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What are Stablecoins and How to Earn Passive Income

What is a stablecoin? Find out about the different types of stablecoins and why you should invest in them

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Are stablecoins a good investment?

Stablecoins are gaining steam as a viable option for those who wish to invest in crypto without exposing their assets to the risks associated with cryptocurrencies’ notorious volatility. Indeed, compared to regrettably low-interest rates that EU banks usually offer to their customers, investment in stablecoins can yield up to 10 times as much without dragging all crypto-related risks into the game, rendering stablecoins one of the best passive crypto income investment options available.

Yet, stablecoins are not as successful as Bitcoin in terms of public awareness, so it is likely that some prospective users have hardly heard about them. In this article, we will cover the basics of stablecoins one should know to use and profit from them, and why you should include stablecoins as part of your investment portfolio.

What are Stablecoins?

Simply put, a stablecoin is defined as a type of cryptocurrency that is backed by or pegged to another asset in order to make its price steady and completely avoid any fluctuations. Those backing assets can include fiat currencies, currency baskets, commodities, other cryptocurrencies, and virtually anything of value. It is safe to say that stablecoins are a fully digital incarnation of real-life physical assets. Each type of backing corresponds to a specific kind of stablecoin. We’ll discuss those different kinds in greater detail later on in this article.

The most popular stablecoins at the time of writing are as follows:

  • USDT aka Tether, the first stablecoin to be issued and by far the most prominent.
  • EURL (Lugh) developed by Société Générale in cooperation with the notable blockchain company Nomadic Labs, a stablecoin pegged to Euro and specifically designed to fully comply with relevant EU regulations and bylaws.
  • USD Coin (USDC), another USD-backed stablecoin that acts as the direct rival and competitor of USDT.
  • DAI, a mixed breed of stablecoin pegged to USD but backed by Ether, is an early example of algorithmic stablecoins whose supply is governed automatically by smart contracts rather than by a person or even a company.
  • TerraUSD (UST), a USD-pegged stablecoin which uses on-chain mint and burn arbitrage mechanics, where traders can swap $1 of UST for $1 worth of LUNA.

If you're new to cryptocurrency, stablecoins are worth considering, as you'll be able to earn higher interest on your deposits, while being protected to some degree against the notorious volatility of the crypto market. By choosing stablecoins like the USDT and USDC, which are pegged to the USD, you'll have the additional guarantee of the issuers that your USDT and USDC are redeemable for 1 USD each.

How do Stablecoins Work?

In most cases, the public demand goes for stablecoins backed by U.S. dollars at the ratio of 1:1. Other options that are pegged to gold or other cryptocurrencies are relatively rare. Thanks to this, USD-backed stablecoins combine the stability of the exchange rate with the practical convenience and high speed of cryptocurrency payments, which is exactly what made those digital coins popular in the first place. The stable exchange rates make stablecoins a safe store of value for traders in between trades, as it completely mitigates the risks of price fluctuations overwhelming their profit.

At Cabital, we’ve chosen USDT because the stablecoin is fully backed by an equivalent amount of USD in cash and cash equivalents in reserves. Tether’s consolidated total assets amounted to almost $35.3 billion as of February 2021, while the value of the stablecoins issued stands at $35.1 billion. 

Because of the demand from investors, stablecoins offer a high interest rate compared to those usually found in banks dealing with savings accounts. This makes stablecoins a great weapon of choice for those wishing to earn more on their savings without risking too much or entering the grey area commonly associated with cryptocurrencies. 

Are Stablecoins Safe?

Asset-Backed Stablecoins

They are subject to specific regulations, such as the EU’s proposed MICA framework (Markets in Crypto-Assets), ensuring full compliance with international monetary laws. This makes stablecoins a great choice for those generally unwilling to risk dealing with cryptocurrency due to legal and/or economic concerns.

Also, the backing of most stablecoins is subject to independent audit as it is imperative to prove that the backing of those crypto-assets actually exists. This adds another layer of financial security to those who use stablecoins on a regular basis, as they have the reassurance that they can convert their holdings back into fiat currency at a fixed exchange rate.

There’s also been talks about subjecting issuers to disclosing the assets that back stablecoins on a monthly basis and auditing reserves quarterly, to ensure that there is sufficient backing for all the stablecoins in circulation. 

Algorithmic Stablecoins

These are potentially less safe than asset-backed stablecoins, as they rely on a set of smart contract algorithms to maintain their peg by increasing or decreasing the supply of tokens according to market conditions. If they are unbacked by sufficient collateral, these algorithmic stablecoins can potentially depeg from the dollar during periods of extreme market volatility. 

How do Stablecoins Make Money?

