Stablecoins: Unpacking Their Role & Impact in the Crypto Market

Stablecoins have become increasingly popular, with their market cap reaching $164 billion in August 2024. But how are they different from other cryptocurrencies? And are they a good investment? Let’s explore more about what it is.

Stablecoins are cryptocurrencies that have their price pegged to or backed by a stable asset, or group of assets. Most are pegged to fiat i.e. real currency. However, some may be pegged to the price of commodities such as gold, or even other cryptocurrencies. Some are not pegged to any asset. 

Many see stablecoins as having the best of both worlds – they possess the blockchain technology that most cryptocurrencies possess, but are without the volatility that Bitcoin and other cryptocurrencies can suffer from. They are stable coins in the literal sense of the word. 

Key Takeaways:

• Stablecoins are cryptocurrencies that have their price pegged to or backed by a stable asset, or group of assets. 

• There are four different types of stablecoins available on the market: three are backed by collateral, and one is not.

How do Stablecoins Work?

How do stablecoins work so they are actually kept stable?

How is Price Stability and Low Volatility Achieved?

Price stability and low volatility are often cited as major advantages of stablecoins. It should be noted however that stablecoins are only as stable as the asset they are pegged to. 

Although by their nature, stablecoins are pegged to assets that are expected to be stable themselves, that’s not to say they are not immune to volatility. 

Price swings could still happen, thus affecting the volatility of the stablecoin. Thankfully, this is rare. Stablecoins are generally very stable because of the high stability of the asset they are pegged to. 

But how are stablecoins kept stable, or in other words, how do they keep their peg maintained? 

This comes down to the issue of trust. For the peg to be maintained, the market needs to have trust in the asset the coin is pegged to. That’s why coins are pegged to trusted assets such as US dollars, gold and oil. 

Tether (USDT), for example, is pegged to the U.S. dollar, meaning that for every unit of USDT, parent company Tether keeps a U.S. dollar in reserves. If the market didn’t hold trust in that one unit of USDT was worth one dollar, then it would crash. However, the fact that USDT for the most part has been always very close to one dollar in value, is a testament to the trust the market has in it.

What are Stablecoins Used For?

Price stability and low volatility can bring convenience, but in what ways are stablecoins used? 

Transactions

Stablecoins are being increasingly used for transactions, with the blockchain technology enabling international transactions to be done significantly more quickly than more traditional means. Additionally, some individuals and merchants may be perhaps understandably resistant to transact in a cryptocurrency which may fluctuate in price massively in a short period of time, such as Bitcoin. With stablecoins, this risk is significantly lower.

Also in developing countries, they are used as an alternative to the failing bank systems where many don’t have a bank account at all and hyperinflation can be a huge problem. The stablecoin project Reserve was launched in Venezuela and Angola in 2019 in an attempt to combat these issues.

To Exchange From Other Cryptocurrencies

Let’s imagine a trader is concerned about the risk of the price of Bitcoin falling against the U.S. dollar. They may not want to exchange to fiat, as this can be expensive due to processing fees. So, that’s where exchanging to a stablecoin can be a handy option. They could be exchanged to a stablecoin pegged to the price of the U.S. dollar, such as USDT or USDC, and this risk is then taken away.

Decentralized Finance (DeFi)

DeFi in recent years has become well-established in the financial sector, and offers a public blockchain-based alternative to traditional financial services through the use of smart contracts. Stablecoins play their part as they offer a stable means of transactions taking place in the DeFi system.

Types of Stablecoins

Four different types of stablecoins exist. Three types are backed by collateral, and one type is not. In addition to this, two types are centralized (held by a central entity), and two types are decentralized (not held by a central entity).

• Fiat backed (centralized)

• Commodity backed (centralized)  

• Cryptocurrency backed (decentralized)

• Algorithmic (decentralized)

Fiat Backed Stablecoins

Most stablecoins are pegged to fiat currencies, such as USD, EUR or GBP. This is done at, or very near to, a 1:1 ratio. This essentially means that for every stablecoin, there is a unit of fiat currency stored somewhere in reserves too.

So let’s imagine that somebody wants to convert their stablecoins into cash. The institution storing the stablecoins will send the fiat currency being stored in reserves to the individual’s bank account, and the amount of stablecoins equating to the amount of fiat circulation will be removed from circulation.

Pros of Fiat Backed Stablecoins: 

• They have the simplest structure to understand, which is no doubt a big factor in their popularity. 

• As long as the fiat currency it is pegged to remains stable, then the stablecoin will remain stable too. 

• With their low fees and volatility, and blockchain technology, fiat-backed stablecoins in particular are being seen as a bridge between more traditional means of payment and the benefits cryptocurrencies can bring in this area. 

Cons of Fiat Backed Stablecoins:

• The fact they are centralized leaves users at the mercy of the entity holding them. Therefore, there is no way to ensure transparency and that protocol is being followed. 

