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What Are Stablecoins and How Do They Work?

April 22, 2022
7
min

A stablecoin is a cryptocurrency just like Bitcoin or Ether. Stablecoins attempt to solve a challenging problem in the cryptocurrency market: volatility.

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The notion of something called a stablecoin may strike some as an oxymoron. Cryptocurrencies, after all, are synonymous with volatility in a market routinely whipsawed by hype and speculation. Yet stablecoins, as their name makes plain, are designed to be a haven from the forces that make investing in cryptocurrencies a white-knuckle ride.

Pegged to assets such as the U.S. dollar, stablecoins aren’t prone to the wild swings that rock Bitcoin and its ilk. These staid coins enable crypto traders to lessen the risk of their portfolios. Stablecoins have also become a useful tool investors can use to trade in the cryptocurrency market. They also form the basis for crypto lending, a growing market itself, and even more exotic algorithmic instruments. As a result, stablecoins have become an indelible part of the crypto ecosystem.

What is a stablecoin? 

A stablecoin is a cryptocurrency just like Bitcoin or Ether. It’s based on a blockchain, which is a decentralized online network. Blockchain development teams or companies can create and release stablecoins the same way they do other tokens, usually by solving complex math puzzles in a process known as proof of work (PoW). There are about a dozen major stablecoins on the market.

Unlike Bitcoin and Ether, stablecoins are pegged to a reserve asset such as the U.S. dollar or gold, or in some cases, other cryptocurrencies. Those reserve assets drive the value of the stablecoin, so if the dollar goes up, so, too, does a dollar-pegged token. Holders of stablecoins should be able to redeem their tokens for the underlying asset when they choose.    

What are the different types of stablecoins?

Stablecoins come in a few variations, but most are pegged to the U.S. dollar. 

  • Fiat-collateralized stablecoins. These tokens are backed by traditional or fiat currencies managed by central banks, as well as government bonds such as U.S. Treasuries. There are no standards governing how stablecoin issuers manage their reserves. As a result, some issuers are more transparent about their practices than others. Some are pegged on a 1-to-1 basis with the U.S. dollar and the reserves are held in custody by a bank. Other issuers are more opaque and don’t disclose details about their reserves. 
  • Metal-collateralized stablecoins. These assets are backed mainly by gold and silver, although some others are pegged to precious metals such as platinum and palladium. They appeal to investors who want stablecoins truly disconnected from central bank policies. Issuers hold reserves of bullion and in some cases investors can redeem their coins for gold, silver, or another metal. Otherwise, they function much the same as fiat-pegged stablecoins.
  • Crypto-collateralized stablecoins. This breed of stablecoins is pegged to Bitcoin, Ethereum, and other digital assets. They are typically used by sophisticated crypto investors to play in decentralized finance. Unlike fiat or metal-backed stablecoins, these tokens require a ratio of greater than 1-to-1 to offset volatility. So $5,000 worth of Ether may be needed to back $2,500 worth of stablecoins. Investors provide the reserves themselves by locking their collateral—cryptocurrencies—into a smart contract for a set period of time. (A smart contract is a software program that manages an agreement between parties.)
  • Non-collateralized or algorithmic stablecoins. These instruments rely on algorithms and smart contracts to regulate the number of tokens in circulation instead of a reserve asset. A software program automatically increases supply when the price of the stablecoin rises, and decreases supply when the price falls. 

How do stablecoins work?

Because they are cryptocurrencies, stablecoins are based on widely used networks such as the Ethereum blockchain. Stablecoins aren’t subject to the direct control of a central bank such as the U.S. Federal Reserve. Yet a stablecoin pegged to the U.S. dollar is indirectly affected by the Fed’s actions. If the Fed raises interest rates, for example, that could strengthen the value of the dollar and any stablecoins that are pegged to the currency. In periods of rising consumer prices, or inflation, the value of the dollar may fall. That, too, would affect the value of stablecoins supported by the greenback.

The management of reserve assets is a key factor in determining the value and credibility of a stablecoin. If doubts arise about the adequacy of the reserve backing the stablecoins in circulation, that could undermine their value. Regulatory officials at the U.S. Treasury and the European Central Bank have expressed concern about this potential flaw in the system and fear stablecoins could melt down and harm investors if they fail.

