What is Stablecoin?

Simple answer, it’s a stable currency, just like the USD, GDP, Euro or Yen, however, its DeFi [Decentralized Finance] so not controlled by any bank or government, which they don’t like!

Stablecoins are de-risked cryptocurrencies whose value is pegged, or tied, to other assets, such as fiat currency or commodities held in reserve. The intent behind them is to create a crypto asset with low price volatility, which makes them better for use in transactions.

Key Takeaways

• Stablecoins are useful as a medium of exchange.

• Stablecoins peg their market value to some external reference.

• Stablecoins may be pegged to a currency like the U.S. dollar.

• Stablecoins pursue price stability by maintaining reserve assets as collateral.

• Stablecoins continue to come under scrutiny of regulators and world banks, as it has the potential to affect the broader financial system.

Stablecoins fall under the category of cryptocurrency however do not have the volatility of high-risk speculative cryptocurrencies like Bitcoin (BTC), which are coincided by many to be a Ponzie scheme.

Why Are Stablecoins So Important?

Though Bitcoin remains the most popular cryptocurrency, it tends to suffer from high volatility in its price. 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.

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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Investors should approach stablecoins cautiously because they require independent auditors to verify collateral or reserves. Auditors are another third party involved in a “decentralized” monetary system intended to remove third parties that have, historically, been the ones propagating fraud and unethical practices.

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 that is not controlled by central banks. With that in mind, four types of stablecoins, based on the assets used to stabilize their value, have been created.

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.

Such reserves are maintained by independent custodians and are regularly audited, something that should be considered cautiously. Tether (USDT) and TrueUSD (TUSD) are popular stablecoins backed by U.S. dollar reserves and denominated at parity to the dollar. As of late June 2024, Tether (USDT) was the third-largest cryptocurrency by market capitalization, worth more than $112 billion, with a total stablecoin market cap of over $200 billion.

Commodity-Backed Stablecoins

Somewhat of a sub-category of fiat-collateralized coins, commodity-backed stablecoins are cryptocurrencies that are pegged to the market value of commodities such as gold, silver, or oil. These stablecoins generally hold the commodity using third-party custodians or by investing in instruments that hold them.

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 generally overcollateralized—that is, the value of cryptocurrency held in reserves exceeds the value of the stablecoins issued.

Cryptocurrencies worth $2 million might be held as a reserve to issue $1 million in a crypto-backed stablecoin, insuring against a 50% decline in the price of the reserve cryptocurrency.

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.

Stablecoin Regulations

Stablecoins continue to come under scrutiny by regulators, given the rapid growth of the $200 billion market and its potential to affect the broader financial system. In October 2021, the International Organization of Securities Commissions (IOSCO) said stablecoins should be regulated as financial market infrastructure alongside payment systems and clearinghouses. Its proposed rules focus on stablecoins that are deemed systemically important by regulators, those with the potential to disrupt payment and settlement transactions.

In Europe, under the Markets in Crypto Assets Regulation, which took effect in 2023, algorithmic stablecoins are essentially banned, and all others must have assets held in custody by a third party. Reserves must be liquid and have a 1:1 ratio of assets to coins.

Is Stablecoin a Bitcoin?

Stablecoins are not bitcoins. Stablecoins aim to provide an alternative to the high volatility of popular cryptocurrencies, which can make cryptocurrency less suitable for common transactions.

How Do Stablecoins Work?

Stablecoins attempt to peg their market value to some external reference, usually a fiat currency. They are more useful than volatile cryptocurrencies as a medium of exchange. Stablecoins may be pegged to a currency like the U.S. dollar, 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.

Which Is the Best Stablecoin?

The most popular and largest stablecoin by market capitalization is Tether (USDT). It is pegged to the U.S. dollar at a 1:1 ratio and backed by reserves. It’s also consistently in the top five cryptocurrencies by market cap. You can find Tether on most major crypto exchanges, including Binance, Kraken and Coinbase.