A stablecoin is a type of cryptocurrency designed to hold a fixed value over time. The value of a stablecoin is usually tied to a specific real currency, often the US dollar. In this configuration, one unit of the cryptocurrency is generally equivalent to one unit of the real currency. Unlike highly volatile cryptocurrencies such as Bitcoin, the price of stablecoins is not meant to fluctuate.
But recent events in the stablecoin market – namely, the drop of TerraUSD – that federal officials look closely at this area. Treasury Secretary Janet Yellen cited risks to general financial stability from stablecoins, while the Federal Reserve released a report on the uncertainty of what actually backs stablecoins and the lack of oversight over it. market.
Here’s how stablecoins work, what risks they pose, and how to check if a stablecoin is safe.
Stablecoins: what they are and how they work
A stablecoin is a cryptocurrency whose value is pegged to another asset, often currencies such as the US dollar or euro, although other assets are possible. This type of cryptocurrency tracks the underlying asset, making its value stable over time, at least relative to the currency it is pegged to. In effect, it is as if the underlying asset had gone electronic, for example, like a digital dollar.
Because their goal is to track an asset, stablecoins are often backed by the specific assets they are pegged to. For example, the organization that issues a stablecoin usually sets up a reserve with a financial institution that holds the underlying asset. So a stablecoin could hold $100 million in reserve and issue 100 million coins with a fixed value of $1 per coin. If the owner of a stablecoin wants to cash out the coin, the real money can ultimately be taken from the reserve.
This structure contrasts with most cryptocurrencies, such as Bitcoin and Ethereum, which are not backed by anything at all. Unlike stablecoins, these other cryptocurrencies fluctuate widely as speculators drive their prices up and down as they trade profits.
While many stablecoins are backed by hard assets, others are not. Instead, these others use technical means (such as destroying part of the coin supply in order to create a shortage) to keep the price of the cryptocurrency fixed. These are called algorithmic stablecoins, and they can be riskier than asset-backed stablecoins.
Why are stablecoins used in crypto trading?
Stablecoins solve one of the key problems with many common cryptocurrencies, which is that their drastic fluctuations make it difficult, if not impossible, to use them for real transactions.
“Digital currencies like Bitcoin and Ethereum are extremely volatile, which makes it very difficult to price things,” says Anthony Citrano, founder of Acquicent, an NFT marketplace. “Stablecoins avoid this problem by locking their prices to a known reserve currency.”
Additionally, their stability allows many stablecoins to be used as a functional currency within a crypto brokerage. For example, traders can convert Bitcoin to a stablecoin such as Tether, rather than dollars. Stablecoins are available 24/7, making them more accessible than cash obtained through the banking system, which is closed at night and on weekends.
Stablecoins can also be used with smart contracts, which are a kind of electronic contract that is automatically executed when its conditions are met. The stability of digital currency also helps circumvent any disagreements that might arise when dealing with more volatile cryptocurrencies.
What are the most popular stablecoins?
Stablecoins generally don’t get the same press (and hype) as other cryptocurrencies, in part because they don’t offer the same kind of “get-rich-quick” opportunity. But a few are among the most popular cryptocurrencies by market capitalization, as of May 2022:
- Tether (USDT): $82 billion
- USD coin (USDC): $49 billion
- Binance USD (BUSD): $17 billion
Of course, the size of these coins pales in comparison to the biggest cryptocurrencies, such as Bitcoin, with a market capitalization of nearly $560 billion, and Ethereum, valued at over $242 billion.
TerraUSD, an algorithmic stablecoin, had been another popular option, but it lost its peg to the dollar in May 2022. This stablecoin used other cryptocurrencies and a sophisticated arbitrage system to maintain its valuation at the 1:1 level . But the decline of the crypto markets and the subsequent loss of confidence in the stablecoin caused its price to plummet.
What are the risks of stablecoins?
