What Are Stablecoins?
Stablecoins are cryptocurrencies whose value is pegged, or tied, to that of another currency, commodity, or financial instrument. Stablecoins aim to provide an alternative to the high volatility of the most popular cryptocurrencies, including Bitcoin (BTC), which has made crypto investments less suitable for common transactions.
KEY TAKEAWAYS
- Stablecoins are cryptocurrencies that attempt to peg their market value to some external reference.
- Stablecoins are more useful than more-volatile cryptocurrencies as a medium of exchange.
- Stablecoins may be pegged to a currency like the U.S. dollar or to the price of a commodity such as gold.
- Stablecoins pursue price stability by maintaining reserve assets as collateral or through algorithmic formulas that are supposed to control supply.
- Stablecoins continue to come under scrutiny by regulators, given the rapid growth of the $128 billion market and its potential to affect the broader financial system.1
Why Are Stablecoins So Important?
Though Bitcoin remains the most popular cryptocurrency, it tends to suffer from high volatility in its price, or exchange rate. For instance, Bitcoin’s price rose from just under $5,000 in March 2020 to over $63,000 in April 2021 only to plunge almost 50% over the next two months. Intraday swings also can be wild; the cryptocurrency often moves more than 10% in the span of a few hours.2
All this volatility can be great for traders, but it turns routine transactions like purchases into risky speculation for the buyer and seller. Investors holding cryptocurrencies for long-term appreciation don’t want to become famous for paying 10,000 Bitcoins for two pizzas. Meanwhile, most merchants don’t want to end up taking a loss if the price of a cryptocurrency plunges after they get paid in it.
To serve as a medium of exchange, a currency that’s not legal tender must remain relatively stable, assuring those who accept it that it will retain purchasing power in the short term. Among traditional fiat currencies, daily moves of even 1% in forex trading are relatively rare.
As the name implies, stablecoins aim to address this problem by promising to hold the value of the cryptocurrency steady in a variety of ways.
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The market price of the TerraUSD (UST) algorithmic stablecoin in the early afternoon of May 11, 2022, after it broke its parity peg to the U.S. dollar.
What Kinds of Stablecoins Are There?
Some would argue that stablecoins are a solution in search of a problem given the wide availability and acceptance of the U.S. dollar. Many cryptocurrency adherents, on the other hand, believe the future belongs to digital tender not controlled by central banks. There are three types of stablecoins, based on the mechanism used to stabilize their value.
Fiat-Collateralized Stablecoins
Fiat-collateralized stablecoins maintain a reserve of a fiat currency (or currencies) such as the U.S. dollar, as collateral assuring the stablecoin’s value. Other forms of collateral can include precious metals like gold or silver as well as commodities like crude oil, but most fiat-collateralized stablecoins have reserves of U.S. dollars.
Such reserves are maintained by independent custodians and are regularly audited. Tether (USDT) and TrueUSD (TUSD) are popular stablecoins backed by U.S. dollar reserves and denominated at parity to the dollar. As of late July 2023, Tether (USDT) was the third-largest cryptocurrency by market capitalization, worth more than $83 billion.
You can invest in stablecoins like Tether on some of the best crypto exchanges and apps like Kraken and Coinbase.
Crypto-Collateralized Stablecoins
Crypto-collateralized stablecoins are backed by other cryptocurrencies. Because the reserve cryptocurrency may also be prone to high volatility, such stablecoins are overcollateralized—that is, the value of cryptocurrency held in reserves exceeds the value of the stablecoins issued.
A cryptocurrency worth $2 million might be held as reserve to issue $1 million in a crypto-backed stablecoin, insuring against a 50% decline in the price of the reserve cryptocurrency. For example, MakerDAO’s Dai (DAI) stablecoin is pegged to the U.S. dollar but backed by Ethereum (ETH) and other cryptocurrencies worth 150% of the DAI stablecoin in circulation.4
Algorithmic Stablecoins
Algorithmic stablecoins may or may not hold reserve assets. Their primary distinction is the strategy of keeping the stablecoin’s value stable by controlling its supply through an algorithm, essentially a computer program running a preset formula.
In some ways that’s not so different from central banks, which also don’t rely on a reserve asset to keep the value of the currency they issue stable. The difference is that a central bank like the U.S. Federal Reserve sets monetary policy publicly based on well-understood parameters, and its status as the issuer of legal tender does wonders for the credibility of that policy.
Algorithmic stablecoin issuers can’t fall back on such advantages in a crisis. The price of the TerraUSD (UST) algorithmic stablecoin plunged more than 60% on May 11, 2022, vaporizing its peg to the U.S. dollar, as the price of the related Luna token used to peg Terra slumped more than 80% overnight.5
A smart contract is a self-executing contract with the terms of the agreement between buyer and seller directly written into lines of code. The code and the included agreements are stored by a distributed, decentralized blockchain network. The code controls the execution of the agreement, and transactions are trackable and irreversible.
