Stablecoins: What You Need To Know
As people look to benefit from both the stability of traditional assets and the flexibility of digital assets simultaneously, stablecoins have become overwhelmingly popular, with coins worth over $113 billion already issued.
What Are Stablecoins?
Stablecoins are a digital currency pegged to a “stable” reserve asset such as the US dollar or gold, designed to reduce volatility relative to unpegged cryptocurrencies such as bitcoin. Because the price of stablecoins is pegged to a reserve asset, they bridge the worlds of crypto and fiat currency, such as the pound sterling, the euro, or the US dollar, significantly lowering the volatility of stablecoin when compared to a cryptocurrency such as bitcoin. Consequently, some consider stablecoins to be better suited to almost everything, including everyday commerce and making transfers between exchanges.
How do stablecoins work?
As the name suggests, stablecoins are designed to function with stability. Multiple sources back stablecoins, including fiat currency, but also other cryptocurrencies, precious metals and algorithmic functions. However, a crypto’s backing source can influence its risk level. For example, a fiat-backed stablecoin may have greater stability because it is linked to a centralised financial system that has an authority figure, such as a central bank, that can control prices when valuations become volatile. However, a stablecoin that isn’t linked to a centralised financial system, such as a bitcoin-backed stablecoin, may change dramatically because, in part, there isn’t a regulating body to control what the coin is pegged to.
Fiat-backed stablecoins: Investors use their fiat currency, whether it be US dollars or euros, to buy stablecoins that they are later able to redeem for their original currency. Unlike other cryptocurrencies that can fluctuate dramatically, fiat-backed stablecoins aim to have limited price fluctuations. However, this does not mean that there is no risk involved. It’s important to note that they are still relatively new and have a limited track record.
Crypto-backed stablecoins: This type of stablecoin is backed by other crypto assets, and because this backing asset can be volatile, crypto-backed stablecoins are overcollateralized to ensure the coin’s value. These assets are more volatile than fiat-backed stablecoins. Consequently, as an investor, it’s wise to keep an eye on how the coin’s underlying crypto asset is performing.
Precious metal-backed stablecoins: These coins use precious metals, such as gold, to help maintain their value. They are centralised, which may be considered a disadvantage by some. However, this also protects the coins from crypto volatility.
Algorithmic stablecoins: Algorithmic stablecoins are often considered to be the most difficult to understand as they aren’t backed by any asset. Instead, they use a computer algorithm to prevent the coins’ value from over-fluctuating. For example, if the price of an algorithmic stablecoin is pegged to $1 but the stablecoin becomes higher, then the algorithm would release more tokens automatically to bring the price back down. Similarly, if the value drops below $1, then the algorithm would reduce the supply to bring the price up again.
The benefits of stablecoin
As well as reduced volatility, there are several benefits to stablecoins:
- Earn interest: Users can earn more interest on a stablecoin investment than what most traditional banks would offer.
- Trade and save assets: A bank account isn’t required to hold stablecoins and they’re typically easy to transfer. Stablecoins’ value can be sent around the world, even to places where the local currency may be unstable.
- Affordable money transfers: The transfer fees for stablecoins are typically very affordable.
- Transfer internationally: Thanks to the low transaction fees and fast processing, stablecoins can be a great choice for transferring money to different countries.
What are the risks of stablecoin?
Despite the benefits of stablecoin, there are nonetheless several risks to be aware of:
- Counterparty risk: With stablecoins, there is the risk that a bank run could lead to the price of the coin dropping substantially. This is because, by trusting a third party to print money and keep a cryptocurrency stable, there’s the possibility that the dollars could be fractionally reserved rather than being fully backed.
- Centralisation risk: A second major risk is that accounts can be blocked, embezzled, or accessed by an unauthorised third party. Centralisation risks also apply to fiat currencies — when a central authority can print money without oversight, a potential consequence is hyperinflation.
- Algorithm manipulations: Another major risk to consider is algorithm manipulations. Most decentralised stablecoins live within smart contracts in protocols such as Ethereum. As such, there’s the risk that the algorithm that keeps the currency stable could fail or even be manipulated by a third party.
While there are many great benefits to stablecoin, there are also significant risks that need to be thoroughly researched and considered. Additionally, there are also many different issuers of stablecoins, with each offering its own policy and varying degrees of transparency. Stablecoin may be highly appealing, but it’s important to tread as carefully as you would with any other type of investment.
This article does not constitute financial advice. The author and Universal Media Ltd. are not qualified financial advisers. All investments are made at the reader’s own risk.