At first glance, stablecoins may seem low risk. In comparison to popular cryptocurrencies which are not backed by anything, they are. But stablecoins come with typical crypto risks and at least one of their own type of risk as well:
- Security: Like other cryptocurrencies, stablecoins need to be held somewhere, whether it’s your own digital wallet or with a broker or exchange. And this poses risks because a given trading platform may not be secure enough or have certain vulnerabilities.
- Counterparty risk: Although it may seem like cryptocurrency is highly decentralized, in reality you are dealing with multiple parties in a transaction, including the bank holding the reserves and the organization issuing the stablecoin. They need to do the right things (security, proper reservation, etc.) for the currency to retain its value.
- Reserve risk: A key part of the stablecoin ecosystem are the reserves backing a stablecoin. These reserves are the last safety net on the value of a stablecoin. Without them, the coin issuer cannot confidently guarantee the value of a stablecoin.
- Lack of confidence: If a stablecoin is not sufficiently backed by durable assets, especially cash, it could suffer a run and lose its peg against its target currency. This is effectively what happened to the algorithmic stablecoin TerraUSD in May 2022, since it was not backed by cash but rather by other cryptocurrencies. The price of the stablecoin broke and tumbled as traders lost faith in its ability to hold the peg.
“The main risk of stablecoins is that they are not fully backed by the reserve currencies they claim to be,” Citrano says. “In an ideal situation, the issuer of the stablecoin has enough currency reserves (in cash or other highly liquid and safe investments) to fully back the stablecoin. Less than 100% and risk is introduced.
How secure are stablecoins?
So how do you know if a stablecoin is safe? You will need to read the fine print on its issuer’s statements. And it’s absolutely essential that you do, says Citrano.
“Check the issuer’s reserve reports,” he says. “If they don’t provide any reserve report, be extremely careful.”
And even then, stablecoin owners need to pay close attention to what is supporting their coin. The stablecoin Tether has to be under fire for his reservations disclosures. And those who think that cryptocurrency is entirely reserved by real dollars should be careful.
In its reserve of March 31, 2021 report, the company has shown that it has more reserves than liabilities. It’s good on the surface, but the devil is in the details:
- Approximately 76% of its reserves are held in the form of cash or cash equivalents (the vast majority of which is short-term corporate debt, also known as commercial paper).
- Almost 13% are secured loans.
- Nearly 10% is made up of corporate bonds, funds and precious metals.
These other assets may act like real money most of the time, but they are not real money.
If you look closely, less than 4% was actual cash, while most is held in the form of short-term corporate debt. This commercial paper is not the same as cash, especially in an emergency. If the markets fall, these assets (and other non-monetary assets) could quickly lose value, rendering the Tether coin less than fully reserved exactly when it needs it most.
Unless a stablecoin pledges to hold 100% (or more) of its reserves in cash, there is no guarantee that the money will be there to redeem the coins. In this case, the value of stablecoins may turn out to be much less than stable. Stablecoin holders may find themselves on the losing side of an old-school banking race, a surprising fate for a technology that bills itself as very modern.
Since then, Tether has reduced its holdings of certain types of these non-monetary assets.
In 2021, the United States Commodity Futures Trading Commission fined Tether $41 million for making false claims that its stablecoin was 100% backed by real currency. Since the March 2021 report, Tether has reduced its commercial paper holdings, and in Q4 2021 they were around 30% of reserves, down from 44% in Q3. The company said it would continue to reduce its reliance on this funding.
Finally, a currency’s best guarantee of security is that people will widely accept it in exchange for goods and services. And the only widely accepted currency in the United States — in fact, the only price at which products are ultimately denominated — is the dollar.
At the end of the line
Stablecoins offer some of the stability that most cryptocurrencies lack, making them unusable as real money. But those who use stablecoins need to know the risks they are taking when they own them. While in most times it may seem like stablecoins have limited risk, stablecoins can become the riskiest in a crisis when it should be the safest to own them.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. Further, investors are cautioned that past performance of investment products does not guarantee future price appreciation.