Stablecoin Regulation
Stablecoins continue to come under scrutiny by regulators, given the rapid growth of the around $130 billion market and its potential to affect the broader financial system.6 In October 2021, the International Organization of Securities Commissions (IOSCO) said stablecoins should be regulated as financial market infrastructure alongside payment systems and clearinghouses. The proposed rules focus on stablecoins that are deemed systemically important by regulators, those with the potential to disrupt payment and settlement transactions.
Moreover, politicians have increased calls for tighter regulation of stablecoins. For instance, in November 2021, Senator Cynthia Lummis (R-Wyoming) called for regular audits of stablecoin issuers, while others back bank-like regulations for the sector.
What Is the Purpose of Stablecoin?
Stablecoins aim to provide an alternative to the high volatility of popular cryptocurrencies, including Bitcoin (BTC), which can make cryptocurrency less suitable for common transactions.
How Does Stablecoin Work?
Stablecoins attempt to peg their market value to some external reference, usually a fiat currency. They are more useful than more-volatile cryptocurrencies as a medium of exchange. Stablecoins may be pegged to a currency like the U.S. dollar or to the price of a commodity such as gold or use an algorithm to control supply. They also maintain reserve assets as collateral or through algorithmic formulas that are supposed to control supply.
There are four main types of stablecoins in circulation: fiat-backed, commodity-backed, crypto-backed and algorithmic.
1. Fiat-Backed Stablecoins
Fiat-backed stablecoins are the cryptocurrencies most closely related to fiat (or traditional) currencies because they are backed by real-world currencies. Each fiat-backed stablecoin is tied to a specific fiat currency in a one-to-one ratio. The most common fiat currency to use is the U.S. dollar.
The stablecoin issuer ensures stability of their cryptocurrency by keeping fiat currency as collateral with a financial institution. The stablecoin always has a set amount of fiat currency in reserve that’s proportionate to the stablecoins it has issued. For example, if a stablecoin issuer has one million U.S. dollars in reserve, it might only offer one million stablecoins, each worth one U.S. dollar.
Examples of fiat-backed stablecoins include Tether (USDT) and USD Coin (USDC).
2. Commodity-Backed Stablecoins
Commodity-backed stablecoins are cryptocurrencies that use commodities such as gold, real estate or metals as collateral to provide their stability. Of these, gold is generally the most popular commodity used as collateral for commodity-backed stablecoins.
Examples here include Paxos Gold (PAXG) or Tether Gold (xAUT). These specific Stablecoins allow holders to participate in the gold market and have the utility benefits of a cryptocurrency without the challenges of physically owning gold bars.
3. Crypto-Backed Stablecoins
Crypto-backed stablecoins are cryptocurrencies that use one or more cryptocurrencies as collateral to provide their stability. These stablecoins use a mix of smart contracts on the blockchain to lock in cryptocurrency reserves instead of relying on a central financial institution to hold reserves like fiat-backed cryptocurrencies.
The process works like this: The buyer locks up their original cryptocurrency (e.g. Ethereum) in a smart contract in return for an equivalent amount in stablecoins. One of the more popular stablecoins to use this approach is the DAI stablecoin.
4. Algorithmic Stablecoins
Algorithmic stablecoins are the outlier in that they do not use any form of collateral to achieve their stability. Instead, these stablecoins achieve their price stability by using algorithms to control the supply and circulation of their tokens on the marketplace. These stablecoins will issue new tokens when the price of stablecoins goes above the target price or above the fiat currency it is tracking. This will reduce its price by increasing supply. Conversely, these stablecoins will stop issuing tokens if the price goes below the target, which will raise the price by limiting supply.
What are the most popular stablecoins?
To give you a taste of the experimentation happening in stablecoin land, let’s run through some of the most popular stablecoins.
Tether
Tether (USDT) is one of the oldest stablecoins, launched in 2014, and is the most popular to this day. It’s one of the most valuable cryptocurrencies overall by market capitalization.
The primary use case for USDT is moving money between exchanges quickly to take advantage of arbitrage opportunities when the price of cryptocurrencies differs on two exchanges; traders can make money on this discrepancy. But it has found other applications: Chinese importers stationed in Russia have also used USDT to send millions of dollars worth of value across the border, bypassing strict capital controls in China.
Tether Ltd. the company that issues USDT, was embroiled in a 22-month legal battle with the New York Attorney General over allegations Bitfinex (a sister company of Tether) tried to cover up an $850 million shortfall using funds taken from Tether.
Eventually, the case was settled on Feb. 23, 2021, with Tether and Bitfinex forced to pay $18.5 million and submit quarterly reports showing Tether’s stablecoin reserves for the next two years.
