What Are Stablecoins — How Do They Work & Should You Invest?

Cryptocurrency was designed to be used for regular transactions. But in today’s financial world, it’s hard to imagine using something like Bitcoin to make daily purchases, especially when its value can be cut in half within a week.

That’s where stablecoins come in. Stablecoins are designed to hold the same value as an underlying currency, such as the U.S. dollar (USD). This makes them much easier to use for everyday purchases.

But what exactly are stablecoins and how do they work? And are they actually safe to use?

In this guide, we’ll cover all the important details about stablecoins, including what they are, the different types of stablecoins, the technology behind them, and which ones are safe to use. We’ll also cover the risks involved in using stablecoins and what to watch out for when choosing one to use. 

What Are Stablecoins?

Stablecoins are a type of cryptocurrency whose price is pegged to a less volatile asset, such as a national fiat currency (for example, the U.S. dollar). Some stablecoin prices are pegged to assets such as precious metals or even to other cryptocurrencies. 

Stablecoins were created as a less volatile way for investors to own cryptocurrency and use it as a cash equivalent for trading and transacting.

There are several types of stablecoins, from “fiat-collateralized” stablecoins, to “algorithmic” stablecoins, and others that offer differing types of collateralization. More on what these mean below. The goal of any stablecoin collateralization is to keep an equivalent amount of value in reserves to back the stated value of the coin. This gives investors confidence that their coin is worth the stated value because it is backed by a real asset.

At a Glance

• Stablecoins are a type of cryptocurrency whose value is tied to a less volatile asset, most commonly a national fiat currency (such as the U.S. dollar)
• Stablecoins are more useful than Bitcoin (or other crypto) as a medium of exchange
• Some stablecoins are backed by the currency they attempt to mirror, while others are collateralized by other cryptocurrencies
• Algorithmic stablecoins aren’t backed by any collateral, but increase or decrease supply to maintain price stability

How Stablecoins Work

Stablecoins are a type of cryptocurrency designed to keep a stable value, with price pegged to an underlying asset. Stablecoins are issued by companies that keep reserves to back the value of the stablecoin, whether that is fiat currency, commodities, crypto, or other assets.

Stablecoins have a controlled supply that moves in tandem with the demand for the coin and the amount of reserves available. 

For example, Tether (USDT) is the most popular stablecoin in the world. New Tether coins are issued when a verified user (or entity) deposits U.S. dollars into Tether’s bank account in exchange for an equivalent amount of tokens. This increases the circulating supply of tokens available, and adds to the overall reserves for the coin. When USDT tokens are redeemed for USD, the tokens are then removed from the circulating supply and the reserves are adjusted, keeping the 1-to-1 value pegged to the U.S. dollar.

Stablecoins have various ways of keeping the value peg for a given asset, with supply and demand being a key factor as well as the amount of reserves stored.

Types of Stablecoins

There are several types of stablecoins based on the backing asset that is used for collateral. Each stablecoin has unique properties and risks. Here are a few examples of the most popular types of stablecoins:

Fiat-Collateralized Stablecoins

Fiat-collateralized stablecoins are cryptocurrencies backed by the fiat currency they are trying to emulate. The U.S. dollar (USD) is the most popular fiat currency for stablecoins, and there are many examples of stablecoins that keep USD and USD-equivalent investments as collateral. 

An example of this is the most popular stablecoin, Tether (USDT). Each coin in circulation is backed by $1 in USD or USD-equivalents.

The idea behind fiat-backed stablecoins is that every coin has a real-world asset that backs the value, thereby giving it the same value as that fiat currency. Coins can vary slightly in value due to the supply and demand of a given marketplace, such as a crypto exchange, but overall, most maintain a 1-to-1 value with the underlying fiat currency.

Fiat-collateralized stablecoins don’t necessarily have to keep reserves 100% in the underlying fiat currency. Many keep reserves in treasury notes and other “fiat-equivalents” instead of holding the underlying currency. This has caused many debates about the true value of fiat-backed stablecoins and has prompted regulatory authorities to further investigate the claims of the reserves of some popular stablecoins.

Crypto-Collateralized Stablecoins

Crypto-backed stablecoins are collateralized by other cryptocurrencies instead of the currency they are pegged to. These stablecoins carry a higher risk because the collateral assets can fluctuate wildly in value. 

Some of these stablecoins are in fact overcollateralized, meaning they carry more value in reserves than the value of its circulation tokens. This allows for the collateralized crypto to drop in value while still maintaining enough reserves to support the stablecoins in circulation.

Collateralized stablecoins are programmatically pegged to real-world assets, such as fiat currency. This keeps their value stable, but they are backed by cryptocurrency instead of the asset whose price they are pegged to.

