What is a Stablecoin?

The text, "stablecoin"

One thing that makes cryptocurrencies less attractive for payments is that their values can be highly volatile. If you’re interested in a cryptocurrency that maintains a more predictable price, stablecoins are worth learning about.

In this article, we’ll define what stablecoins are, explain the various available types, and explore different stablecoins’ advantages and drawbacks. We’ll also look at what the future may hold for this class of cryptocurrency.

A stablecoin definition

A stablecoin is a type of cryptocurrency that ties or ‘pegs’ its value to that of another financial instrument. The intention is for the stablecoin to closely track the value of the pegged instrument.

The goal is to provide a more reliable type of decentralized currency that could more easily be used as a means of exchange. Stablecoins give merchants and consumers more confidence that they will pay and receive the intended price. They also help participants in decentralized projects to collaborate, pooling resources without worrying about price variability.

Stablecoins help unbanked people conduct cross-border transactions with low fees, helping to boost crypto adoption. They aim to be a less speculative, more stable way to participate in crypto, compared with other cryptocurrencies.

Secured vs algorithmic stablecoins

There are two basic ways a stablecoin may be structured in order to help maintain its price or peg. It’s important to understand what mechanism is being used, since this may affect its stability.

The first type of stablecoin is secured by an asset. In this model, a quantity of the pegged asset is supposed to be held in reserve. The reserve’s value should be equivalent to the value of the quantity of that stablecoin in circulation. There are three different asset types that thus far have been used for secured stablecoins:

1. Fiat currency

By far the most popular fiat currency for stablecoins to date is the U.S. dollar. But there are also stablecoins pegged to the EU, GBP, and other currencies.

Since most transactions in the world are still conducted using fiat currency, stablecoins pegged to the dollar or other fiat currencies have been the most popular. But the inflation seen in many fiat currencies including the dollar since the end of the pandemic have pointed up a drawback of this type of stablecoin. As the dollar or Euro sees its value erode due to inflation, any stablecoin pegged to that traditional currency loses buying power as well.

Additionally, stablecoins with reserves held in fiat currency run counter to one of the main tenets of cryptocurrency: decentralization and the opportunity to transact outside of the requirements of centralized banks.

2. A commodity

A commodity-backed stablecoin is secured by a physical reserve of the chosen commodity. It could be tied to a reserve of gold, silver, oil, or other physical assets. Proponents believe commodities are less affected by inflation and may serve as a counter-cyclical hedge against stock-market fluctuations.

Detractors say commodity prices can be volatile too, as they can be influenced by investor sentiment about the economy and where the markets are headed. Commodities trading also tends to be controlled by large traditional institutions, making commodity-backed stablecoins less decentralized.

An interesting variant would be to back a stablecoin with a basket of commodities chosen to correlate with consumer purchasing power, analogous to the Consumer Price Index.

3. Another cryptocurrency

Stablecoins designed to operate in a more decentralized way use coins backed by another cryptocurrency. These stablecoins are supposed to hold reserves of their backing cryptocurrency in excess of their value in circulation as a hedge against volatility.

While this approach has the advantage of offering a 100% decentralized structure, an obvious negative is that volatility in a stablecoin’s underlying cryptocurrency could create instability for the stablecoin itself.

Algorithmic stablecoins

The second type of stablecoin is controlled by smart contracts. The smart contracts increase or decrease the supply of the stablecoin to keep the price stable. These stablecoins are usually not secured by a reserve.

This stablecoin structure is also sometimes called seigniorage. The available supply of the stablecoin is regulated to keep it on par with demand, helping to prevent price fluctuation.

Algorithmic stablecoins carry the risk of not being secured by reserves. On the other hand, proponents point out that algorithmic stablecoins are a truly decentralized product that shouldn’t be as impacted by turbulence in country-specific or global economies.

Examples of stablecoins

We’ve noted some of the most popular examples of each type below. Please bear in mind we’re not endorsing any particular stablecoin, just noting the coins that are popular in each category and have a track record of maintaining their peg.

Secured by fiat currency

Tether (USDT), Circle’s USDC, and Binance USD (BUSD) are the top three stablecoins when ranked by market capitalization. All three are secured by the US dollar, and are at or within a tiny fraction of their $1 target.

Secured by commodity

One of the best-known commodity-backed stablecoins is Pax Gold (PAXG). Each coin is backed by a troy ounce of gold stored in London. Note that commodity-backed stablecoins tend to have smaller daily trading volumes, making them less liquid than fiat-backed stablecoins. On the plus side, commodity-backed stablecoins can be redeemed for the commodity itself–in PAXG’s case, physical gold.

