While the price of Bitcoin, Ethereum, and other cryptocurrencies continue to change significantly, there is one category of cryptocurrencies whose goal is to use the benefits of digital payment technology while maintaining price stability. In doing so, these stablecoins can offer fast, cheap, digital payments for anyone around the world.
What Are Stablecoins?
Bitcoin was originally envisioned as a solution to the expensive and bloated fiat currency market. Yet, its price volatility has made it ill-equipped to be a true currency for the masses. Bitcoin, along with other major cryptocurrencies, remains a poor choice for everyday purchases and remittances.
Stablecoins, on the other hand, are cryptocurrencies that are designed to be price-stable and therefore useful as currencies. This stability is markedly different from most cryptocurrencies which are perceived as highly valuable and speculative in nature. Using the blockchain as a technological backbone while maintaining price stability, stablecoins present a viable option as digital cash. They’re analogous to money market funds at a brokerage account. Stablecoins are not supposed to fluctuate in price, hence the name.
How Do They Work?
Stablecoins aim to have their price “pegged” or permanently established in relation to another asset or fiat currency. Through the mechanism of pegging, stablecoins can maintain relative price stability as compared to their underlying asset(s).
There are a few ways this can be accomplished:
- Fiat-based – Maintaining the digital asset price to a fiat currency (or basket of currencies) by holding fiat reserves equivalent to the amount of tokens outstanding.
- Asset-based – Similar to fiat-based, except using another asset such as gold, oil, etc.
- Crypto-based – Backed by cryptocurrency holdings.
- Algorithmic – Uses algorithms to balance the circulating supply of tokens.
Why Use Stablecoins?
Cryptocurrency traders can use stablecoins as cash positions instead of paying to turn their digital assets into fiat. This makes stablecoins useful as a place to park capital between trades or during bear markets. By using stablecoins, crypto traders can ride out periods of volatility without ever cashing out of the market entirely, making it easy to move back-and-forth between stablecoins and the rest of the crypto market. In this case, stablecoins are like a sweep account at a brokerage; simply a parking place for undeployed assets.
As a currency
Much like fiat currencies, stablecoins can be used as digital currency themselves, whether it be to pay wages, take out loans, earn interest, etc. In fact, stablecoins can earn more interest on deposits than traditional fiat, depending on where they are held. Many crypto investors loathe to buy or transact with their beloved bitcoin or heirloom ethereum because the price might go up after they’ve completed the transaction. Stablecoins are a way of using crypto as currency without the angst of lost opportunities.
Stablecoins provide an improvement to fiat due to their extremely fast transaction times and low fees. Traditionally, if you wanted to send money to someone in another country, you would have to either complete a wire transfer through the SWIFT banking system or use a third-party service like MoneyGram or Western Union. These options can be both time-intensive and expensive.
At the same time, such a money transfer across borders would require converting currencies, which can come with its own fees and/or losses on exchange rates. For instance, someone sending money from the United States to Mexico would have to convert dollars to pesos, but when sending the funds using stablecoins, no currency conversion is necessary.
The remittances market is enormous and will be closing in on $1 trillion by 2026. Stablecoins have an opportunity to take a massive portion of this market thanks to their decentralized technology, which allows payments to be made instantly at low fees. This makes cross-border commerce fast and cheap for anyone, even those that are currently unbanked.
Some stablecoins, like those pegged to assets instead of fiat currencies, are valuable tools for investors. These stablecoins allow traders to move between cryptocurrencies and stablecoins backed by valued assets quickly and at low costs. Take a gold-backed stablecoin as an example. Traders can easily move from Bitcoin into a gold-backed stablecoin instead of transferring their Bitcoin to fiat currency to buy gold itself. In addition, this also makes it easy to purchase assets without physically storing or securing them.
How Are They Different from Bitcoin and Other Cryptocurrencies?
