Jul 7, 2022
What Is a Stablecoin?
Stablecoins are digital currencies pegged one-to-one to a “stable” fiat currency, such as the US dollar or another form of collateral. They’re designed to minimize the volatility that’s usually associated with cryptocurrencies and maintain a predictable, fixed value over time. They are minted on the blockchain so users can buy, sell, and trade them on an exchange like any other cryptocurrency. But because they’re tied to a reserve of tangible assets, stablecoins are governed by a centralized system.
Stablecoins were created to bridge the gap between cryptocurrency and traditional fiat currency: they offer the privacy and security of crypto and the flexibility and convenience of fiat currency to pay for everyday goods and services.
In this article, we’ll cover:
- Stablecoins vs. other cryptocurrencies
- How stablecoins work
- Types of stablecoins
- Benefits of stablecoins
- Risks of stablecoins
Stablecoins vs. traditional cryptocurrencies
The biggest difference between stablecoins and traditional cryptocurrencies is right in the name: stability. Cryptocurrency is subject to a high level of volatility, while stablecoins are designed to maintain a more fixed value within the unpredictable world of crypto. With stablecoins, the underlying asset is tracked, ensuring that the stablecoin remains pegged to that asset.
|Volatility||Low; tied to the underlying asset||High; subject to market forces|
|Value||Pegged to value of collateral||Fluctuates|
|Primary uses||Transactions, lending||Transactions, investing|
By way of example, if you were to buy Ether, a popular traditional cryptocurrency, and Tether, a popular stablecoin, you’d notice several differences. The value of your Ether coins may fluctuate quite a bit from day to day, while your Tether coins would remain worth $1 each. And while you can use both of these currencies to make transactions, you might be more likely to spend your Tether, since its value is unlikely to change, while you could treat Ether coins like an investment and hope their value increases.
How stablecoins work
In general, you can buy, sell, and trade stablecoins on an exchange like any other digital currency. Stablecoins can be stored in your digital wallet, just like crypto. Any stablecoin holder should be able to redeem their tokens at any time on a 1:1 basis. For example, one stablecoin backed by the US dollar will always equal $1 in that fiat currency. Stablecoins can make digital transactions simpler because of their stable value. If you use US dollars to purchase $1,000 in US dollar-backed stablecoins, you will have 1,000 stablecoin tokens. Those tokens can be used to purchase the equivalent of $1,000 in goods and services or exchanged for crypto or another fiat currency.
Types of stablecoins
There are a few different types of stablecoins available. The difference between them is in the way the stable value is maintained, and whether a centralized or decentralized system governs them. Fiat-backed and commodity-backed coins rely on a centralized system of collateralization, while crypto-backed coins rely on a decentralized system. Alternatively, algorithmic coins use an on-chain algorithm to facilitate supply and demand changes in the stablecoin and the cryptocurrency that supports them.
The asset to which a stablecoin is pegged is its collateral, which serves to stabilize and assure its value.
- Fiat-backed stablecoins (centralized): These stablecoins are pegged 1:1 to a national fiat currency to ensure their value. So, for every single US dollar-backed stablecoin in circulation, there is $1 in reserve either in cash or cash equivalents. These reserves are maintained by regularly audited independent custodians. Tether and TrueUSD are two of the most popular fiat-backed stablecoins in circulation.
- Commodity-backed stablecoins (centralized): These stablecoins are tied to physical assets like precious metals, oil, and real estate. The value of commodity-backed stablecoins is more likely to fluctuate based on the market value of the linked commodities. Gold is the most popular collateralized commodity, with each stablecoin token representing an equal real-world value in gold. PaxGold and Tether Gold are currently two of the most liquid gold-backed stablecoins.
- Crypto-backed stablecoins (decentralized): Also known as “over-collateralized” stablecoins, crypto-backed stablecoins are collateralized by other crypto assets. These are typically less stable than fiat-backed stablecoins, as the underlying cryptocurrency may fluctuate in value. For example, a $1 crypto-backed stablecoin might be pegged to a crypto asset worth $2 or $3. If the underlying cryptocurrency loses value, the stablecoin has a cushion allowing it to stay valued at $1. Crypto-backed stablecoins include DAI and the Bitcoin-backed Wrapped Bitcoin.
Also known as “undercollateralized stablecoins,” algorithmic stablecoins maintain their 1:1 peg with specific pieces of code that dictate a process, aka smart contracts. Algorithmic stablecoins require both the stablecoin token and a native cryptocurrency to support the stablecoin. They don’t have asset reserves in place to back up the stablecoin’s value, so the smart contract algorithm regulates the relationship between the stablecoin and the native cryptocurrency. TerraUSD and Magic Internet Money (MIM) are two examples of algorithmic coins.
Benefits of stablecoins
There are several potential benefits to buying stablecoins instead of traditional crypto, especially for those new to the world of crypto. Less volatility and 1:1 ties to fixed assets may make stablecoins a less risky bet in the vast world of digital currency.
- Fiat-backed stablecoins retain the same value of their fiat currency
- Stablecoins are less influenced by market conditions, as they are tied to more stable/fixed assets
- They maintain the benefits of cryptocurrency like privacy, security, and low transaction fees
The risk of stablecoins
There are also several risks and disadvantages to consider when investing in stablecoins. As with all forms of crypto, security breaches are possible. And the more centralized system that sounds appealing to some investors may be perceived as a disadvantage by others.
- Stablecoins are built to keep their prices stable, not rise in value, so gains are less likely
- Newer technology means more potential bugs and vulnerabilities, including fraud
- There’s currently a high level of regulatory uncertainty regarding stablecoins
- More parties are involved in each transaction, including the bank holding the reserves and the party issuing the stablecoin
Stablecoins and crypto investing
Now that you understand a bit more about what stablecoins are, you may be curious about investing in crypto. Stash offers Smart Portfolios with cryptocurrency exposure in Grayscale Investments so you can start making the most of diversifying your investment portfolio according to your risk tolerance and time horizon.
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Stash has full authority to manage a “Smart Portfolio,” a discretionary managed account. Crypto is relatively new and can be volatile. Investments are Delaware Statutory Trusts and offer indirect exposure to Crypto.
Are stablecoins safe?
While stablecoins are less volatile than traditional cryptocurrency, there are risks and disadvantages to investing in stablecoins. All investing involves risk, including the risk that you could lose money.
How do stablecoins remain stable?
Stablecoins are backed 1:1 by real-world assets like fiat currency or commodities. Since fiat currency is generally not subject to extreme market fluctuations, stablecoins tend to maintain a more fixed value.
How do stablecoins work?
You can buy, sell, and trade stablecoins on an exchange like any other digital currency, but since stablecoins are pegged 1:1 to a fiat currency or commodity, any stablecoin holder should be able to redeem their tokens at any time on a 1:1 basis.
What’s the purpose of a stable coin?
Stablecoins are used to reduce the volatility associated with cryptocurrency while maintaining the privacy and security of crypto transactions. They can be an investment tool, but are particularly well-suited for paying for goods using cryptocurrency instead of traditional money like the US dollar.