Stablecoins Explained: What are They?

JOSH GILBERT
Despite existing in the crypto space for a few years, stablecoins have built more prominence in Australia in the last year or so, stablecoins such as Tether’s USDT or Pax are often used as safeguard portfolio balancers against volatile crypto assets like bitcoin or Dash.

However, as of late, global governments are becoming increasingly vocal about stablecoins, meaning these once under-the-radar crypto assets are now facing more scrutiny than ever.

So, what are stablecoins? And why are they suddenly causing a kerfuffle in the crypto world?

Stablecoins are crypto assets that are pegged to other assets or benchmarks, such as the US Dollar (USD) or Gold. Known as inherently ‘stable’ crypto assets, stablecoins hold appeal for both crypto and traditional investors alike.

As price-steady digital currencies that behave like fiat currencies, but maintain the decentralised nature and utility of crypto assets, stablecoins are generally considered a safe haven against the volatility of cryptocurrencies.

Stablecoins are able to mimic the relatively-stable price of real-world assets because the entity producing the stablecoin will usually set up a reserve to store the asset pegged to the stable coin. The real-world asset serves as collateral for the stablecoin, meaning you can essentially swap one unit of a stablecoin for one unit of its corresponding asset.

What are the different types of stablecoins?

There are four primary stablecoin types, which are identifiable by its underlying collateral structure.

1) Fiat-backed: The most simple stablecoin mimics fiat currency such as the US Dollar or Pound Sterling. During times of volatility, some investors will choose to park their profits in stablecoins to retain as much of that profit as possible, while reducing risk of loss if the crypto market dips significantly.

A common argument against fiat-backed stablecoins is that it relies on the issuing party to be properly regulated (generally by a government) which can contradict the deregulated and decentralised spirit of cryptocurrencies.

Some examples of fiat-backed stablecoins include the likes of Tether (USDT), USD Coin (USDC) or Gemini Dollar (GUSD).

2) Crypto-backed: As the name suggests, this version uses other crypto assets such as Ethereum or Bitcoin, as collateral for the stablecoins. However, as crypto values are not stable, crypto-backed stablecoins are overcollateralized to ensure the price stays as stable as possible. This means one unit of a crypto backed stablecoin is pegged by about double of underlying crypto asset to account for volatility. Well known crypto-based stablecoins include MakerDAO’s Dai (DAI).

3) Commodity-backed: These stablecoins are backed by precious metals such as gold or oil. Some of the most popular stablecoins in this category include Tether Gold (XAUT) and Paxos Gold (PAXG). Commodity-backed stablecoins are often more susceptible to price movements, but since commodities increase in value over the long term, investors can buy and hold this asset for capital appreciation.

4) Algorithmic: Algorithmic stablecoins are different to other versions, as they are not backed by any collateral. Instead, these coins simulate the way fiat currencies work, but where fiat currencies are governed by a sovereignty and often generate value via seigniorage, these assets instead leverage an algorithm that manages supply and demand without human interference. Algorithmic stablecoins system issues more coins when price increases, and buys them off the market when the price falls.Examples of algorithmic stablecoins include Ampleforth (AMPL), DefiDollar (USDC) or Frax (FRAX).

The pros and cons of stablecoins

While some stablecoins can reward budding investors, not all are created equal. This means that there are a handful of pros and cons associated with stablecoins.

Pros:

The main feature of a stablecoin is that its value will remain stable, even after five years or so, and this can help ease losses and protect gains when a significant drop occurs in a volatile market.

Stablecoins act as a store of value and can be used as legitimate digital currencies to purchase goods or services, or to make trade settlements.

Cons:

While fiat-backed stablecoins are considered the most steady, it’s important to remember that even fiat currencies experience bouts of volatility. Stablecoins are fully dependent on the underlying asset. If the price or value of the asset depreciates (which, for crypto assets can be quite rapid and significant), so will the stablecoin, resulting in a potential loss. Just like their fiat counterparts, these assets are also not immune to the impact of inflation.

When purchasing stablecoins, investors must also consider whether the issuer actually has the collateral it claims it owns. Most entities don’t disclose information about their reserves so it can be difficult to discern how risky the stablecoin is.

The future of stablecoins: Will the crypto asset remain stable?

With over one hundred different stablecoin projects that exist in the market today, and several more to be launched in the coming year, the stablecoin market has reached nearly $40 billion in supply and, in January 2021, monthly transaction volume exceeded $200 billion.

The circulating supply of the four leading stablecoins – Tether’s USDT, USD Coin, Binance USD, and Dai – grew by 23.8% in May, to hit an all-time-high of $95.1 billion.

Stablecoins are emerging as the private sector’s answer to central bank digital currencies (CBDCs), with the likes of Facebook-backed Diem using these crypto assets to transform payments and other financial services. In fact, PayPal has reportedly been developing its own stablecoin as it works to allow its US users to withdraw crypto assets in their wallets.
While there are a few setbacks associated with stablecoins, some experts predict that they are the future of the crypto market.

Main image source: Skorzewiak/Shutterstock.com.au


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Josh Gilbert is an analyst at eToro. The eToro platform enables people to invest in the assets they want, from stocks and commodities to crypto assets.

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