Cryptocurrencies are notoriously known for being volatile investment instruments when it comes to the movement of their price. The drastic jumps and crashes in their price makes it difficult for them to be used for everyday activities.
To counteract this problem, stablecoins were introduced. They are pegged to stable currencies such as the US dollar, however, they still maintain the main benefits of cryptocurrencies.
What is a stablecoin?
A stablecoin is a type of cryptocurrency designed to maintain a stable price over time. It is pegged to the value of fiat currencies like dollars or pounds.
Stablecoins are often backed by the specific assets that they are pegged to. An organisation that issues out stablecoins usually sets up a reserve at a financial institution that holds the underlying asset, or fiat currency, that it is pegged to. For example, a stablecoin could issue 100 million coins with a fixed value of $1 and, therefore, have a reserve of $100 million.
Why are stablecoins used?
Stablecoins are used for most of the same reasons other digital assets are used. The main reasons are to store value or be used as a means for exchange.
For traders, stablecoins are useful when they want to momentarily safeguard their funds from the volatility of the crypto market.
For these reasons, stablecoins have become widely popular–with coins such as Tether USD amassing a market cap of $70 billion.
Types of Stablecoins with examples
To maintain their price peg to an asset, stablecoins use different techniques. Two common methods are to maintain a pool of reserve assets as collateral or use an algorithmic formula that controls the supply of a coin.
Algorithmic stablecoins maintain their price through means of algorithms that control the supply of a coin.
If the market price of a stablecoin falls below the price of the fiat currency that it is pegged to, the algorithm will reduce the number of coins in circulation, restoring the price. Alternatively, if the market price of a stablecoin goes above the price of the fiat currency that it is pegged to, then the algorithm will release new coins into circulation.
Collateralized stablecoins are supported by a pool of reserve assets to support their price.
When a stablecoin holder decides to cash out their coins, an equal amount is removed from the reserve of the collateralizing assets.
Commodity-backed stablecoins are collateralized using physical assets such as precious metals, oil and real estate. These commodities are prone to fluctuate in price and can lose their value. Gold is the most popular collateralized asset. Gold is the most common commodity to be collateralized.
Commodity-backed stablecoins facilitate investments in situations where an asset is not accessible. For example, in many places, collecting gold bars is difficult due to the complexity of finding a safe storage place and the costs involved. Commodity-back stablecoins make it possible to invest in precious metals, without having to worry about storage. It is also possible to take possession of the underlying asset.
Examples of commodity-backed stablecoins include Tether Gold (XAUT) and Paxos Gold (PAXG).
Can stablecoins fall below $1
Yes, stablecoins can fall below $1. Although they are programmed to maintain their value, there are cases when they have failed to do so.
TerraUSD (UST) was one of the largest stablecoins in the world which sunk below $1 before
completely losing its value.
Why did TerraUSD crash?
TerraUSD was an algorithmic stablecoin which got its price from the minting (creating) and burning (destroying) of itself and LUNA. This worked well, however, because of too much downward pressure the algorithm was no longer able to keep up the price of UST.
TerraUSD did not have any collateralization, which was a problematic model that spurred the collapse of the token from its $1 price.
List of Popular Stablecoins
- Tether (USDT)
- USD Coin (USDC)
- True USD (TUSD)
- Binance USD (BUSD)
- Paxos Standard (PAX)
- Gemini Dollar (GUSD)
- Ampleforth (AMPL) (algorithmic)
- Binance GBP Stable Coin (BGBP)
- Stasis Euro (EURS)
Turkish Lira (TRY)-pegged
- BiLira (TRYB)
Korean Won (KRW)-pegged
- Binance KRW (BKRW)
- Tether Gold (XAUt)
- Paxos Gold (PAXG)
- CACHE Gold (CACHE)
- Petro (PTR) (oil-backed)
What are the risks of stablecoins?
Stablecoins may be a safer option to hold compared to other cryptocurrencies because of their price stability. However, stablecoins still share some of the risks involved with any other cryptocurrency:
- Security: Trading platforms and crypto wallets are highly exposed to hacker threats. Although there are safety measures that can be taken to convolute the threats, the risk is still big because unlike traditional banking, crypto transactions cannot be reversed.
- Counterparty risk: As a result of being “decentralized”, multiple parties are involved in the management of a stablecoin. For the coin to maintain its value, all the parties involved need to be properly performing their tasks (security, reserving properly, etc).
- Reserve risk: Without reserves being secure, the coin issuer cannot guarantee the value of a stablecoin with full confidence. Reserves are vital as they are the final backer of a stablecoin’s value.
- Lack of confidence: The price of a stablecoin can flutter if traders lose confidence in its ability to maintain the peg. This usually happens when a stablecoin is not sufficiently backed by hard assets or cash, as it could suffer a run and lose its peg against its target currency.