Centralised stablecoins, like USDT (Tether) and USDC, make money through lending and investing, in a manner similar to traditional banks. They do these through fractional reserve banking, where only a fraction of deposits are backed by physical cash on hand that can be withdrawn by investors. Stablecoin issuers operate on the assumption that not everyone will be redeeming their stablecoins for dollars at the same time, freeing up capital for investing.

For example, a part of Tether’s Asset Breakdown include commercial papers and treasury bills, which are short term debts that are issued at a discount to its full value, and the investor receives the full value back when the debt matures. Other investments include corporate bonds, funds, precious metals, and even other digital assets. 

As a user, you’ll also incur fees when you deposit fiat money for USDT, or when you withdraw your USDT as fiat money through Tether. The fee is 0.1%, which doesn’t sound too much, but with a current minimum fiat withdrawal or deposit of 100,000 USD, the fees start at US $1,000. This also dissuades users from making low-volume redemptions. 

If the minimum amount (and fees) of redeeming directly through Tether are too high for you, you can also withdraw your USDT via Cabital, by converting your crypto holdings into supported fiat currencies (EUR, GBP and CHF). With a minimum withdrawal limit of EUR 25, GBP 20, or CHF 25, you’ll be able to turn your crypto into cash according to your liquidity requirements.

Stablecoin vs Bitcoin

As a cryptocurrency, stablecoins are inevitably compared to Bitcoin, the first currency of this kind. Nonetheless, while they share some technological fundamentals, such as the use of blockchain technology, there are more differences than common features between them. In brief, Bitcoin and stablecoins are different in the following terms:

  1. Their value and economic nature.
  2. Their technological essence.
  3. The presence of backing.
  4. Their legal position in different jurisdictions.
  5. The extent of risks involved.

First of all, Bitcoin is a speculative tool with a higher volatility rate, and its price rises and crashes down like the ocean tide on a stormy day. Unlike stablecoins, Bitcoin works very poorly both as money and as a store of value. Indeed, it’s quite unreasonable to use something with an extremely unsteady price as a means of payment or as a safe haven. Stablecoins, on the other hand, work perfectly as day-to-day money; are similar to fiat in terms of value storage, and can successfully be used for investment without too much of a risk. After all, unlike Bitcoin’s, a stablecoin’s price remains the same by definition.

Secondly, Bitcoin is backed solely by its own supply rate, the complexity of puzzle-solving required for its mining, and the extent of faith crypto-traders have in it. On the other hand, stablecoins are not mined but released to represent the units of an existing asset on the blockchain, and those assets are actually audited and accounted for. 

Stablecoins usually require independent auditors and fully compliant bank accounts. Therefore, they are well within the legal framework of the developed world, especially in the U.S. and the European Union. Nonetheless, Bitcoin is downright banned in some jurisdictions, seriously frowned upon in others, and usually involves troubles with bank accounts and barrages of questions from tax authorities. 

It all basically means that Bitcoin is much riskier when compared to stablecoins. The losses one may incur due to Bitcoin trading can be enormous, but so can profits. Stablecoins, on the other hand, offer a more reasonable alternative where risks are comparable to those present in a regular bank handling your savings account while profits are much higher.

That is not to say, of course, that stablecoins are completely risk-free. Their risks mostly have to do with those faced by banks or certified auditors as the availability of the backing directly depends on their continuous operation.

Table 1. Comparison of practical aspects of Bitcoin and stablecoins

In the end, preferring Bitcoin or stablecoins comes down to its intended use, so it would be unreasonable to say that one is fundamentally better than the other. Thus, if your goal is to make profits from risky trading, Bitcoin is obviously more suitable for such purposes due to its high volatility and popularity. Still, if your goal is to profit in the mid to long term, investing in your stablecoins seems like a more viable option due to their low volatility. 

Are Stablecoins Securities?

This is the question that might pop up for everyone remembering how the ICO craze of 2017 was cut short by the decision of the U.S. regulator, the Securities Exchange Commission, to apply the securities bylaws to tokens issued by projects to raise funds. The American regulator’s opinion is usually taken for an example by securities authorities in other countries, most notably European Securities and Markets Authority (ESMA), so it often comes down to their judgement.

So, are stablecoins actually securities? To answer this question, it is worth remembering the so-called Howey Test used by the SEC. Basically, it says that whatever you are dealing with is indeed security and has to be treated as such if it meets all four requirements listed below:

  1. It is an investment of money.
  2. The investment was made to a common enterprise.
  3. The investment was made with the expectation of profit.
  4. The profit was expected solely from someone else’s effort.

