What Are Stablecoins and How to Best Use Them
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Stablecoins have become an essential piece in the cryptocurrency space. These crypto assets offer stability in a market with high volatility and price fluctuations. The demand for these digital assets is so high that the total stablecoin supply recently passed $164 billion. The biggest and most popular stablecoins are Tether (USDT) with a market capitalization of $114 billion, USD Coin (USDC) with $33 billion, and Binance USD (BUSD) with $69 million.
Aside from the many advantages of this digital currency, stablecoins have risks involved and have recently garnered a lot of attention from governments all over the world. Treasury Secretary Janet Yellen held meetings with the heads of the Federal Reserve, the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC) to discuss stablecoins and “to assess the potential benefits of stablecoins while mitigating risks they could pose to users, markets, or the financial system”. China's central bank is "quite worried" by the potential impact of global stablecoins on the international financial system, CNBC reported.
So, here's what you need to know about stablecoins and understand why governments are eager to regulate them.
In this article
What are stablecoins?
Stablecoins are a class of cryptocurrencies that are pegged to a fiat currency like the US dollar or the euro, or to exchange-traded commodities like gold. They are often backed by the asset they are pegged to, as a mechanism to keep the price stable.
Cryptocurrencies like Bitcoin (BTC) and Ethereum (ETH) are notorious for their volatility. Stablecoins try to tackle price fluctuations by tying the value of cryptocurrencies to other, more stable, assets, making them ideal for payments.
Stablecoins were created as a tool to more easily move in and out of more volatile cryptocurrencies without having to cash out into fiat currencies. This was especially welcome during the early days of cryptocurrencies. Back then, the biggest exchanges, which offered the most cryptocurrencies for trading, didn’t offer trading pairs with fiat currencies because of regulatory hurdles. So, the only way to exit the crypto market was to sell your cryptocurrencies for stablecoins and ride the storm out while holding stable assets.
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How do stablecoins work?
From a technological viewpoint, stablecoins are cryptocurrency tokens, so they all run on a blockchain, often Ethereum. They can be traded for other cryptocurrencies, withdrawn to a crypto wallet, and even traded for fiat currencies, depending on the exchange.
Stablecoins are pegged to an asset, often the US dollar. A custodian then holds the collateral for the stablecoin and releases the cryptocurrency tokens. For example, if a crypto exchange needs 1 million USD Coin (USDC), they would transfer $1 million to Centre, the company behind USDC, and Centre would mint and send the exchange 1 million USDC tokens. Centre would then keep the U.S. dollars as a collateral for the tokens, and offer them up to be redeemed in exchange for USDC tokens at a later date, which is then burned.
There are a few different types of stablecoins, each of which goes about pegging and backing their tokens in different ways. Here are some of the most common types of stablecoins.
Fiat-backed stablecoins
The most popular kind of stablecoin is that which is directly backed by fiat currency with a 1:1 ratio. The value of fiat-backed stablecoins is based on the value of the backing currency, which is held by a third-party regulated financial entity. The trust placed on the custodian of the backing asset is crucial for the stability of the price of the stablecoin. Fiat-backed stablecoins can be traded on exchanges and are redeemable 1:1 from the issuer.
USDT, the first successful fiat-backed stablecoin and still by far the biggest, was launched in late 2014 by a group called Tether Limited. Tether introduced a relatively simple concept for creating a cryptocurrency that maintained a stable price. It is pegged one-to-one to the US dollar and Tether claims that every token is backed by a dollar held in its reserves.
USDC is another stablecoin backed by the US dollar. It was launched in 2018 by Coinbase and Circle and has quickly gained market share.
Cryptocurrency-backed stablecoins
Cryptocurrency-backed stablecoins are issued with other cryptocurrencies as collateral, which is similar to fiat-backed stablecoins. However, the significant difference between the two designs is that while fiat collateralization typically happens off the blockchain with a regulated custodian, the cryptocurrency used to back this type of stablecoins is done on the blockchain, using smart contracts in a more decentralized fashion.
Since the reserve cryptocurrency may also be prone to high volatility, such stablecoins are “over-collateralized”—that is, a larger number of cryptocurrency tokens is maintained as reserve for issuing a lower number of stablecoins.