Secured by cryptocurrency

MakerDAO’s DAI leads the pack in size for a crypto-secured stablecoin. Debuted in 2017, DAI has over 5 billion coins in circulation. It’s the only crypto-secured stablecoin in the top five in terms of market cap. DAI runs on the Ethereum blockchain and is secured by collateralized debt held in Ether (ETH).

Algorithmic stablecoin

USDD and FRAX are both algorithmic stablecoins with substantial capitalization that have succeeded in keeping their price very close to their target $1. FRAX has garnered buzz for introducing the first fractional stablecoin, and for taking a hybrid approach–it is now partially collateral-backed and partly stabilized by its algorithm.

A brief history of stablecoins

You may be wondering how long stablecoins have been around, and what sort of track record they’ve built over time. They’re not exactly new, as the first stablecoins were introduced back in 2014. NuBits and BitShares’ BitUSD both debuted in that year. Also launched that year was RealCoin, which became Tether (USDT).

All of these three pioneers are still around, though NuBits struggled as the first algorithmic stablecoin. BitUSD was collateralized by another cryptocurrency. USD-backed Tether is the star of this initial crop.

As use of crypto increased over the past decade, public and regulatory pressure for more robust reporting has grown. In particular, issuers of asset-backed stablecoins have seen calls to demonstrate they in fact have the reserves they claim.

Stablecoins have proven popular over time. In the first quarter of 2023, the stablecoin marketplace was valued at $133 billion.

Their growth comes despite the fact that some stablecoins fail to maintain their peg. This fate befell BitUSD, which came untethered from its $1 target in 2017 and is no longer traded.

When stablecoins depeg

The largest stablecoin failure to date is that of TerraUSD (UST). Over the course of a week in May 2022, UST failed to sustain its $1 target value and crashed in price, wiping out an estimated half-trillion in value. It was backed by its own floating-price LUNA coin. For a while, investors were high on the future of Terra, sending the value of LUNA to $120.

But when investors lost confidence, the equivalent of a bank run occurred. Massive withdrawals within a short timeframe caused the value of both LUNA and TerraUSD to sink to near zero.

A hard fork at Terra in the aftermath of the implosion rebranded these two coins LUNA Classic (LUNC) and TerraClassicUSD (USTC). Neither has recovered their price peg–USTC is lately worth about 2 cents, while LUNC is worth a tiny fraction of a penny. It’s notable that on its new Terra blockchain, the platform hosts TerraKRW (KRT), a stablecoin backed not by another cryptocurrency but by the South Korean won.

Top exchange platform Binance saw a similar scare in February 2023. Sudden withdrawals of $2.3 billion in its dollar-backed BUSD stablecoin in the aftermath of the implosion of the FTX exchange caused the New York State Department of Financial Services to order Paxos to stop issuing BUSD.

The move seemed to help bolster confidence and equalize supply and demand. While the coin depegged and lost 9 percent of its value during the 4-day run, it has since recovered and is worth $1 again.

Know the risks of buying stablecoins

The price stability of stablecoins can be affected by many of the same problems that afflict other coins. These include:

  • New regulations on crypto that change the rules for how stablecoins operate
  • Counterparty risk that your buyer or seller may default on their obligation
  • Custody risk that the wallet holding your stablecoins could be lost, stolen, or hacked
  • Economic risks tied to what a stablecoin is pegged to
  • Price attacks and other market manipulation
  • Mismanagement by the issuing team

As with any investment decision, it pays to be diverse. Don’t put all your funds into a single stablecoin.

Always do thorough due diligence before investing in a stablecoin or any other cryptocurrency. As we saw with TerraUSD, things can change very quickly.

Analyzing a stablecoin

If you’re looking at getting into stablecoins, you should understand how to compare various stablecoins. Key questions to ask when you look at a stablecoin include:

  • How long has this stablecoin been around?
  • Is it secured by an asset, and if so what? Is there proof of reserves?
  • If it’s secured by another cryptocurrency, what is the price history of the latter?
  • Are there any lawsuits or regulatory action pending against this coin?
  • How liquid is this coin–how many shares are trading?
  • Has this stablecoin been able to maintain its target price?

That last question is the most important one. Not all stablecoins succeed in their goal of maintaining a set price, as we saw with Luna.

The future of stablecoins

The future of stablecoins looks promising as they continue to gain mainstream adoption and solve some of the key issues associated with cryptocurrencies. As more people become comfortable using stablecoins for daily transactions, we can expect to see increased demand and innovation in the space, with new stablecoin models being developed and existing ones evolving to become more efficient and user-friendly. Additionally, as central banks around the world explore the potential of issuing their own digital currencies, we may see stablecoins emerging as a significant alternative for those who prefer greater independence from the traditional financial sphere.

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