What are Stablecoins?
Stablecoins are a type of cryptocurrency whose value is tied to less volatile external assets in order to stabilize the price. These external assets may include fiat currency such as the U.S. Dollar, Euro, or even gold. The assets remain in reserves and act as collateral for the stablecoin. If a stablecoin holder withdraws their tokens, the assets in the reserve are reduced by an equal amount.
While other cryptocurrencies such as Bitcoin and Ethereum may frequently rise and fall, stablecoins maintain their value. In an unpredictable crypto market, they serve the purpose of providing price stability as investors transact across coins or between fiat and digital currencies.
Types of Stablecoin Collateral
There are multiple types of stablecoins, and they are stabilized by a range of assets for collateral.
Traditional currencies held in regulated accounts are commonly used as collateral for stablecoins, particularly the U.S. dollar. USD Coin (USDC) is a popular stablecoin that has its value tied to the U.S. dollar, so 1 USDC is always equivalent to 1 USD. The price maintains stability, and USDC is an Ethereum token, so it may be stored in an Ethereum-Compatible wallet, and your Coin account.
Some stablecoins are backed by other cryptocurrencies. Users can deposit their cryptocurrencies to create stablecoins, and often they are over-collateralized to account for volatility in cryptocurrency value. For example, the stablecoin DAI is USD backed, so one DAI equates to 1USD. However, if it was crypto-backed, users may have to deposit $150 worth of ETH as collateral to create USD 100 of DAI.
The first and largest stablecoin is Tether (USDT), and over 50% of Tether’s assets, more than $30 billion worth, are in commercial paper, a form of short-term corporate debt.
How do you use Stablecoins?
Stablecoins are typically used for digital transactions and converting crypto assets to “real” money or exchanging them for other crypto assets. Stablecoins allow users to transact seamlessly in cryptocurrencies such as Bitcoin or Ethereum, acting as a bridge between volatile cryptocurrencies and stable real-world assets. By trading with stablecoins instead of U.S. Dollars, users can maintain their transactions within crypto exchanges, avoiding exchange fees.
For example, a user may hold both Bitcoin and Ethereum, and they may want to buy more Bitcoin with their Ethereum. However, Ethereum and Bitcoin are separate blockchains and exchanging them directly may cost the user trading fees and their crypto may lose value in the process due to market volatility. Instead, they could exchange the ETH for a stablecoin such as USDC at a stable U.S. dollar value. Then, they could use the USDC tokens to purchase more Bitcoins. In this way, stablecoins can act as an intermediary to maintain the value of crypto.
Risks Associated with Stablecoins
Stablecoins are not backed by large companies or a centralized government. The collateral system is entirely decentralized, and in the absence of clear regulations, there may be some risks that investors need to remain mindful of.
Reserves are held and regulated by a third party, primarily banks, so there may be a possibility of counterparty risk where the third party fails to provide the collateral. While unlikely, it may be possible that the reserves backing a stablecoin are insufficient to redeem every token, which impacts investor confidence. However, this space is evolving quickly, and the next few years will likely see greater regulatory clarity and reduced systemic risk of stablecoins as new coins enter the diversifying market.