Stablecoins: Definition and How They Work

We break down the different types of this emerging investment and explain its risks.

blockchain concept art
(Image credit: Getty Images)

Over the last few years, through surging market highs and painful downturns, stablecoins have become an integral part of both the DeFi and broader cryptocurrency ecosystems. With a total market cap of over $150 billion, stablecoins have drawn crypto novices and experienced investors alike, enthralled by their compelling value proposition: the stability of a traditional low-risk asset with the flexibility of a digital currency. But with the recent crash of the once-revered Terra ecosystem, stablecoins have found themselves under heavy scrutiny, with many investors looking for answers regarding their safety and utility.

What Is a Stablecoin?

A stablecoin is a type of cryptocurrency whose value is pegged to an external, generally stable, asset class such as a fiat currency or gold. Given the wild volatility of most cryptocurrencies like Bitcoin and Ether, stablecoins offer a less risky alternative to store money on the blockchain and facilitate payments between individuals and institutions alike.

To maintain this price peg, stablecoins often set up a reserve of a single asset or basket of assets responsible for backing the stablecoin. For example, the reserve of a fiat-backed stablecoin like USDC may contain $1 million in U.S. dollars to serve as collateral for a million USDC. The stablecoin and reserve move in unison, so when a stablecoin holder chooses to cash out their tokens, an equal amount of the backing fiat asset is taken from the reserve and sent to the user’s bank account.

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Relative to fiat currency, stablecoins come with a handful of benefits:

Accessibility: Stablecoins are globally accessible to anyone with an internet connection and are functional 24/7. Unlike central banks, the crypto market, and by extension the stablecoin market, never close.

Speed and cost: Stablecoins are fast and cheap to use. International payments can be sent within seconds and seven-figure transactions cost no more than a dollar to execute.

Programmable: Through the use of smart contracts, stablecoin transactions can be automatically executed within specific parameters.

In addition to individual and business payments, stablecoins can be used for trading, borrowing and lending, earning yield, as alternatives to banking, for sending remittances, as stores of value, and more.

Types of Stablecoins

Fiat-Collateralized

The most popular, and generally most secure, stablecoins are backed 1:1 by fiat currency like the USD, euro or British pound. As mentioned in the USDC example above, each fiat-backed stablecoin has a reserve with an equal amount of fiat collateral held by a central bank or regulated financial institution. Many popular exchanges like Coinbase and Gemini offer their own fiat-backed stablecoin products.

Fiat-backed stablecoins include:

  • USDC (Coinbase)
  • Tether
  • GUSD (Gemini)
  • BUSD (Binance)

Crypto-Collateralized

As the name suggests, crypto-collateralized stablecoins are backed by cryptocurrencies (usually ETH), rather than fiat currencies. Instead of relying on a central issuer to store the reserve, crypto-backed stables use smart contracts to secure assets as collateral. To account for the unpredictable volatility of the cryptocurrency market, many decentralized crypto-backed stablecoins like MakerDAO’s DAI token are over-collateralized, with most requiring a 200% collateralized ratio. This means that for every $100 of DAI you wish to borrow, you must back it with $200 worth of ETH. This allows ETH to maintain its peg even during times of intense market volatility.

To purchase DAI, users may use any major exchange, like Coinbase and Gemini.

But to borrow DAI, users must lock cryptocurrency into a smart contract called a collateralized debt protocol (CDP) via the MakerDAO ecosystem. Once a user locks cryptocurrency into the CDP, they will then receive an equally representative amount of DAI. When it’s time to withdraw the original collateral amount, the user must put the initial amount of DAI, plus interest, back into the smart contract.

Algorithmic

Rather than being backed by cryptocurrency, algorithmic stablecoins use specialized algorithms and smart contracts to control token supply. It’s important to note that algorithmic stablecoins have no reserves at all. Instead, these algorithms link two coins (a stablecoin and a cryptocurrency that backs it) and adjust their price depending on the tenets of supply and demand. If the market price of the stablecoin falls below the price of the fiat currency it tracks, token supply is reduced. If the price of the stablecoin rises above the price of its pegged fiat currency, the algorithm increases token supply to put downward pressure on the stablecoin value.

As indicated by the groundbreaking crash of algorithmic stablecoin Terra, algorithmic stablecoins need sufficient demand to maintain value. And while the idea of algorithmic stablecoins has merit, there is still a lot to figure out here, so proceed with caution.

Commodity-Backed

Commodity-backed stablecoins are backed by reserves of physical assets like precious metals, oil and real estate. It’s important to note that while commodities markets may not be as volatile as cryptocurrencies, commodity-backed stablecoins are still riskier than fiat-backed stablecoins. That being said, they do provide the potential for great yield. While not particularly popular among the general cryptocurrency population, most commodity-backed stablecoins are used as a way to access asset classes that were previously inaccessible to small investors.

Examples of gold-backed stablecoins include Tether Gold (XAUT) and PAX Gold (PAXG).

Risks and Drawbacks of Stablecoins

Once thought to be fool-proof digital equivalents, the last 12 months have highlighted a handful of major drawbacks to stablecoins. It’s important to note that while stablecoins are considered low-risk relative to other digital assets, this does not mean they are no-risk.

Security: Unlike traditional bank accounts, digital wallets – and digital currencies for that matter – are not FDIC-insured. If your hot or cold wallet gets hacked, lost or stolen, your funds disappear with it.

Counterparty risk: Given recent developments with Celsius, BlockFi, and even Coinbase, there is ample counterparty risk in where you purchase and transact with your stablecoins. Make sure you do your research on any third parties responsible for storing your cryptocurrency.

Reserve risk: Does the entity behind the stablecoin actually have the collateralized assets and reserves to back the stablecoin? Even a token like Tether, which is considered among the most trustworthy, has raised concern about the legitimacy of its reserves.

Technical risk: This is specifically important for algorithmic stablecoins, which do not have actual cash reserves behind them. As we saw with the Terra fiasco, stablecoins may not be as stable as they appear. Algorithms aren’t perfect, and with the newness of the space, very few have been battle-tested during downturns or periods of low demand.

Bottom Line

Despite the recent downturn in the markets, stablecoins are still a promising, relatively low-risk and legitimate way to gain cryptocurrency exposure. But as with all investments, it’s more important than ever to do your own research when deciding which coins to invest in and where to store them. For safety purposes, it’s best to stick with fiat-backed stablecoins associated with major exchanges, as they provide the most insight into their reserves and come with the least counterparty risk.

Randy Ginsburg
Contributing Writer, Kiplinger.com