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What is a stablecoin?

Key takeaways

  • A stablecoin is a cryptocurrency with a value that is "pegged" (meaning tied) to another asset—often a traditional fiat currency like the US dollar.
  • There are 4 main types of stablecoins: fiat-backed, commodity-backed, crypto-backed, and algorithmic.
  • Stablecoins can be volatile and unpredictable. It's vital to understand the risks before buying.

A stablecoin is a cryptocurrency whose value is "pegged" (meaning tied) to another asset—often a traditional fiat currency like the US dollar. For example, one unit of a stablecoin that's pegged to the US dollar should always be worth $1. This peg can also be lost, but more on that later.

Stablecoin advocates believe these cryptocurrencies are critical for bridging “real-world” assets like fiat currencies with digital assets on the blockchain. Others are skeptical, noting that they've played major roles in the collapse of several cryptocurrencies and crypto institutions.

But what exactly is a stablecoin? Let's explore how they work, including why its name implies stability, even though it's been associated with a lot of crypto drama.

What is a stablecoin?

A stablecoin is a cryptocurrency that is designed to make transacting with crypto more practical. Currently, cryptocurrencies are volatile and can experience dramatic price fluctuations in a short period of time. Bitcoin, for example, can rise or drop by double-digit percentages in just a few hours.

In light of this, transactions using bitcoin can be risky. Imagine you want to buy a $5 cup of coffee with bitcoin. $5 worth of bitcoin may be worth $5 at the time of the transaction, but by the time you walk out of the coffee shop, that $5 could be worth $4 or $6. This uncertainty can make both buyers and sellers hesitant to transact in crypto.

Stablecoins aim to solve this uncertainty, attempting to combine the stability of cash with the benefits of crypto technology. On one hand, they operate on blockchains, which supporters believe provide greater security, transparency, cost efficiency, and speed. On the other, they try to reflect the value of real-world assets like the US dollar. Proponents argue this combination makes stablecoins particularly useful as they act as a kind of bridge between traditional assets and the crypto economy.

Another challenge the crypto industry faces is that it's relatively slow and expensive to convert dollars into crypto, and vice versa. This can make it inconvenient and inefficient for crypto investors looking to trade in and out of crypto. Using stablecoins as a trading pair for more volatile tokens like bitcoin can be a more efficient option for traders. This is because stablecoins are cryptocurrencies themselves.

Image shows the major types of stablecoins, which are cryptocurrencies with values that are “pegged” (meaning tied) to another asset.

How do stablecoins work, and how many types are there?

Currently, there are 4 main types of stablecoins.

Fiat-backed stablecoins

These are the stablecoins we mentioned above, where the value is pegged to a traditional fiat currency. Fiat-backed stablecoins are run by centralized companies, which make their existence possible by holding reserves in the fiat currency. For example, if Company A has $10 billion worth of their stablecoin in circulation, they will hold $10 billion or more in US dollars in their reserves. If their reserves fall below $10 billion, their stablecoin may "depeg," or lose its 1:1 value with the US dollar. We'll talk more about this below.

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Commodity-backed stablecoins

These stablecoins are similar to fiat-backed stablecoins. Instead of fiat currencies, however, they're pegged to commodities—typically gold. For example, if Company B has $10 billion of their stablecoin in circulation, they will need to hold $10 billion or more in gold in their reserves for the stablecoin to be usable.

Crypto-backed stablecoins

Similar to the types of stablecoins listed above, crypto-backed stablecoins are pegged to other cryptocurrencies. However, there are 2 key differences to note. First, crypto-backed stablecoins are often run by decentralized companies or organizations through smart contracts.

Second, because cryptocurrencies are usually more volatile than other assets, these organizations typically hold more in their reserves than the amount in circulation. For example, if Organization C has $10 billion of their ethereum-backed stablecoin in circulation, they will hold more than $10 billion of ethereum in reserves. This is called "overcollateralization," which attempts to smooth out some volatility. Note that fiat-backed and commodity-backed stablecoin organizations can also choose to overcollateralize.

Algorithmic stablecoins

Unlike the types above, algorithmic stablecoins are typically uncollateralized. Instead, they're run by computer algorithms. To illustrate how this works, let's assume an algorithmic stablecoin's price is pegged at $1. If this stablecoin's price rises above $1, the algorithm creates new coins and puts them in circulation to deflate its price. If the price falls below $1, the algorithm "burns," or removes, coins from circulation to increase its price.

What does it mean when a stablecoin "depegs"?

Depegging is a risk for all types of stablecoins. If a stablecoin loses its intended value and is unable to quickly recover it, it becomes functionally useless. Remember, a stablecoin's primary purpose is to provide value stability where other cryptocurrencies may not be able to. If it can't deliver on this, there is no reason for anyone to use it. This can cause its value to drop to $0.

It’s important to note the risk of depegging may be higher for algorithmic stablecoins than for other types that have sufficient and transparent reserves. For example, in 2022, the algorithmic stablecoin TerraUSD (formerly traded under the ticker UST) lost its peg after an unknown individual or organization suddenly sold $2 billion worth of UST, dropping its value to $0.91 from its intended $1.00 peg. During the same time, the broader crypto market was experiencing a sell-off. Both these factors occurring simultaneously sent the stablecoin spiraling, making it essentially worthless overnight. 

Prior to the event, the TerraUSD project was widely regarded by crypto enthusiasts as one of the most exciting stablecoin innovations. Its demise created a domino effect in the industry, bringing down multiple crypto institutions that had assets stored in UST and accelerating a downturn in the crypto market.

Note: While large fluctuations in value are dangerous, it's also normal for fiat-backed stablecoins to regularly experience slight fluctuations, though there is no hard definition for "slight." For context, fluctuations of a few cents are common when they’re due to large shifts in trading behaviors and are temporary. This is different from fluctuations that happen because the value of the underlying asset or reserves tied to the stablecoin can’t cover for the value of the stablecoins in circulation, which is more severe.

Considerations for buying stablecoins

If you've done the research, understand the risks, and have decided you want to use stablecoins to facilitate your crypto transactions, you should only buy an amount you're willing to lose. Remember that the crypto world can be unpredictable, as 2022's TerraUSD collapse showed.

Also note that crypto and crypto-related assets may be more susceptible to market manipulation than securities, and crypto holders don't benefit from the same regulatory protections applicable to registered securities. The future regulatory environment for crypto is currently uncertain, and crypto is not insured by the Federal Deposit Insurance Corporation (FDIC) or the Securities Investor Protection Corporation (SIPC).

In light of these factors, limiting your purchases to a size you're comfortable with losing may help you reduce some portfolio volatility in case of unforeseen events.

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