- Stablecoins are digital assets that are designed to maintain a stable price over time.
- They are often pegged to fiat currency, such as the US dollar, and backed by collateral.
- People primarily use stablecoins on DeFi platforms and to hold money within the crypto ecosystem.
While cryptocurrencies and the crypto ecosystem may present interesting and rewarding opportunities, many investors are cautious about investing in them due to their extremely volatile nature. But here's where stablecoins step in.
Stablecoins are another type of decentralized digital currency that can be bought and sold on the blockchain. However, these coins are pegged to other assets, often commonly used and relatively secure ones, such as the U.S. dollar or gold. For example, one stablecoin might be pegged to the U.S. dollar, with one coin equaling one dollar. If the dollar gains or loses value, so does that stablecoin, but considering that assets like the U.S. dollar are relatively stable, these coins tend to be much less volatile than other crypto.
As such, stablecoins often provide a useful store of value within the cryptocurrency and decentralized finance (DeFi) world, and they can provide an easy way to use crypto for everyday transactions.
In this guide, we'll take a closer look at how stablecoins work and what you should know before investing in one.
Quick tip: While creating crypto-backed stablecoins may require over-collateralization, you can swap cryptocurrencies for stablecoins or buy stablecoins through an exchange. Many of the best cryptocurrency exchanges, and some of the best investment apps, also offer stablecoin trading.
How stablecoins work
As the name implies, stablecoins are a type of digital currency that's designed to offer stability while benefitting from blockchain technology. They're often pegged (i.e., have a fixed exchange rate) to a fiat currency, such as the U.S. dollar.
"In an ecosystem like cryptocurrencies, where volatility is typically high, this is an important property," says Paul Brody, principal and global blockchain leader at EY. "If you want to take advantage of blockchain technology without exposing yourself to the volatility in crypto prices, this is the way to do it."
For example, one USD Coin (USDC) is intended to always be worth $1. While the dollar's purchasing power could change over time, it's much less volatile than cryptocurrencies.
Some of the most popular stablecoins are:
- Tether
- USD Coin
- Dai
- First Digital USD
- USDD
- Ethena USDe
- TrueUSD
- Pax Gold
Pegging to an asset
A stablecoin's pegged value is what makes it useful within the world of crypto. But that's possible only if coin holders can be assured they'll be able to cash out their stablecoins. To ensure this can happen, stablecoin creators hold onto reserves of other currencies or assets, in a process known as collateralization.
For instance, a stablecoin issuer may promise to hold $1 in a bank account for each of the cryptocurrency coins it creates. As long as the collateral (or reserves) are available, coin holders know that they'll be able to exchange a coin for $1. However, there's a risk that the stablecoin issuer doesn't actually have enough reserves.
Typically, fiat currencies are the most popular peg and form of collateral.
Maintaining stability
While stablecoins are meant to reflect the value of another asset, that doesn't happen by default. Instead, maintaining price stability depends on actions taken by the coin creator, such as adjusting the amount of collateral or using algorithmic adjustments to change the supply of the stablecoin so its price moves up or down in line with its pegged asset. Also, arbitrage can be used to find pricing mismatches and bring the stablecoin back in line with its peg through buying and selling across different markets.
These stability-driven moves are often facilitated by smart contracts, which are contracts that self-execute on blockchain technology.
Types of stablecoins
Stablecoin issuers can choose how they want to hold the collateral for their stablecoins in reserves. The specifics vary depending on the stablecoin, but most fall into three categories:
Fiat-collateralized stablecoins
Some examples of fiat-collateralized stablecoins include Tether (USDT), USD Coin (USDC), and Binance USD (BUSD). These work by holding reserves of the pegged fiat currency, typically on a 1:1 ratio between the stablecoin and fiat currency.
Crypto-collateralized stablecoins
Crypto-backed stablecoins use cryptocurrencies as collateral. You can deposit and lock other cryptocurrencies to create these stablecoins, and they're generally over-collateralized to account for volatility. For instance, the stablecoin DAI is pegged to the USD (one DAI equals $1). But you could have to lock up $150 worth of ether (ETH) to create $100 worth of DAI.
