News
Definition, how they work and types
What are stablecoins?
Stablecoins are cryptocurrencies whose value is pegged or tied to that of another currency, commodity, or financial instrument. Stablecoins aim to provide an alternative to the high volatility of popular cryptocurrencies, including Bitcoin (BTC), which has made cryptocurrency investments less suitable for everyday transactions.
Key points
- Stablecoins are cryptocurrencies that attempt to peg their market value to an external reference.
- Stablecoins are more useful than volatile cryptocurrencies as a medium of exchange.
- Stablecoins can be pegged to a currency, such as the U.S. dollar, or to the price of a commodity, such as gold.
- Stablecoins pursue price stability by holding reserve assets as collateral or through algorithmic formulas that are supposed to control supply.
- Stablecoins continue to come under scrutiny from regulators, given the rapidly growing market, now worth over $162 billion, and its potential to impact the broader financial system.
Investopedia / Daniel Fishel
Why are stablecoins so important?
While Bitcoin remains the most popular cryptocurrency, it tends to suffer from high volatility in its price, or exchange rate. For example, the price of Bitcoin rose from just under $5,000 in March 2020 to over $63,000 in April 2021, only to crash nearly 50% in the next two months. Intraday swings can also be wild; the cryptocurrency often moves more than 10% in the span of a few hours.
All this volatility may be great for traders, but it turns routine transactions like purchases into risky speculations for the buyer and seller. Investors who hold cryptocurrencies for long-term appreciation don’t want to become famous for paying 10,000 Bitcoin for two pizzasMeanwhile, most traders do not want to find themselves taking a loss if the price of a cryptocurrency crashes after they receive payment.
To serve as a medium of exchange, a currency that is not legal tender must remain relatively stable, ensuring those who accept it that it will retain purchasing power in the short term. Among traditional fiat currencies, daily movements of even 1% in forex trading are relatively rare.
As the name suggests, stablecoins aim to solve this problem by promising to keep the value of the cryptocurrency stable in several ways.
Investors should approach stablecoins with caution because they require independent auditors to verify collateral or reserves. Most auditors are honest in their work, but the fact remains that there must be an auditor to verify that the raw materials are held. Auditors are another third party involved in a “decentralized” monetary system designed to remove third parties who have historically been the ones to propagate fraud and unethical practices.
Some argue that stablecoins are a solution in search of a problem, given the widespread availability and acceptance of the US dollar. Many cryptocurrency proponents, on the other hand, believe that the future belongs to the digital race that is not controlled by central banksWith this in mind, four types of stablecoins have been created, based on the assets used to stabilize their value.
Fiat-backed stablecoins
Fiat-backed stablecoins hold a reserve of a fiat currency (or currencies), such as the U.S. dollar, as warrantyguaranteeing the value of the stablecoin.
These reserves are managed by independent custodians and are subject to periodic auditing, which should be treated with caution. Bind (U.S. dollar) and TrueUSD (TUSD) are popular stablecoins backed by U.S. dollar reserves and denominated at par with the dollar. As of the end of June 2024, Tether (USDT) was the third largest cryptocurrency by market capitalization, valued at over $112 billion.
Commodity-backed stablecoins
A sort of subcategory of fiat-backed coins, commodity-backed stablecoins are cryptocurrencies pegged to the market value of commodities such as gold, silver, or oil. These stablecoins typically hold the commodity through third-party custodians or by investing in instruments that hold them.
One of the most popular commodity-backed tokens is Tether Gold (XAUt), a cryptocurrency backed by gold reserves. The gold is believed to be held by an unidentified custodian in Switzerland, as the terms of service state:
A redeeming Gold Token holder may choose to receive physical delivery of his gold bar at a location of his choosing, reasonably, in Switzerland (subject to payment of fees in accordance with the Gold Token fee schedule in effect at the time of redemption).
