Stablecoins ?

Stablecoins: 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 the most popular cryptocurrencies, including?Bitcoin?(BTC), which has made crypto investments less suitable for common transactions.

KEY TAKEAWAYS

• Stablecoins are cryptocurrencies that attempt to peg their market value to some external reference.
• Stablecoins are more useful than more-volatile cryptocurrencies as a medium of exchange.
• Stablecoins may be pegged to a currency like the U.S. dollar or to the price of a commodity such as gold.
• Stablecoins pursue price stability by maintaining reserve assets as collateral or through algorithmic formulas that are supposed to control supply.
• Stablecoins continue to come under scrutiny by?regulators, given the rapid growth of the $153 billion market and its potential to affect the broader financial system.

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Why Are Stablecoins So Important?

Though Bitcoin remains the most popular cryptocurrency, it tends to suffer from?high volatility in its price, or?exchange rate. For instance, Bitcoin's price rose from just under $5,000 in March 2020 to over $63,000 in April 2021 only to plunge almost 50% over the next two months. Intraday swings also can be wild; the cryptocurrency often moves more than 10% in the span of a few hours.

All this volatility can be great for traders, but it turns routine transactions like purchases into risky speculation for the buyer and seller. Investors holding cryptocurrencies for long-term appreciation don't want to become famous for paying?10,000 Bitcoins for two pizzas. Meanwhile, most merchants don't want to end up taking a loss if the price of a cryptocurrency plunges after they get paid in it.

To serve as a?medium of exchange, a currency that's not?legal tender?must remain relatively stable, assuring those who accept it that it will retain?purchasing power?in the short term. Among traditional?fiat currencies, daily moves of even 1% in?forex trading?are relatively rare.

As the name implies, stablecoins aim to address this problem by promising to hold the value of the cryptocurrency steady in a variety of ways.

The market price of the?TerraUSD?(UST) algorithmic stablecoin in the early afternoon of May 11, 2022, after it broke its parity peg to the U.S. dollar.

What Kinds of Stablecoins Are There?

Some would argue that stablecoins are a solution in search of a problem given the wide availability and acceptance of the U.S. dollar. Many cryptocurrency adherents, on the other hand, believe the future belongs to digital tender not controlled by?central banks. There are three types of stablecoins, based on the mechanism used to stabilize their value.

Fiat-Collateralized?Stablecoins

Fiat-collateralized?stablecoins maintain a reserve of a fiat currency (or currencies) such as the U.S. dollar, as?collateral?assuring the stablecoin's value. Other forms of collateral can include precious metals like gold or silver as well as commodities like crude oil, but most fiat-collateralized stablecoins have reserves of U.S. dollars.

Such reserves are maintained by?independent custodians and are regularly audited.?Tether?(USDT) and TrueUSD (TUSD) are popular stablecoins backed by U.S. dollar reserves and denominated at?parity?to the dollar.

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As of late August 2022, Tether (USDT) was the third-largest cryptocurrency by market capitalization, worth more than $67 billion.

Crypto-Collateralized?Stablecoins

Crypto-collateralized?stablecoins are backed by other cryptocurrencies. Because the?reserve cryptocurrency?may also be prone to high volatility, such stablecoins are overcollateralized—that is, the value of cryptocurrency held in reserves exceeds the value of the stablecoins issued.

A cryptocurrency worth $2 million might be held as reserve to issue $1 million in a crypto-backed stablecoin, insuring against a 50% decline in the price of the reserve cryptocurrency. For example, MakerDAO's Dai (DAI) stablecoin is pegged to the U.S. dollar but backed by?Ethereum?(ETH) and other cryptocurrencies worth 150% of the DAI stablecoin in circulation.

Algorithmic Stablecoins

Algorithmic stablecoins may or may not hold reserve assets. Their primary distinction is the strategy of keeping the stablecoin's value stable by controlling its supply through an?algorithm, essentially a computer program running a preset formula.

In some ways that's not so different from central banks, which also 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 U.S.?Federal Reserve?sets?monetary policy?publicly based on well-understood parameters, and its status as the issuer of legal tender does wonders for the credibility of that policy.

Algorithmic stablecoin issuers can't fall back on such advantages in a crisis. The price of the TerraUSD (UST) algorithmic stablecoin?plunged more than 60% on May 11, 2022, vaporizing its peg to the U.S. dollar, as the price of the related?Luna token used to peg Terra?slumped more than 80% overnight.

A smart contract is a self-executing contract with the terms of the agreement between buyer and seller directly written into lines of code. The code and the included agreements are stored by a distributed, decentralized?blockchain?network. The code controls the execution of the agreement, and transactions are trackable and irreversible.

Stablecoin Regulation

Stablecoins continue to come under scrutiny by?regulators, given the rapid growth of the $130 billion market and its potential to affect the broader financial system.6

?In October 2021, the?International Organization of Securities Commissions?(IOSCO) said stablecoins should be regulated as financial market infrastructure alongside payment systems and clearinghouses. The proposed rules focus on stablecoins that are deemed systemically important by regulators, those with the potential to disrupt payment and settlement transactions.

Moreover, politicians have increased calls for tighter regulation of stablecoins. For instance, in September 2021, Senator Cynthia Lummis (R-Wyoming) called for regular audits of stablecoin issuers, while others back bank-like regulations for the sector.

What Is the Purpose of Stablecoin?

Stablecoins aim to provide an alternative to the high volatility of popular cryptocurrencies, including?Bitcoin?(BTC), which can make cryptocurrency less suitable for common transactions.

How Does Stablecoin Work?

Stablecoins attempt to peg their market value to some external reference, usually a fiat currency. They are more useful than more-volatile cryptocurrencies as a medium of exchange. Stablecoins may be pegged to a currency like the U.S. dollar or to the price of a commodity such as gold or use an algorithm to control supply. They also maintain reserve assets as collateral or through algorithmic formulas that are supposed to control supply.

Which Is the Best Stablecoin?

The most popular and largest stablecoin by market capitalization is Tether (USDT). It is pegged to the U.S. dollar at a 1:1 ratio and backed by?gold reserves. It's also consistently in the top five cryptocurrencies by market cap. You can find Tether on most major crypto exchanges, including?Kraken, Binance, and Coinbase.?

Investing in cryptocurrencies and other Initial Coin Offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein.

By Krishna Dixit...