What is a Stablecoin?

Blockchain Basics

Volatility is one of the main hindrances to the large-scale adoption of cryptocurrency. When prices frequently rise and fall by 5% or more in a day, it’s challenging to envision using cryptocurrency as an actual means of exchange. Why would you purchase something today with a currency that could be worth 10% more tomorrow? On the other hand, why would merchants with quotas accept payment that declines by 20% in a week?

The US dollar is currently dealing with its biggest inflation bout in 40 years. The result? A 9% year-over-year decline in value. With cryptocurrencies, a 9% decline could happen in a single afternoon! Volatility may benefit those looking at digital assets for speculation and long-term investment, but paying for everyday items with crypto still makes little sense in most instances.

A stablecoin is a new digital asset that seeks to reduce the volatility inherent in most other forms of cryptocurrency. While even the most significant tokens like BTC and ETH can double or get chopped in half in weeks, stablecoins seek to maintain a 1-to-1 relationship with another underlying asset.

Stablecoins Explained

The US dollar is a fiat currency, meaning it's not backed by an underlying asset but by the faith and credit of the federal government. The Federal Reserve System sets inflation targets and controls how much money enters or leaves the economy. Since US dollars have a predictable future value and little day-to-day fluctuations, they make for a simple medium of exchange. As a result, some foreign nations use the US dollar as a ‘peg’ for their currency. A peg is a fixed exchange rate, and countries with volatile economies often peg their money to the US dollar. For example, Qatar, where the World Cup soccer tournament is taking place this year, pegs its currency to USD. Currently, each dollar is worth 3.64 Qatari Riyal.

Stablecoins can be explained similarly. Cryptocurrencies are usually volatile, with nothing backing the underlying asset. Why is a Bitcoin token worth $20,000 today? Because that’s the price buyers and sellers have agreed upon in the market. But like some fixed currencies, stablecoins use pegs to maintain their value in relation to an underlying fixed asset. Not even stablecoin pegs its value to the same asset, nor do they all even hold underlying assets as collateral. But stablecoins are an attempt to use cryptocurrency as a suitable means of exchange, and having stablecoins in certain accounts can even provide interest.

Types of Stablecoins

Stablecoins can be broken down into two broad categories - collateralized stablecoins and algorithmic stablecoins. Here are a few of the main differences between the two:

  • Collateralized Stablecoins - A stablecoin backed by some underlying asset is a collateralized stablecoin. Some stablecoins are backed by fiat currencies, such as USDC, which holds a combination of US dollars and short-term US treasuries in reserves at specific financial institutions. Other stablecoins are collateralized by assets like gold, other cryptocurrencies, or various underlying collateral structures. Stablecoins that use crypto as reserves are often overcollateralized to compensate for the volatility of the underlying token.
  • Algorithmic Stablecoins - A stablecoin with no underlying asset backing is called an algorithmic stablecoin. Instead of holding assets like dollars or gold in reserve, these stablecoins usually mint or burn supply as determined by the system's algorithm. They’re often paired with another token, such as the stablecoin DAI and its partner token Maker (MKR). 

Algorithmic stablecoins received some (deserved) negative press thanks to the UST debacle, which saw the value of the underlying LUNA token plummet nearly 100% in hours. This caused the UST stablecoin to shatter its peg and lose value as well. This incident was a good reminder: always understand the underlying collateral structure before investing in stablecoins.

Advantages of Stablecoins

Stablecoins have several advantages for investors, including:

Minimal Volatility - Since stablecoins are backed by collateral or programming, investors typically don’t have to deal with the volatility that Bitcoin, Ethereum, or even stock investors do. 

Ability to Earn Interest - Stablecoins can be purchased on all the most popular exchanges like Coinbase, Gemini, and Binance. Additionally, many of these exchanges allow investors to stake their stablecoins for interest. For example, Gemini Dollar (GUSD), a USD-backed stablecoin, currently has a 5.92% APR on the Gemini exchange.

Backed by Hard Assets - Collateralized stablecoins have assets in reserve to reinforce the value of their tokens, such as USDC with US dollars and PAXG with troy ounces of gold.

Disadvantages of Stablecoins

There are a few drawbacks those investing in stablecoins should understand, such as:

Complex Collateral Structures - Simple is usually better in finance, and stablecoins are often no different. Unfortunately, LUNA and its algorithmic stablecoin UST had a nebulous relationship with a collateral structure that was difficult to explain.

Centralization - Since hard assets have to be held somewhere, stablecoins are often very centralized, with a small group of people determining issuance and structure.

Fluctuating APY - The coin's value may be pegged, but the interest rate is not. APY earned on stablecoins can fluctuate rapidly, and different exchanges offer different rates for the same coins.

Blockchain Basics