Unlike other cryptocurrencies, stablecoins seek to maintain price stability relative to their other crypto counterparts. While Bitcoin, Ethereum, and other cryptocurrencies see their price fluctuate greatly at any given time, stablecoins are designed to hold their value throughout any market conditions. Therefore, investors looking to make money on the price appreciation of digital assets will desire to invest in other cryptocurrencies. In contrast, those who want to utilize digital assets as a means of actual, real-world currency will gravitate to stablecoins.
What are the Downsides of Stablecoins?
Underlying asset risk
Stablecoins carry with them the risk of their underlying assets, whether that be a fiat currency or other investments. Price fluctuations in the underlying asset will result in a fluctuating value of the stablecoin compared to the rest of the market. For instance, a stablecoin pegged to the price of gold will fluctuate in value based on gold’s value at any given time. This creates volatility for the stablecoin even if it maintains its peg.
There’s also the potential for misleading investors about the specific underlying assets backing a stablecoin’s value. For instance, while Tether is the largest stablecoin currently on the market, it also is a prime example of one of the biggest perceived underlying asset risks. Tether has repeatedly been questioned as to whether it actually holds the dollar reserves it claims in accordance with its outstanding stablecoin balance and recently came to an $18.5 million settlement with the New York Attorney General for possibly issuing Tether tokens without the required fiat reserves.
Price peg risk
Another stablecoin risk involves the price of the coin itself fluctuating away from the asset on which it is pegged. Like any other asset, stablecoins operate on a supply and demand curve, with prices fluctuating slightly as demand for a stablecoin token changes. Generally, this price fluctuation is quite small, and investors are not concerned with a less than 1% change in the stablecoin price on the open market.
However, there have been instances where the price of stablecoins have fluctuated so much as to “break” the peg to their underlying asset. In 2020, demand for the DAI stablecoin skyrocketed, causing its peg to the dollar to break, sending its price to $1.10. This type of event (or more likely, its opposite) can cause investors to lose faith in the stability of stablecoins altogether.
Currently, all cryptocurrencies are treated as property by the IRS. This does include stablecoins, for now. In the past few years, the SEC has hinted that stablecoins may actually be violating securities laws due to the way they operate under a centralized entity. According to Valerie Szczepanik, a senior member of the SEC, “It’s these kinds of projects where there is one central party controlling the price fluctuation over time that might be getting into the land of securities.” A change in the classification of stablecoins could jeopardize their entire role as a digital currency.
What Are the Most Common Stablecoins?
|Stablecoin||Pegged to…||Backed by…|
|Tether (USDT)||US dollar||US dollars and cash equivalents|
|USD Coin (USDC)||US dollar||US dollars and cash equivalents|
|Binance USD (BUSD)||US dollar||US dollars and cash equivalents|
|Dai (DAI)||US dollar||Ethereum reserves|
|PAX Gold (PAXG)||1 oz gold||Gold reserves|
|Digix Gold Token (DGX)||1 g gold||Gold reserves|
|Digital Yuan||Chinese yuan||Chinese government|
“Cash equivalents” is a finance term that refers to short-term deposits including commercial paper (very short-term, sometimes overnight, loans to corporations), U.S. Treasury bills maturing within three months, bank CDs, acceptances (a bank’s promise to pay), money market deposits and so on. Cash equivalents are highly liquid and very low-risk.
The Future of Stablecoins
Stablecoins could be the next evolution of cryptocurrencies. The ability for users to make digital payments with currencies price-pegged to fiat currencies makes them much more usable in daily life. But stablecoins could also be the key to unlocking the power of decentralized finance (DeFi) through their use in lending and asset exchange.
Governments still don’t know what to make of these digital assets. In the United States, stablecoins are still categorized under the same umbrella of all virtual currencies, even though their value proposition is quite different. If the government decides to categorize these assets similarly as cash positions, it could make them even more appealing in crypto trading.
Stablecoins are an excellent way for new cryptocurrency users to get their feet wet with this growing technology. The price stability of stablecoins allows the uninitiated to make or send payments without the worry of price fluctuation. As a result, it could be stablecoin that provides the key to unlocking mass adoption in the crypto world.