Legally speaking, this divides all stablecoins into two distinct groups. In practical terms, regulators usually consider items 1 and 3 through 4 met by default when it comes to stablecoins. What really matters, therefore, is whether you are dealing with a common enterprise. So, for the stablecoin to be viewed as a security, the money you spend buying stablecoins must go to the common pool of funds set by the issuer and used for profit-making.

The table below can be used as a brief guideline to determine whether the stablecoin in question is a security.

Table 2. A brief description of what makes stablecoin a security

That said, to be sure you are on the safe side, you should seek professional legal counselling or work with a company like Cabital that ensures full legal compliance for its customers.

Types of Stablecoins

As mentioned above, stablecoins are primarily different in what is used as their backing. The type of asset underpinning a given stablecoin determines not just its relative price but also its intended use. Below we listed the most widespread kinds of stablecoins as well as their most fundamental features.

Fiat-collateralised Stablecoins

  • Uses a fiat currency or, more rarely, a basket of fiat currencies (most likely the most stable ones like USD, EUR, JPY, SWF, and GBP) as collateral
  • The most popular type of stablecoins
  • Good for day-to-day payment or making an investment
  • Regulated and audited
  • Typical specimen: Tether (USDT)

Commodity-collateralised Stablecoins

  • Most likely uses a precious metal like gold or silver as collateral
  • Offers full backing but redemption is usually complex and takes several phases as it covers working with actual gold and certificates
  • Regulated and audited
  • Price follows the price of the chosen commodity
  • Popular among some long-term investors
  • Typical specimen: Digix Gold Token (DGX)

Crypto-collateralised Stablecoins

  • Uses other cryptocurrencies as collateral
  • Fully decentralized
  • Usually unregulated, auditing is not mandatory 
  • Good for speculations, often used at decentralized exchanges as a replacement for fiat
  • Moderately popular mostly among daily traders
  • Typical specimen: DAI

Non-collateralised Stablecoins

  • Not backed by any actual asset but governed algorithmically (hence the alternative moniker, algo-stablecoins)
  • Supply and demand are automatically regulated in such a way as to keep the price at the same level
  • Unregulated, auditing is not mandatory
  • In need of continuous growth of capitalization to remain stable
  • The least popular kind of stablecoins, sometimes regarded as non-stablecoins
  • Typical specimen: Ampleforth

How to Make Money with Stablecoins

Similar to the assets they represent, stablecoins can be used to make an investment of some form. The properties of such an investment closely mimic the conditions you would have faced had you decided to use the non-digitized form of said assets. That being said, there are three fundamental ways of profiting from stablecoins.

Earn Interest on Stablecoins

In this case, you have a third party, like Cabital, to work with your stablecoins. Simply put, you deposit the desired amount of stablecoins, which the company then uses to make secured loans to other parties. At the end of the agreed period, you get your money back plus the interest accrued over time. This allows you to enjoy passive income while spreading the lending risks. This works well with fiat and commodity-collateralized stablecoins. Cabital works with USDT as it is fully audited and compliant with stablecoin regulations in key jurisdictions.

Lending Stablecoins on Your Own

This option is quite similar to the previous one except you handle crypto lending on your own, and therefore, bear all the risks yourself. On a platform like Compound, you can borrow and lend cryptocurrency on a short term basis, moving your assets around liquidity pools in a constant chase for the one currently offering the highest annual percentage yield (APY). In order to fully enjoy this method, you have to duly research all lending outlets present on the market, assess the risks, sometimes handle the paperwork etc. Knowing all the nuts and bolts of the industry is a must here, otherwise, risks get way higher, and compared to the method above they are elevated by default. 

Staking Stablecoins

If you lock your stablecoins to ensure the proper operation of the entire network they circulate on, the network will pay you rewards for doing so. This process is called staking and is quite common in systems using the Proof-of-Stake algorithm. A user puts their money in a special wallet, node, or platform and does not access it. In exchange, they get a stake in the system in the form of network voting rights, mining rewards, or other perks as the case may be. Similar to making a bank deposit in more than one way, this method returns a small but surefire interest. This method suits those interested in the technological advancement of the cryptocurrency in question as the economic stimulus might be negligible.

Afterword

All in all, dealing with stablecoins is one of the best ways for an investor with a moderate risk appetite to profit from cryptocurrencies. They offer a wide range of collateralisation options fitting different investment tastes and generally represent a decent way to hedge against the risks normally inherent in crypto. While not entirely risk-free, they offer more financial reliability and legal safety than any other kind of crypto asset.

This article has been prepared by Cabital Fintech (LT) UAB  (the “Company”) and is general background information about some of the Company’s activities at the date of this presentation.

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