need to understand a concept called bank runs where fear fuels customers to withdraw their money from a bank especially when solvency concerns are involved. If a bank does not have enough reserves backing its fiat deposits, then it will not have enough money to give back to its customers.

The bank run risk

What if a bank run type of situation occurs in the crypto market and a stablecoin does not have enough fiat backing it? Such an event would likely knock the stablecoin off its peg, thus causing losses. A black swan event can potentially cause such a situation, leading to potentially huge losses if a mass withdrawal took place. Tether, the most popular stablecoin cryptocurrency has lately been under scrutiny due to concerns that it is not fully backed especially after the continued minting of more USDT.

Tether claims to be 100% backed by other assets, including the U.S dollar but the interesting thing is that cash, only accounts for 3.87% and commercial paper accounts for the lion’s share at 65.39%. Roughly 9.96% of USDT is backed by corporate bonds, precious metals, and funds, while 12.55% of USDT is backed by secured notes.

Although it is a good thing that USDT has a diversified approach to the assets backing it, the main concern is how liquid those assets are. Will users be able to redeem them quick enough to avoid loss of value? At least it is more backed than banks that have fractional reserves.

What about decentralized stablecoins?

Decentralized stablecoins have also been gaining popularity because they do not have to be backed by fiat money. They can also be backed to whatever asset that holds value although most are pegged to the value of a fiat currency. DAI is currently one of the most popular decentralized stablecoins and it maintains its peg to the U.S dollar through collateralized crypto debt maintained by smart contracts on a decentralized ledger.

Maker DAO, the organization that developed DAI rolled out an overcollateralized approach that plays an important part in disincentivizing users from liquidation. It also uses debt auctions when users cannot take over the collateral shortfalls in the vault. DAI leverages robust mechanisms that allow it to hold its peg but that does not mean that it is completely safe from a black swan event. However, one could argue that it is better positioned to recover quickly compared to USDT.

Summary

The good thing about stablecoins is that they come in different varieties for users to choose from. If you are not comfortable with USDT, you can switch over to others such as USDC which is 100% backed by USD reserves. DAI makes a more appealing case for those that want to use a fully decentralized approach. The fact that the above stablecoins are pegged to the USD means their value will fall in case the US dollar’s value plummets. This can be a concern especially when you consider the rising inflation rates in the U.S., and it seems like a higher risk than a bank run on USDT.