A stablecoin is a cryptocurrency whose value is fixed to another asset, often currencies such as the U.S. dollar or the euro, though other assets are possible. This kind of crypto coin tracks the underlying asset, making its value stable over time, at least relative to the currency it’s pegged to. In effect, it’s as if the underlying asset has gone electronic, for example, like a digital dollar.
Because their goal is to track an asset, stablecoins are often backed by the specific assets they’re pegged to. For example, the organization issuing a stablecoin typically sets up a reserve at a financial institution that holds the underlying asset. So, a stablecoin could hold $100 million in reserve and issue 100 million coins with a fixed value of $1 per coin. If a stablecoin’s owner wants to cash out the coin, the real money can ultimately be taken from the reserve.
This structure stands in contrast to most cryptocurrencies, such as Bitcoin and Ethereum, which are backed by nothing at all. Unlike stablecoins, these other cryptocurrencies fluctuate greatly, as speculators push their prices up and down as they trade for profits.
While many stablecoins are backed by hard assets, others are not. Instead, these others use technical means (such as destroying some of the coin supply in order to create scarcity) to keep the price of the crypto coin at the fixed value. These are called algorithmic stablecoins, and they can be riskier than stablecoins backed by assets.
Why are stablecoins used in crypto trading?
Stablecoins solve one of the key problems with many mainstream cryptocurrencies, namely, that their drastic fluctuations make it tough, if not impossible, to use them for real transactions.
“Digital currencies like Bitcoin and Ethereum are tremendously volatile, which makes pricing things in their terms very difficult,” says Anthony Citrano, founder of Acquicent, a marketplace for NFTs. “Stablecoins avoid this issue by locking their prices to a known reserve currency.”
In addition, their stability allows many stablecoins to be used as a functional currency within a crypto brokerage. For example, traders might convert Bitcoin into a stablecoin such as Tether, rather than into dollars. Stablecoins are available 24/7, making them more accessible than cash obtained through the banking system, which is closed overnight and on weekends.
Stablecoins can also be used with smart contracts, which are a kind of electronic contract that is automatically executed when its terms are fulfilled. The stability of the digital currency also helps circumvent disagreements that could arise when dealing with more volatile cryptocurrencies.
What are some of the most popular stablecoins?
Stablecoins don’t usually get the same press (and hype) as other cryptocurrencies, in part because they don’t offer the same type of “get rich quick” opportunity. But a few are among the most popular cryptocurrencies by market capitalization, as of May 2022:
- Tether (USDT): $82 billion
- USD Coin (USDC): $49 billion
- Binance USD (BUSD): $17 billion
Of course, the size of these coins pales in comparison to the largest cryptocurrencies, such as Bitcoin, with a market cap of nearly $560 billion, and Ethereum, valued at more than $242 billion.
TerraUSD, an algorithmic stablecoin, had been another popular option, but it lost its peg to the dollar in May 2022. This stablecoin used other cryptocurrencies and a sophisticated system of arbitrage to maintain its valuation at the 1:1 level. But the decline in crypto markets and the subsequent loss of confidence in the stablecoin have sent its price plummeting lower.
What are the risks of stablecoins?
At first glance, stablecoins may appear to be low risk. In comparison to popular cryptocurrencies that are backed by nothing, they are. But stablecoins present some typical crypto risks and at least one of their own kind of risk, too:
- Security: Like other cryptocurrencies, stablecoins must be held somewhere, whether it’s your own digital wallet or with a broker or exchange. And that presents risks since a given trading platform may not be secure enough or may have some vulnerabilities.
- Counterparty risk: While it may seem like cryptocurrency is highly decentralized, in reality you’re dealing with several parties in a transaction, including the bank holding the reserves and the organization issuing the stablecoin. They must be doing the right things (security, properly reserving, etc.) for the currency to maintain its value.
- Reserve risk: A key element of the stablecoin ecosystem are the reserves backing a stablecoin. Those reserves are the last backstop on a stablecoin’s value. Without them, the coin issuer cannot guarantee the value of a stablecoin with full confidence.
- Lack of confidence: If a stablecoin is not sufficiently backed by hard assets, especially cash, it could suffer a run and lose the peg against its target currency. That’s effectively what happened to the algorithmic stablecoin TerraUSD in May 2022, since it wasn’t backstopped by cash but rather by other cryptocurrencies. The price of the stablecoin broke and spiraled downward, as traders lost confidence in its ability to maintain the peg.
“The primary risk of stablecoins is that they aren’t fully backed by the reserve currencies they say they are,” says Citrano. “In an ideal situation, the issuer of the stablecoin has enough reserves of the currencies (in cash or other highly liquid, safe investments) to fully support the stablecoin. Any less than 100 percent and risk is introduced.”
How safe are stablecoins?
- About 76 percent of its reserves are held as cash or cash equivalents (the vast majority of which is short-term corporate debt, also known as commercial paper).
- Almost 13 percent is secured loans.
- Nearly 10 percent is corporate bonds, funds and precious metals.