DAI is the most popular cryptocurrency-backed stablecoin. It is pegged to the U.S. dollar and backed by ether on the Ethereum blockchain. The value of DAI is kept stable through a dynamic system of over-collateralized debt positions, autonomous feedback mechanisms, and appropriately incentivized external actors.
Commodity-backed stablecoins
These stablecoins are often pegged to and backed by precious metals like gold and silver. Since they are pegged to commodities like gold, they are more susceptible to fluctuations in price. It is like holding digital gold. The most popular commodity-backed stablecoins are PAX Gold (PAXG) and Tether Gold (XAUT).
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How to best use stablecoins
The use cases for stablecoins are many. Like most cryptocurrencies, stablecoins are primarily used as a store of value and as a medium of exchange. Users can send money anywhere in the world in a matter of seconds. Let’s list the best and most common use cases.
- Minimizing volatility. Due to having a stable price, stablecoins are perfectly suited for reducing volatility. Instead of taking part in the fluctuations of other cryptocurrencies, traders and investors can instead park their holdings in stablecoins, and trade back into those cryptocurrencies at a better time.
- Earning interest. A way to put your stablecoins to work for you is to lend them out. Stablecoins currently offer high-interest rates, between 3% and 10% on most exchanges. The rates are especially high when the crypto market is bullish because there's a stronger demand for stablecoins from investors who plan to go long.
- Transferring money. Being a cryptocurrency, it is fast and cheap to send stablecoins, especially internationally. Instead of paying for wire transfers and waiting for days, a stablecoin transfer can be done in seconds and cost less than a dollar. They are a good choice to send money anywhere in the world.
- Investing. When buying a commodity-backed stablecoin, you are essentially investing in that commodity. Buyers of PAXG are exposed to a digital version of gold and subject to its price fluctuations. So, if the goal is to own digital gold, gold-backed stablecoins could be an alternative to physical gold.
Related: How to Invest in Crypto in 2021
Pros and cons of stablecoins
Pros
- High liquidity: Since most trading pairs on cryptocurrency exchanges are with stablecoins, stablecoins are highly liquid. The daily trading volume of USDT is even higher than BTC. Therefore, it is easy and fast to exchange them into other cryptocurrencies or fiat currencies if so desired.
- Low volatility: Because they are backed by fiat currencies and other assets, owners can be confident the value of each token will remain stable. They act as a safeguard against volatility and are a great tool to take advantage of when building a crypto portfolio.
- Speed and cost: Stablecoins are fast, cheap, and secure to send and receive. And because they are tokens on top of blockchains, they are accessible to anyone with an internet connection, 24/7.
Cons
- Counterparty risk: This risk is often ignored until it’s too late. The stablecoins are backed by reserves that a third party holds. But does the third party have the collateral it claims to have? Without more regulation, it is hard to know for sure. And if a run to redeem the tokens takes place and the collateral isn’t there, it can all quickly go to zero.
- Regulatory concerns: The U.S. government, China, and many other countries have already stated growing concerns regarding stablecoins, because they undermine fiat currencies and no government likes to lose power. Therefore, more regulation is on the horizon and it’s unclear how it will affect established stablecoins.
- Protocol-level risks: Especially in the Defi space, where stablecoins are programmed with smart contracts, there’s the risk for bugs to be found in the code and end up exploited. Stablecoin SafeDollar was exploited by attackers and the value quickly plummeted to $0.
FAQs
How many stablecoins are there?
There are over 150 stablecoins out there, but the biggest seven account for more than 90% of the total market share.
Can stablecoins lose value?
Yes. While it is not supposed to happen, they can lose value if the assumed collateral is not there, or if there’s a bug in the code of the smart contract that gets exploited.
What is the safest stablecoin?
The consensus is that USD Coin (USDC) is the safest fiat-backed stablecoin, and Dai (DAI) is the safest cryptocurrency-backed stablecoin.
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The bottom line
Even though stablecoins have some risks and disadvantages, they are an essential part of the whole cryptocurrency space. Their ability to remain stable in this highly volatile space is a welcome feature and offers a safe haven for traders and investors. They have also become an attractive alternative to keeping your dollars in a savings account since the interest offered on stablecoins dwarfs the rates offered on US dollars by banks.
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Writer
Claudio is a freelance copywriter specialized in finance and cryptocurrencies. Besides writing, he is interested in biohacking, trading cryptocurrencies and being curious.
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