What are stablecoins and why invest in them?
A stablecoin is a type of cryptocurrency designed to maintain a fixed value over time. The value of a stablecoin is usually tied to a specific real currency, often the US dollar. In this configuration, one unit of cryptocurrency is usually equivalent to one unit of real currency. Unlike highly volatile cryptocurrencies such as Bitcoin, the price of stablecoins is not expected to fluctuate.
Here’s how stablecoins work, what risks they pose, and how to check if a stablecoin is safe.
Stablecoins: what are they and how they work
A stablecoin is a cryptocurrency whose value is fixed on another asset, often currencies such as the US dollar or the euro, although other assets are possible. This type of crypto coin tracks the underlying asset, making its value stable over time, at least relative to the currency to which it is pegged. Indeed, it is as if the underlying asset has become electronic, for example, like a digital dollar.
Because their purpose is to track an asset, stablecoins are often supported by the specific assets to which they are attached. For example, the organization issuing a stable coin typically sets up a reserve with a financial institution that holds the underlying asset. So a stable coin could hold $ 100 million in reserve and issue 100 million coins with a fixed value of $ 1 per coin. If the owner of a coin wants to withdraw the coin, the real money can ultimately be withdrawn from the reserve.
This structure contrasts with most cryptocurrencies, such as Bitcoin and Ethereum, which are not backed by anything at all. Unlike stablecoins, these other cryptocurrencies fluctuate widely as speculators push their prices up and down as they trade for profit.
While many stablecoins are backed by durable assets, others are not. Instead, these others are using technical means (such as destroying part of the coin supply in order to create a shortage) to keep the price of the crypto coin at the fixed value. These are called algorithmic stablecoins.
Why are stablecoins popular in crypto trading?
Stablecoins solve one of the key problems with many traditional cryptocurrencies, which is that their drastic fluctuations make it difficult, if not impossible, to use them for real transactions.
“Digital currencies like Bitcoin and Ethereum are extremely volatile, which makes it very difficult to price things in their terms,” says Anthony Citrano, founder of Acquicent, a marketplace for NFTs. “Stable coins avoid this problem by locking their prices on a known reserve currency.”
In addition, their stability allows many stable coins to be used as functional currency within a crypto brokerage. For example, traders can convert Bitcoin to a stablecoin such as Tether, rather than dollars. Stablecoins are available 24/7, making them more accessible than cash obtained through the banking system, which is closed at night and on weekends.
Stablecoins can also be used with smart contracts, which are a kind of electronic contract that is automatically executed when its conditions are met. The stability of digital currency also helps bypass disagreements that might arise when dealing with more volatile cryptocurrencies.
What are the most popular stablecoins?
Stables generally don’t have the same press (and hype) as other cryptocurrencies, in part because they don’t offer the same type of ‘get-rich-quick’ opportunity. But a few are among the most popular cryptocurrencies by market cap, as of October 2021:
- Attached (USDT): $ 68 billion.
- USD coin (USDC): $ 33 billion.
- TerraUSD (UST): $ 3 billion.
Of course, the size of these coins is paltry compared to larger cryptocurrencies, such as Bitcoin, with a market cap of nearly $ 1.1 trillion, and Ethereum, valued at over $ 400 billion.
What are the risks of stablecoins?
At first glance, stablecoins may seem like low risk. In comparison to popular cryptocurrencies (which aren’t backed by anything), they are. But stablecoins have typical crypto risks and at least one of their own kind of risk:
- Security: Like other cryptocurrencies, stablecoins need to be held somewhere, whether it’s your own digital wallet or a broker or stock exchange. And this presents risks because a given trading platform may not be secure enough or may have vulnerabilities.
- Counterparty risk: While it may appear that cryptocurrency is highly decentralized, in reality you are dealing with multiple parties in a transaction, including the bank holding the reserves and the organization issuing the stablecoin. They have to do the right things (security, proper reservation, etc.) for the currency to maintain its value.
- Reserve risk: A key part of the stablecoin ecosystem are the reserves supporting a stablecoin. These reserves are the last safety net on the value of a stablecoin. Without them, the coin issuer cannot guarantee the value of a stable coin with confidence.
“The main risk with stablecoins is that they are not fully backed by the reserve currencies they claim to be,” says Citrano. “In an ideal situation, the issuer of the stablecoin has enough currency reserves (in cash or other very liquid and safe investments) to fully support the stablecoin. Less than 100 percent and the risk is introduced.
How safe are stablecoins?
So how do you know if a stablecoin is safe? You will need to read the fine print on its issuer’s statements. And it’s absolutely essential that you do, says Citrano.
“Check out the issuer’s reserve reports,” he says. “If they don’t provide any back-up report, be extremely careful.”
And even then, stable coin owners need to be very careful about what exactly is supporting their coin. Recently, stablecoin Tether has come under fire for its disclosures on reserves. And those who think cryptocurrency is fully reserved should be careful.
In its reserves report of March 31, 2021, the company showed that it has more reserves than it has liabilities. It looks good, but the devil is in the details:
- Approximately 76% of its reserves are held in the form of cash or cash equivalents (the vast majority of which is short-term corporate debt, also known as commercial paper).
- Almost 13 percent are secured loans.
- Almost 10 percent are corporate bonds, funds and precious metals.
These other assets can act like real money most of the time, but they are not real money.
If you take a closer look, less than 4% is real cash, while most of it is held in short-term corporate debt. And this commercial paper is not the same as cash, especially in an emergency. If the markets go down, these assets (and other non-cash assets) could quickly lose value, making the Tether crypto coin less than fully booked at exactly when it needs it most.
Unless a stablecoin commits to holding 100 percent (or more) of its reserves in cash, there is no guarantee that the money will be there to exchange coins. In this case, the value of stable coins may turn out to be much less than stable. Stable coin holders can find themselves on the losing side of an old-fashioned banking rush, a surprising fate for a technology that bills itself as very modern.
Finally, the best guarantee of the security of a currency is that people will widely accept it in exchange for goods and services. And the only widely accepted currency in the United States – in fact, the only price in which products are ultimately denominated – is the dollar.
At the end of the line
Stablecoins offer some of the stability that most cryptocurrencies lack, making them unusable as real currency. But those who use stable coins should be aware of the risks they take when they have them. While in most times it may seem like stablecoins have limited risk, stablecoins can become the riskiest in a crisis when it should be the safest to own.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past performance of investment products is not a guarantee of future price appreciation.