USD Coin
USD Coin is a stablecoin launched jointly by cryptocurrency firms Circle and Coinbase in 2018 through the Centre Consortium.
Like tether before its shift towards a mix of collateral assets, USD Coin is pegged to the U.S. dollar. USDC is an open-source protocol, which means any person or company can use it to develop their own products.
On July 8, 2021, Circle announced plans to go public through a $4.5 billion SPAC merger deal with Concord Acquisition Corp. The news came one month after Circle closed a $440 million funding round involving big industry names such as FTX, Digital Currency Group (the parent company of CoinDesk) and Fidelity Management and Research Company.
Read More: How USD Coin Works
Dai
Running on the MakerDAO protocol, dai is a stablecoin on the Ethereum blockchain. Created in 2015, dai is pegged to the U.S. dollar and backed by ether, the token behind Ethereum.
Unlike other stablecoins, MakerDAO intends for dai to be decentralized, meaning there’s no central authority trusted with control of the system. Rather, Ethereum smart contracts – which encode rules that can’t be changed – have this job instead.
Why Are Stablecoins Important to Cryptocurrency?
Stablecoins have become an important part of the cryptocurrency ecosystem because they provide a cryptocurrency option wherein stability is a key requirement of the financial transaction.
Stablecoins offer a way for consumers to use cryptocurrencies to buy financial products that require more stability such as mortgages and some insurances, thus opening up new markets and financial options for cryptocurrencies that were traditionally restricted to fiat currencies.
Cryptocurrencies are typically much more volatile than traditional assets such as stocks, commodities or currencies. For example, in May 2017, Bitcoin reached a price of $2,000 but then skyrocketed to an eye-popping $19,000 by December 2017. In 2020 as the world entered Covid lockdowns, Bitcoin’s price was around $7,000 but then skyrocketed again to over $19,000 by November 2020.
This volatility means it’s hard to predict and rely on the value of a cryptocurrency over the medium or long term. Without the ability to rely on the value of these coins, cryptocurrencies are less suitable for financial transactions that require a stable value over a longer period of time, such as real estate transactions.
Stablecoins were invented to fill this need and provide an important addition to the cryptocurrency marketplace. Stablecoins were created to provide stability, long-term purchasing power and the predictability of a fiat currency alongside the utility benefits of cryptocurrencies. These utility benefits may include fast and straightforward international money transfers without the expensive fees charged by banks.
Which Is the Best Stablecoin?
The most popular and largest stablecoin by market capitalization is Tether (USDT).1 It is pegged to the U.S. dollar at a 1:1 ratio and backed by gold reserves. It’s also consistently in the top five cryptocurrencies by market cap. You can find Tether on most major crypto exchanges, including Kraken, Binance, and Coinbase.
Investing in cryptocurrencies and other Initial Coin Offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual’s situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein.
Do stablecoins have any drawbacks?
There are a few drawbacks to stablecoin to keep in mind. Because of the way stablecoins are typically set up, they have different pain points than other cryptocurrencies.
If the reserves are stored with a bank or some other third party, another vulnerability is counterparty risk. This boils down to the question: Does the entity really have the collateral it claims to have? This has been a question frequently posed to Tether, for instance, over whether it maintains a true 1-1 backing between USDT tokens and U.S. dollars.
In the worst-case scenario, it’s possible the reserves backing a stablecoin could turn out to be insufficient to redeem every unit, potentially shaking confidence in the coin.
Cryptocurrencies were created to replace intermediary companies that are typically trusted with a user’s money. By their nature, intermediaries have control over that money; for example, they are typically able to stop a transaction from occurring. Some stablecoins add the ability to stop transactions back into the mix.
USD Coin openly has a back door to stop payments if coins are used in an illicit manner. Circle, one of the firms behind USDC, confirmed in July 2020 that it froze $100,000 of the stablecoin at the behest of law enforcement.
The Future of Stablecoin
Stablecoins have become a popular option for consumers wanting to own cryptocurrencies but who also desire the stability and predictability of fiat currencies. As of writing this article, the stablecoin market is worth nearly 140 billion U.S. dollars. The stablecoin with the highest market capitalization value is Tether, which is pegged to the U.S. dollar as its fiat-backed currency. Tether has a total market value of just over 66 billion U.S. dollars.
That said, some have called for more regulation around stablecoin given their rapid and popular growth. Stablecoins have significant potential to disrupt traditional payment systems and financial infrastructure while also being the clearest cryptocurrency competition to fiat currencies, which are carefully regulated by governmental bodies and central banks. This may mean stablecoin providers come under scrutiny as their cryptocurrencies displace traditional fiat currencies while providing new forms of financial products and platforms.
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