Intro to stablecoins
You can tell from the name that stablecoins are a type of cryptocurrency that is created to keep a fixed value over time. Usually, the value of a stablecoin is fixed to a real and specific currency, typically the U.S. dollar.
In this structure, one unit of the crypto usually equals one unit of the real currency, or rather dollars. Far from highly unstable cryptocurrencies like Bitcoin, stablecoins are not meant to vary.
This combination of digital-asset flexibility and traditional-asset stability has proven to be a wildly accepted idea. Stablecoins go after price stability by maintaining the reserve assets as collateral or through algorithmic formulas which control supply.
How do they work?
Since their goal is to track an asset, stablecoins are often supported by the specific asset they are fixed to. They track the underlying asset, making its value stable over time, at least relative to the currency they are fixed to.
This system stands in contrast to many cryptocurrencies, like Bitcoin and Ethereum, but they are not supported by anything at all. Unlike stablecoins, these cryptocurrencies vary greatly.
Other stablecoins that are not backed by assets use technical means to keep the price of the coin at a fixed value. They often destroy some of the coin supply to create a shortage. They are called algorithmic and they tend to be riskier than supported stablecoins.
Use of stablecoins
These stablecoins solve one of the main problems with mainstream cryptocurrencies, specifically, their drastic variations make it hard, if not impossible to use them for real transactions.
Being very stable allows them to be used as a functional currency within a crypto brokerage. Stablecoins are available 24/7, and they are more accessible than cash acquired via the banking system, which is closed on weekends and overnight.
Also, stablecoins can be used with smart contracts, and the stability of the digital currency helps to avoid disagreements that could happen when dealing with more unstable cryptocurrencies.
Stablecoins don’t usually get the same attention and hype as other cryptocurrencies, mostly because they don’t offer the same type of “get rich quick” opportunity.
With stablecoins you can:
- Minimize instability – many cryptocurrencies vary a lot, sometimes by the minute. An asset that’s fixed to a more stable currency can give users certainty that the value of their coins won’t crash or rise unpredictably.
- Save or trade assets – to hold stablecoins you don’t need a bank account, and they are really easy to transfer, too. Their value can be easily sent around the world, including places where the dollar or euro can be hard to obtain.
- Send internationally – low transaction fees and fast processing make stablecoins a good choice for sending money anywhere in the world.
- Earn interest – there are simple ways to earn interest, even higher than what a bank would offer, on a stablecoin investment.
Risks of stablecoins
At first look, stablecoins seem to be low risk. In comparison to other cryptocurrencies, they really are stable. However, stablecoins present some typical risks and at least one of their own kind.
Like any other cryptocurrencies, stablecoins also have to be held somewhere, whether it’s an exchange, with a broker, or your own digital wallet. This gives some risks since a trading platform may not be secure enough or it can have some vulnerabilities.
Even though it may seem like cryptocurrency is highly decentralized, in reality, there are several parties in a transaction, including the bank. They have to have security, proper reserving, etc. for the currency to keep its value.
The main element of the stablecoin ecosystem is the reserves which are supporting a stablecoin. They are the last backstop on a stablecoins value. Without them, the coin lender cannot guarantee the value of a stablecoin with full confidence.
Unfortunately, we witnessed a situation when stablecoin is not adequately backed by a solid asset, especially cash, it could suffer a run and lose the peg with its target currency. We are talking about TerraUSD, which faced a downward spiral when the price of the stablecoin broke in May 2022, because it wasn’t supported by cash or any other cryptocurrencies.
Are stablecoins safe?
So how can you tell if stablecoin is safe? It’s not only recommended, it essential that you read the fine print on the issuer’s statements. If the issuers don’t provide any reserve reports, you should be extremely cautious.
Even then, owners of stablecoins should be careful and pay attention to what is exactly backing their coin. And those who think that the actual dollar is completely supporting crypto should reconsider and be careful.
Unless a stablecoin commits to holding 100 or more percent of its reserves in cash, there is no warranty that the cash will be there to justify coins. In this particular case, the value of stablecoins can prove to be quite the opposite of stable.
In the end, the best guarantee of its safety is that people will come to accept it in exchange for services and goods.
Type of stablecoins
There are three types of stablecoins based on the mechanism used to balance their value.
These stablecoins keep a reserve of a fiat currency, such as the U.S.dollar, as collateral guaranteeing the stablecoins value.
Unlike other cryptos, with values that can alter wildly, fiat-collateralized stablecoins tend to have very small price variations.
But that’s not to say stablecoins are completely safe, they are still relatively new with a limited track record and unknown risks, and should be invested in with great caution.
The cryptocurrency exchange Coinbase offers a fiat-collateralized stablecoin called USD Coin (USDC), which can be exchanged on a 1-to-1 ratio for one U.S. dollar.
Crypto-collateralized stablecoins are supported by other cryptocurrencies. Because the reserve cryptocurrency can also be vulnerable to high instability, the value of cryptocurrencies that are held in reserves beats the value of the stablecoins issued.
These assets are less stable than fiat-collateralized stablecoins, and it’s a good idea to keep track of how the underlying crypto behind your stablecoin is doing.
Algorithmic stablecoins have an option when it comes to holding reserve assets. Their main difference is the strategy of keeping the stablecoin’s value stable by controlling its supply via an algorithm, usually a computer program running a formula.
It’s not that different from central banks, however algorithmic stablecoin issuers can’t rely on advantages a bank has, when in a crisis.
Precious metal-collateralized stablecoins
These stablecoins use gold or any other precious metal to help keep their value. These stablecoins are centralized and this protects them from crypto fluctuating.
For quite some time now, gold has been seen as a barrier to stock market instability and inflation.
What is next?
Given that cryptocurrencies are getting more popular and accepted, the role stablecoins play in the ecosystem is practically integral. Stablecoins bring steadiness to the DeFi, they provide easy trading of crypto and staking.
While constitutions of some countries may give some additional requirements and restrictions on stablecoin issuers, it is also expected that financial regulatory agencies and stakeholders continue to work closely on ways to promote financial innovation while minimizing risks.
As we mentioned above stable coins provide some stability that is truly lacking in most cryptocurrencies, making them unusable as real currency.