What Are Stablecoins?

Stablecoins are a relatively new class of digital assets designed to offer price stability. Unlike other cryptocurrencies such as Bitcoin, stablecoins are pegged to the value of an external asset, such as a fiat currency like the dollar or the euro, or a physical asset like gold. Stablecoins attempt to bring together the innovations of cryptocurrencies — like speed of processing and the security and privacy of payments — with the stability (reduced volatility) of traditional fiat currencies and other commodities. 

Stablecoins can be bought and sold on cryptocurrency trading platforms just like other cryptocurrencies. They can be used as a store of value, a unit of account, or a “bridge” between fiat currencies and cryptocurrencies. Early stablecoins — beginning with Tether in 2014 — were primarily used to buy other cryptocurrencies, since most crypto platforms could not access the traditional banking system. Stablecoins offer investors who would like to gain exposure to the cryptocurrency market, but are more risk averse and want to avoid the volatility of crypto, a way to participate in the market.

As an asset class, stablecoins make up a growing share of the cryptocurrency market as a whole. In August 2021 Remarks before the Aspen Security Forum, U.S. Securities and Exchange Commission Chair Gary Gensler said that the existing stablecoins market is worth $113 billion. In that same month, Unstoppable Domains CEO Matthew Gould predicted that the stablecoin market would hit $1 trillion by 2025.

The applicability of stablecoins goes far beyond cryptocurrency trading and decentralized finance. As noted recently in the Harvard Business Review, “stablecoins have the potential to play an important (if yet to be defined) role in the future of global finance. They could even become a backbone for payments and financial services.”

Types of Stablecoins

Fiat-Collateralized Stablecoins (off-chain stablecoins)

What many consider to be “true” stablecoins are fiat-collateralized stablecoins, which are fully backed — or “collateralized” — one-to-one by fiat currencies or treasuries held in reserves by the issuer of the stablecoin. Tether, the world’s third biggest cryptocurrency by market cap, is a fiat-collateralized stablecoin tied to the value of the U.S. dollar. Other examples of fiat-backed stablecoins are USD Coin (USDC), an Ethereum-based stablecoin launched in September, 2018; Gemini Dollar (GUSD), which is held in reserve at State Street Bank and Trust Company; and Binance USD (BUSD), a one-to-one USD-backed stablecoin issued by the cryptocurrency exchange Binance (in partnership with Paxos, the blockchain infrastructure platform).

Crypto-Backed Stablecoins (on-chain stablecoins)

Crypto-backed stablecoins are coins backed by other cryptocurrencies like Bitcoin or Ethereum. Since the cryptocurrencies backing these stablecoins are volatile, these crypto-collateralized stablecoins are typically over-collateralized with a greater than one-to-one asset-to-asset ratio to ensure the stabelcoin’s value. For example, $1 worth of stablecoin may be tied to a backing asset worth $2 (thus accommodating up to a 50% price swing). Crypto-backed stablecoins are less stable than fiat-backed stablecoins. An example of a crypto-backed stablecoin is Dai, which is regulated by MakerDAO (a decentralized autonomous organization) and runs on the Ethereum blockchain.

Algorithmic Stablecoins

Algorithmic stablecoins — unlike the other stablecoins discussed so far — are not backed by an asset. Instead, they use an underlying algorithm to provide price stability and balance the circulating supply of the asset. For example, if the price of an algorithmic stablecoin is pegged to the US dollar, so that one coin = $1 USD, and the price of the stablecoin rises, the algorithm would automatically increase the number of tokens in circulation. Ampleforth’s AMPL stablecoin, for example, has a protocol that automatically adjusts supply in response to demand daily, helping keep the price per AMPL around $1.

Commodity-Backed Stablecoins

Commodity-backed stablecoins are collateralized by physical assets such as gold, silver, or real estate. In essence, these stablecoins are blockchain representations of the commodities they are correlated to, and the physical reserve of these assets are used to back the stablecoin. These commodities often fluctuate in price, which means the corresponding stablecoin will also change in price as the commodity value moves up and down. Commodity-backed stablecoins allow investors to invest in assets that they may not be able to obtain directly. Take for instance, gold. There are operational logistics involved in owning a physical gold bar: namely, obtaining it and securely storing it. An investor that wants to participate in the gold market could choose to buy a stablecoin like PAX Gold (PAXG) or Tether Gold (XAUT) that can then be exchanged for cash or used to gain custody of the underlying asset. It is important to note that not all commodity-backed stablecoins can be exchanged for the underlying asset.

Why Stablecoins Matter

Stablecoins offer investors a price-controlled place to park their funds digitally, if they are seeking to secure funds from potential losses in “bearish” crypto markets. While Bitcoin remains the most popular cryptocurrency, it has experienced drastic volatility many times over the past few years. In 2021, for example, Bitcoin first reached $65,000 in April, only to plummet over 50% in June and then made its way to over $67,000 in November of the same year. 

The fact that some cryptocurrencies experience these major swings in both directions, makes them difficult assets for day-to-day transactions because the value of one’s holdings can change at any given moment. On the other hand, stablecoins offer crypto exposure with relatively steady value, when compared to other cryptocurrencies. This inherent price stability means that stablecoins are suitable in applications where Bitcoin and other highly volatile cryptocurrencies are not. Everyday digital payments, as well as cross-border remittances both require stable currency valuation, and stablecoins are increasingly being used for these purposes. 

Stablecoins also offer the benefits of the blockchain — the distributed database that acts as a digital ledger for cryptocurrency transactions — without the volatility of Bitcoin. This makes them highly useful in the development of decentralized finance (or “DeFi”) applications, which seek to reimagine the financial services landscape using digital currencies running on Ethereum-based smart contracts. 

Should You Buy Stablecoins?

Although in theory stablecoins are built to offer more stability than other more volatile cryptocurrencies, they are still a new technology and a class of cryptocurrency. Investors looking to explore stablecoins should do their research before buying and investing in this asset class. Just like any other cryptocurrency investment, there is risk involved. Investors who do decide to purchase stablecoins should only invest money they are willing to lose. Commodity-backed stablecoins also carry potential risks with regard to how the reserve assets backing the stablecoin are held and maintained. The future of stablecoins is still very undecided, with increasing scrutiny by regulators and calls for oversight by politicians.

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