Cryptographically backed stablecoin
Cryptocurrency stablecoins are backed by other cryptocurrencies. Since the cryptocurrency reserve They can also be subject to high volatility, such stablecoins are generally overcollateralized, meaning the value of the cryptocurrency held in reserves exceeds the value of the stablecoins issued.
Cryptocurrencies worth $2 million could be held in reserve to issue $1 million in a cryptocurrency-backed stablecoin, insuring against a 50% drop in the price of the reserve cryptocurrency. For example, Dai (COME ON) stablecoin pegged to the US dollar but backed by Ethereum (ETH) and other cryptocurrencies worth approximately 155% of the DAI stablecoin in circulation.
Algorithmic Stablecoins
Algorithmic stablecoins may or may not hold reserve assets. Their main distinction is the strategy of keeping the stablecoin’s value stable by controlling its supply via an algorithm, essentially a computer program that runs a preset formula.
In some ways, it’s not that different from central banks, which don’t rely on a reserve asset to keep the value of the currency they issue stable. The difference is that a central bank like the US Federal Reserve publicly sets monetary policy based on well-understood parameters, and its status as a legal tender issuer does wonders for the credibility of that policy.
Algorithmic stablecoin issuers cannot resort to such advantages in a crisis. The price of the algorithmic stablecoin TerraUSD (UST) collapsed by more than 60% on May 11, 2022, evaporating its peg to the US dollar, as the price of its Moon token used to dock with Earth It dropped more than 80% overnight.
Stablecoin Regulation
Stablecoins continue to come under scrutiny from regulatorsgiven the rapid growth of the $162 billion market and its potential to impact the broader financial system. In October 2021, the International Organization of Securities Commissions (IOSCO) has said that stablecoins should be regulated as financial market infrastructure alongside payment systems and clearinghouses. Its proposed rules focus on stablecoins that regulators consider systemically important, those with the potential to disrupt payment and settlement transactions.
Additionally, politicians in the United States have increased calls for stricter regulation of stablecoins. For example, in November 2021, Senator Cynthia Lummis (R-Wyoming) called for regular audits of stablecoin issuers, while others advocated for bank-like regulations for the sector. In 2024, Senators Lummis and Kirsten Gillibrand introduced a bill to create a regulatory framework for stablecoins. Their proposed framework would prohibit anyone from issuing a stablecoin unless it was a registered non-depository trust or a depository institution authorized to issue them.
In Europe, under the Markets in Crypto Assets Regulation, which came into force in 2023, algorithmic stablecoins are essentially banned and all others must have assets held in third-party custody. The reserves must be liquid and have a 1:1 ratio of assets to coins.
Is Stablecoin a Bitcoin?
Stablecoins are not bitcoin. Stablecoins aim to provide an alternative to the high volatility of popular cryptocurrencies, which can make cryptocurrency less suitable for common transactions.
How do stablecoins work?
Stablecoins attempt to peg their market value to an external benchmark, usually a fiat currency. They are more useful than volatile cryptocurrencies as a medium of exchange. Stablecoins can be pegged to a currency like the U.S. dollar, the price of a commodity like gold, or use an algorithm to control supply. They also hold reserve assets as collateral or through algorithmic formulas that are supposed to control supply.
What is the best stablecoin?
The most popular and largest stablecoin by market cap is Tether (USDT). It is pegged to the US dollar at a ratio of 1:1 and is backed by reserves. It is also consistently among the top five cryptocurrencies by market cap. You can find Tether on most major cryptocurrency exchanges, including The KrakenBinance and Coinbase.
The bottom line
Stablecoins are cryptocurrencies that are pegged to other assets, such as fiat currency or commodities held in reserve. The intent behind them is to create a crypto asset with much lower price volatility, making them better for use in transactions.
Stablecoins have become or are becoming regulated in many jurisdictions due to the instabilities and losses that have occurred in past attempts to create stablecoins.
The comments, opinions and analyses expressed on Investopedia are for informational purposes only. Read our warranty and disclaimer for more information. As of the time this article was written, the author does not own any cryptocurrencies.