What is the point of a stablecoin?

Stablecoins provide a less speculative way for investors to operate in the cryptocurrency market. Think of them like the tickets you buy at carnivals. With them, you can go on the rides, try your luck at the ring toss, and buy cotton candy and popcorn. If you want to return the next day for more fun, you don’t have to cash in your tickets. You can just use them again, and they’ll be worth the same amount.  

Stablecoins do the same thing in the crypto carnival. By exchanging money for a stablecoin like USDC pegged to the U.S. dollar, a holder can swap them for other cryptocurrencies, maybe at a time when Bitcoin or Ethereum have fallen in value. In other words, using stablecoins may increase a holder’s purchasing power. About three-quarters of all trading on cryptocurrency platforms in 2021 involves the use of a stablecoin, according to the European Central Bank. 

Thanks to their minimal volatility, stablecoins hold their value during bear markets. This lets investors park their assets while they wait out the downturn without having to convert back into dollars or euros or other traditional currencies. On the flipside, of course, investors won’t reap gaudy returns during bull runs. But it’s easy for traders to quickly convert a stablecoin into the token of their choice when the market turns. 

Investors also use stablecoins as collateral for cryptocurrency loans. This is a burgeoning business in the decentralized finance, or DeFi, sector. Depositors place stablecoins with lending platforms to take out loans in other cryptocurrencies, and the lender doesn’t have to fret about the collateral melting down because it’s pegged to a hard currency.

Likewise, many investors make their stablecoins available to cryptocurrency exchanges to facilitate trades in what are called liquidity pools. Investors who engage in this practice are called liquidity providers, or LPs, and they reap fees for providing their stablecoins to platforms like Uniswap.

What are some examples of stablecoins?

There is a wide variety of stablecoins with differing levels of transparency.

  • Tether. As the most valuable cryptocurrency after Bitcoin and Ethereum as of March 2022, the U.S. dollar-backed Tether is a widely used stablecoin. It has also been the subject of controversy for the opaqueness of its reserves. Numerous news articles have questioned whether Tether has the dollars to back its stablecoin.
  • USDC. This dollar-pegged token is rapidly gaining on Tether. USDC is backed on a 1-to-1 basis by reserves and managed by a consortium, including Circle and Coinbase, that sets and publishes policy and technical standards. Circle has said the reserves are audited by an accounting firm.
  • MakerDAO. As one of the oldest platforms in decentralized finance, MakerDAO’s DAI has become one of the most widely used crypto-backed stablecoins in the market. It issues DAI in exchange for other tokens and maintains them in a smart contract. 
  • Tether Gold. This issuer backs each one of its stablecoins with one troy ounce of gold and holders can redeem the shares for physical metal.
  • Ampleforth. This algorithmic stablecoin is designed to help investors execute cryptocurrency trades by providing liquidity, or a flow of tokens, to exchanges. Ampleworth adjusts its token supply to maintain a steady price. 

What are the potential risks associated with stablecoins?

Because cryptocurrencies are largely unregulated, stablecoin providers don’t have to comply with industry standards.  

  • Lack of transparency. Some issuers do not disclose proof or data about their reserves making it impossible to know if they adequately support their stablecoins. There are no audit or reporting requirements in the industry. This raises fears the tokens may collapse. 
  • Lack of precision. Stablecoins often deviate in value from their underlying pegs which can undermine confidence in their usefulness. 

The bottom line

Stablecoins attempt to solve a challenging problem in the cryptocurrency market: volatility. As long as prices swing wildly it will be virtually impossible to build a viable new financial industry based on digital currencies. By pegging a digital token to the U.S. dollar or gold, issuers create a way to establish a degree of certainty in an otherwise uncertain business. Now exchanges, lenders, traders, and investors are using stablecoins to facilitate their activities. 

Yet many stablecoin issuers remain inscrutable when it comes to disclosing and auditing their reserves to prove they can support their tokens in circulation. If some or even one of these platforms were to crash, it could damage confidence in the entire sector.

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