Commodity-collateralized stablecoins
Asset-backed stablecoins maintain reserves in non-blockchain assets. The safest options may be those that hold fiat currency in regulated accounts, but some may hold commodities, such as gold, in reserve.
"There's a bit more risk here because major price changes in those assets could threaten the ability of token-holders to cash out," says Brody.
Some common examples of commodity-collateralized stablecoins include Digix Gold (DGX) and Pax Gold (PAXG)
Algorithmic stablecoins
There's another type of stablecoin that doesn't have any collateral. Instead, it uses automated algorithms to try to create or decrease supply and hold a steady price. However, these algorithmic or "seigniorage-style" stablecoins haven't caught on much. They can also be risky, such as TerraUSD (UST), an algorithmic stablecoin that ended up failing.
Benefits of stablecoins
Stablecoins can offer several benefits to holders, especially compared to other crypto, such as in the following ways:
Price stability
Stablecoins typically have much less volatility than other cryptocurrencies. Many fiat-collateralized ones, for example, have similar price stability to the U.S. dollar, so these are often accepted for everyday online transactions and payments.
Bridge between fiat and crypto
Stablecoins can also be useful as a bridge currency between the fiat and crypto systems. For example, if you want to exchange dollars for a cryptocurrency like bitcoin, some brokerages first have you convert dollars into stablecoins and then use stablecoins to trade bitcoin.
Also, you might want to keep money in the cryptocurrency system, but you don't think it makes sense to invest in bitcoin (or a different cryptocurrency) right now. Holding the funds in a stablecoin could limit your risk. It's a bit like keeping cash in a brokerage account while waiting to make an investment.
Accessibility
Stablecoins are often much more accessible than other cryptocurrencies. And they can offer coin holders entry into new ecosystems.
Perhaps the most popular way that people use stablecoins is to participate in DeFi projects, such as crypto lending and borrowing platforms. Minimizing the volatility risk for users could make it easier to understand the cost (or profit) that can come from these transactions.
"For most companies and individual users, the ability to use stablecoins to manage risk while accessing DeFi and other online services is going to be the key value proposition and it's certainly what our enterprise users are interested in," says Brody.
Risks of stablecoins
While stablecoins offer several possible advantages, there are risks to consider too, such as:
Counterparty risk/collateral risk:
If you're considering buying stablecoins, a lack of proper reserves is one potential risk to be aware of. That could be due to issues with the stablecoin issuer, or its custodian might have its own lapses that result in the currency not having the collateral it's supposed to have to maintain stability.
"In my view, the only really acceptable answer is with an independent audit," says Brody. "Not only do you need to know what assets are backing a particular token — if it's an asset-backed token — but you also need the assurance that those assets are not pledged against other liabilities."
De-pegging risk
Stablecoins tend to be significantly less volatile than other cryptocurrencies, but they are still susceptible to de-pegging or peg failures, which can cause volatility. For example, algorithmic stablecoins use an algorithm to get as close as possible to their desired peg value and adjust as needed with the market. But an error in the model or an unexpected, fast-moving economic event could disrupt the ability to adjust to the peg.
Regulatory uncertainty
Government agencies have discussed ways to regulate stablecoins, and have taken action against organizations that may have misrepresented their reserve holdings. Still, this remains new territory that could take time to sort out from a regulatory perspective. Ultimately, new regulations in the U.S. and other countries could affect the value and availability of stablecoins.
Security risks
Stablecoins, as digital currencies, are subject to security risks. For instance, smart contracts used for some stablecoins can be vulnerable to hacks or exploits.
FAQs about stablecoins
Are stablecoins a good investment?
Whether stablecoins are a good investment or not depends on your situation. For example, if you're trying to access DeFi projects like crypto lending and want to minimize volatility compared to other crypto, then stablecoins can be good investments. But these often hold their value rather than growing, so they're not traditional investments. If you're trying to maximize returns and are willing to take on more risk, you might prefer other crypto.
How do I choose a stablecoin?
Choosing a stablecoin depends on your comfort with what it's pegged to, and you might look at factors such as market capitalization to see if it's popular enough among investors in a way that often minimizes volatility.
Where can I buy and sell stablecoins?
You can buy and sell stablecoins on crypto exchanges, or some traditional brokerages now offer access to crypto trading, including for stablecoins.
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