Stablecoins: What Are They and How Do They Work?

digital rendition of blue stablecoins, some with a dollar sign and others that read USDC

(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 decentralized finance (DeFi) and broader cryptocurrency ecosystems.

With a total market cap of roughly $250 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.

With the Senate's recent passage of the GENIUS Act, a bill that seeks to create a regulatory framework for dollar-pegged stablecoins, many investors are now looking for answers regarding their safety and utility.

From just $107.88 $24.99 for Kiplinger Personal Finance

Become a smarter, better informed investor. Subscribe from just ~~$107.88~~ $24.99, plus get up to 4 Special Issues

CLICK FOR FREE ISSUE

https://cdn.mos.cms.futurecdn.net/flexiimages/y99mlvgqmn1763972420.png

Sign up for Kiplinger’s Free Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

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 such as 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 such as USDC might 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.

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 such as the U.S. dollar, euro or British pound.

As mentioned in the USDC example, 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 such as Coinbase Global (COIN) and Gemini offer fiat-backed stablecoin products.

Fiat-backed stablecoins include:

USDC (Circle)
Tether
GUSD (Gemini)
PayPal USD (PayPal)

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 such as Sky's SAI token, which was formerly known as MakerDAO's DAI, are over-collateralized, with most requiring a 150% collateralized ratio.

This means that for every $100 of DAI you wish to borrow, you must back it with $150 worth of ether. This allows ETH to maintain its peg even during times of intense market volatility.

To purchase DAI, users might use any major exchange, such as 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, the token supply is reduced.

If the price of the stablecoin rises above the price of its pegged fiat currency, the algorithm increases the token supply to put downward pressure on the stablecoin value.

Following the groundbreaking crash of algorithmic stablecoin Terra in 2022, algorithmic stablecoins need sufficient demand to maintain value.

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 pegged to reserves of physical assets such as gold, oil and real estate.

It’s important to note that while commodity markets might 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).

Are stablecoins safe?

Once thought to be foolproof digital equivalents, the past few years have highlighted a handful of 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, most 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 are likely to disappear with it.

Counterparty risk: Given the collapses of Celsius and BlockFi, folks should be aware that there is ample counterparty risk related to 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 such as 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 might not be as stable as they appear. Algorithms aren’t perfect, and with the relative newness of the space, very few have been battle-tested during downturns or periods of low demand.

The bottom line on stablecoins

Stablecoins are 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.

The passage of the GENIUS Act "will enable U.S. businesses and consumers to take advantage of the next generation of financial innovation,” said Sen. Kirsten Gillibrand, (D-NY), who co-sponsored the bill.

"A product of months of bipartisan negotiations, the GENIUS Act will protect consumers, enable responsible innovation, and safeguard the dominance of the U.S. dollar," she added.

Randy is a New York-based freelance writer and author covering the world of emerging technology and entrepreneurship. Deeply interested in the way technology will impact his grandkids' lives, Randy has been featured in several publications, including NFT Now, Forbes and Newsweek.