While cryptocurrencies and the crypto ecosystem may present interesting and rewarding opportunities, many cryptocurrencies are extremely volatile.
You might not want to spend a bitcoin if you think its price could increase 10-fold within a year. Or you may not want to borrow a cryptocurrency that’s value could drop after you receive the funds. Additionally, it can be difficult and costly to move money between traditional financial systems and cryptocurrency networks.
Stablecoins help crypto users address both of these concerns.
What are stablecoins?
As the name implies, stablecoins are cryptocurrencies that are designed to offer stability within a cryptocurrency system. They’re often pegged (i.e., have a fixed exchange rate) to a fiat currency, such as the US dollar.
“In an ecosystem like cryptocurrencies, where volatility is typically high, this is an important property,” says Paul Brody, principal and global blockchain leader at Ernst & Young. “If you want to take advantage of blockchain technology without exposing yourself to the volatility in crypto prices, this is the way to do it.”
For example, one USD Coin (USDC) is intended to always be worth $1. While the dollar’s purchasing power could change over time, it’s much less volatile than cryptocurrencies.
There are also stablecoins that are pegged to a commodity, such as gold or oil, but fiat-pegged stablecoins are currently the most popular options.
How do stablecoins work?
A stablecoin’s pegged value is what makes it useful within the world of crypto. But that’s possible only if coin holders can be assured they’ll be able to cash out their stablecoins. To ensure this can happen, stablecoin creators hold onto reserves of other currencies or assets.
“This is called collateralization,” explains Stephen Stonberg, CEO of Bittrex Global, a cryptocurrency trading platform. “Apart from being tied to another asset, collateralization also includes the buying and selling of affiliated assets through algorithmic mechanisms.”
For instance, a stablecoin issuer may promise to hold $1 in a bank account for each of the cryptocurrency coins it creates. As long as the collateral – or reserves – are available, coin holders know that they’ll be able to exchange a coin for $1. However, there’s a risk that the stablecoin issuer doesn’t actually have enough reserves.
Government agencies have discussed ways to regulate stablecoins, and have taken action against organizations that may have misrepresented their reserve holdings. And stablecoin issuers may share some details about what and where they’re holding their reserves.
In the news: The issuers of the tether token (USDT), one of the most widely used stablecoins, were fined $41 million in October 2021 for allegedly misrepresenting that they had held the proper amount of US dollars in reserve to back their tokens.
Still, if you’re considering buying stablecoins, a lack of proper reserves is one potential risk to be aware of. “In my view, the only really acceptable answer is with an independent audit,” says Brody. “Not only do you need to know what assets are backing a particular token, if it’s an asset-backed token, but you also need the assurance that those assets are not pledged against other liabilities.”
Two common approaches to stablecoin collateral
Stablecoin issuers can choose how they want to hold the collateral for their stablecoins in reserves. The specifics vary depending on the stablecoin, but most fall into two categories:
- Off-chain or asset-backed collateral. Asset-backed stablecoins maintain reserves in non-blockchain assets. The safest options may be those that hold fiat currency in regulated accounts. But some may hold commodities, such as gold, in reserve. Or some keep part of the funds in fiat currencies and invest the rest of the collateral. “There’s a bit more risk here because major price changes in those assets could threaten the ability of token-holders to cash out,” says Brody.
- On-chain or crypto-backed collateral. Crypto-backed stablecoins use cryptocurrencies as collateral. You can deposit and lock other cryptocurrencies to create these stablecoins, and they’re generally over-collateralized to account for volatility. For instance, the stablecoin DAI is pegged to the USD (one DAI equals $1). But you could have to lock up $150 worth of ether (ETH) to create $100 worth of DAI.
“Another variation of stablecoins are on-shore and off-shore stablecoins,” says Stonberg, a reference to whether the stablecoin issuers keep the reserves within our outside the US, which could impact regulatory oversight. “Ultimately, there will be a market for both types of stablecoins.”
Quick tip: While creating crypto-backed stablecoins may require over-collateralization, you can swap cryptocurrencies for stablecoins or buy stablecoins through an exchange. Because new stablecoins aren’t being created – they’re only changing hands – you don’t need to offer additional cryptos or payment.
There’s another type of stablecoin that doesn’t have any collateral. Instead, they use automated algorithms to try to create or decrease supply and hold a steady price. However, these algorithmic or “seigniorage-style” stablecoins haven’t caught on.
How do people use stablecoins?
Stablecoins are primarily used in two ways.
First, you might want to keep money in the cryptocurrency system, but you don’t think it makes sense to invest in bitcoin (or a different cryptocurrency) right now. Holding the funds in a stablecoin could limit your risk. It’s a bit like keeping cash in a brokerage account while waiting to make an investment.
The other and perhaps more popular way that people use stablecoins is to participate in decentralized finance (DeFi) projects, such as crypto lending and borrowing platforms. Minimizing the volatility risk for users could make it easier to understand the cost (or profit) that can come from these transactions.
“For most companies and individual users, the ability to use stablecoins to manage risk while accessing DeFi and other online services is going to be the key value proposition and it’s certainly what our enterprise users are interested in,” says Brody.
The financial takeaway
For individuals and institutions alike, stablecoins let people stay in the crypto world without the risk that’s commonly associated with cryptocurrencies. In Stonberg’s eyes, “what’s unique and important about stablecoins is they represent the bridging of two worlds – cryptocurrencies and traditional finance.”
However, if you’re considering buying stablecoins or using them to lend or borrow money through a DeFi platform, know that there’s still risk involved.
Asset-backed stablecoins might not actually hold enough assets to fully collateralize their outstanding coin balance. And even if they’re over-collateralized, crypto-backed stablecoins could run into trouble if other cryptos experience major downswings.