• If the currency it is pegged to does crash, then so does the stablecoin (although that is why most are pegged to the historically strong U.S. dollar)

Commodity Backed Stablecoins

Most stablecoins in this category are collateralized to gold, but they can be collateralized to other commodities too, including metals, oil, or real estate. These commodities act as mechanisms to limit price volatility. Commodity-backed stablecoins can give everyday investors the opportunity to invest in commodities. Although investments in assets such as gold have traditionally been for the rich, these types of stablecoins have opened them up to potentially a whole new demographic of people.

Pros of Commodity Backed Stablecoins:

• Users can be assured that the volatility of commodities compared to assets such as cryptocurrency is relatively low.

• Users are holding a tangible asset, and their value has the potential to appreciate over time. 

Cons of Commodity Backed Stablecoins:

• Commodity-backed stablecoins can be more difficult to redeem than fiat-backed stablecoins. If you want to exchange a stablecoin pegged to an asset such as gold, it may be quite easy to do, but doing the same for real estate may take some time due to the potentially complicated process involved. 

• As they are centralized, a level of trust is needed between the user and the central entity holding the commodity.

Cryptocurrency Backed Stablecoins

Some stablecoins are pegged to cryptocurrencies. In contrast to fiat-backed stablecoins, cryptocurrency-backed stablecoins are issued through smart contracts. As cryptocurrency prices can be notoriously volatile, coins are often backed by multiple cryptocurrencies. So if one suffers price volatility, the others can absorb the shock while remaining stable. 

Additionally, some are protected by a process called over-collateralization. It means when the coin is backed by an asset more than the value of the coin, and is used as a protective measure. So, instead of a ratio 1:1 like fiat, the ratio may be 1:2 instead, meaning that the stablecoin is backed up by cryptocurrency collateral double its value.

Pros of Cryptocurrency Backed Stablecoins:

• They are decentralized, and as transactions take place on blockchains, complete security and transparency are ensured. 

• They will often have higher amounts of liquidity, meaning they can be converted quickly and at a low cost.

Cons of Cryptocurrency Backed Stablecoins:

• Their operating mechanisms are quite complex, meaning they haven’t caught on in popularity like some other types of stablecoins, at least not yet.

• If the price of the reserve cryptocurrency becomes high, over-collateralization can prove to be expensive.

Algorithmic Stablecoins

Believe it or not, noncollateralized stablecoins do exist: this type of stablecoin is known as the algorithmic stablecoin. The supply of these stablecoins is controlled by algorithmic pegging and smart contracts. Supply and demand drive the prices of these stablecoins. The supply of these stablecoins is controlled by an algorithm-based model known as seigniorage shares.

If the price of the stablecoin increases, then coins will be issued by the algorithm until the supply and demand achieve equilibrium. If the price of the stablecoin decreases, then the supply of the coins will be reduced until supply and demand also achieves equilibrium. By doing these things, the algorithm can keep the price of the coin stable.

Pros of Algorithmic Stablecoins

• As they aren’t centralized to any asset at all, they are in essence the most decentralized stablecoin, and the algorithm is openly transparent and auditable for anyone to see.

• As they are not pegged to anything, they are not reliant on collateral. 

Cons of Algorithmic Stablecoins

• Although issuing coins to achieve equilibrium between supply and demand is easy, it may be difficult to reduce the supply of the coins while attempting to maintain value. 

• Continuous growth is needed for the peg to be maintained.

Are Stablecoins a Good Investment?

There are contrasting options on whether stablecoins are a good investment or not. Let’s look at some of the arguments for and against.

Reasons for Stablecoins Being a Good Investment

• Investing in fiat-backed stablecoins such as USDT or USDC can be a handy option for investors who are biding their time to invest in a volatile asset such as Bitcoin. They can be converted quickly and easily, and can be converted back when confidence is restored of the asset’s volatility.

• As they are generally considered low risk, they can form a worthy part of a diversified portfolio of investments (where it is always wise to possess lower-risk investments alongside higher risk ones). Over time, the assets may appreciate in value and they may prove to be profitable long-term investments. In particular this may be the case for commodity-backed or cryptocurrency-backed stablecoins. 

Reasons for Stablecoins not Being a Good Investment

• As with any investment, the higher the potential gain, the higher the risk. So while some stablecoins may appreciate in value over time, they could also depreciate. In particular, this may be a risk with cryptocurrency-backed stablecoins, despite the mechanisms in place to deal with the inevitable price volatility.

• Fiat-backed stablecoins are considered to be the most stable of stablecoins, but this stability doesn’t make them a very profitable long-term investment and their value is unlikely to increase significantly over time. If anything, with fiat-backed stablecoins, their value is likely to decrease over time. When central banks print more money, it devalues the currency. Inflation means that you’ll be able to buy less with one dollar in 10 years than now, and even less in 20 years' time.

The Bottom Line

Although the question of if stablecoins are a good investment is open to debate, what isn’t is that they have much potential. They bring the benefits of blockchain technology and stability, meaning they can be relied upon for transactions in the crypto ecosystem. Their mass adoption has the potential to revolutionize traditional means of financial transactions and provide a much-needed avenue for the billions unbanked (those without a bank account) around the world. They could prove to be a safe haven from the hyperinflation which plagues some third-world countries. The future is bright for stablecoins. 

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