The most popular crypto-backed stablecoin is Dai (DAI). The issuance of DAI is managed by the Maker Protocol and is pegged to the U.S. dollar. Users can deposit different cryptocurrencies into Maker in exchange for DAI, thereby backing each coin with the deposited crypto. Maker Protocol runs on the Ethereum blockchain and manages issuance of DAI tokens through smart contracts.

Algorithmic Stablecoins

Algorithmic stablecoins are not backed by anything, but use an advanced algorithm to inflate or reduce the supply of the coin to keep a stable price. Unfortunately, because these coins are not backed by any other asset, there is significant risk to owning them. 

There have been many attempts at creating a sustainable algorithmic stablecoin, with the most popular being TerraUSD (UST). This algorithmic stablecoin was pegged to the U.S. dollar and technically backed by another cryptocurrency, Terra (LUNA), but both coins held artificial value based on an algorithmically-controlled arbitrage system.

Long-story short, the price of UST de-pegged due to a massive selloff of UST, and in turn, both UST and LUNA crashed, losing tens of billions of dollars in value for LUNA and UST investors. As such, algorithmic stablecoins are seen as a very risky investment because most have failed.

Commodity-Backed Stablecoins

Commodity-backed stablecoins are exactly that — stablecoins backed by a commodity, such as gold. These stablecoins follow a similar principle to fiat-backed stablecoins, pegging their value to a specific commodity, and backing each coin with an equivalent value of that commodity.

Perhaps the most popular commodity-backed stablecoin is Paxos Gold (PAXG), which backs each coin with a physical ounce of gold stored in professional vault facilities, according to the Paxos website. This means the price of PAXG mirrors the price of one ounce of gold.

Even though commodity-backed stablecoins are backed by a physical asset, there are still risks associated with investing in them. This includes selling pressure on crypto exchanges that could de-peg the price, causing a loss in value.

Pros & Cons of Stablecoins

Stablecoins have made cryptocurrency more approachable for investors and users who want to treat crypto more as a currency than an investment. But while the stable prices and ease of use are great, there are also a few downsides and risks to be aware of. Here are a few pros and cons of using stablecoins:

Pros

Stablecoins have a lot of promise, helping bridge the gap between cryptocurrencies and traditional fiat currencies. Here are a few advantages to using stablecoins:

1. Pegged to Known Currency. Although other cryptocurrencies fluctuate in price purely based on supply and demand of the marketplace, stablecoins are pegged to popular and known currencies or commodities, such as U.S. dollars or gold. The value is universally translatable globally.
2. Backed by Other Assets. Most stablecoins (with the exception of algorithmic stablecoins) are backed by other assets, protecting their value. If there is a fluctuation in price, the collateral is available to help stabilize the value of the currency and ensure investors can “cash out” if needed.
3. Available on Most Exchanges. Stablecoins have become a staple on most crypto exchanges, making them easy to use for trading with other cryptocurrencies or to cash out.
4. Hold Cash in Crypto Form. Stablecoins allow investors to hold a stable crypto asset that does not fluctuate in value, without the need to exchange for a real-world asset. This gives investors a way to “hold cash” in digital form.

Cons

Stablecoins are an awesome way to hold “cash” in crypto-form, but there are a few downsides to them that need to be discussed:

1. Risk of De-Pegging. Stablecoins are pegged to a fiat currency or other asset, but the value of stablecoins is still affected by supply and demand in the marketplace. If there is a large sell-off of a particular stablecoin, it may risk de-pegging and losing value. This happened to UST and lost investors billions of dollars.
2. Regulatory Scrutiny. Regulatory authorities are increasing their scrutiny of stablecoins because they undermine national currencies and pose much more risk to consumers. This scrutiny may cause some coins to lose value over time, especially if regulation restricts the use of a stablecoin in certain markets.
3. Underlying Assets Can Lose Value. Although most stablecoins are backed by collateral, that collateral can lose value, especially in crypto-backed stablecoins. But fiat-backed stablecoins are at risk of this as well. A collapse in the underlying asset can destabilize the currency and possibly cause it to de-peg.
4. Lack of Transparency. Stablecoins sometimes lack transparency, especially in regards to their collateral holdings. This lack of transparency is a risk to investors and stablecoin holders, who perceive the “safety” of the stablecoin may be in jeopardy if the collateral is not sufficient.

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Should You Invest in Stablecoins?

Stablecoins are not a traditional investment; most of them are pegged to a regular fiat currency. Investing in stablecoins is akin to investing in the U.S. dollar. But holding stablecoins in your crypto portfolio can be a good idea for a few reasons:

• Makes Trading Easier. Most crypto exchanges support stablecoins, and most trading pairs involve use of a stablecoin like USDT. This makes trading crypto much easier.
• Can Transfer Money 24/7. Stablecoins make it easy to transfer money around the clock, and since they are pegged to a known currency, the value is easily understood globally.
• Like Keeping Cash on Hand for Crypto Investing. Since stablecoins are available on most crypto apps, having stablecoins in your digital wallet is similar to having cash on hand for investment opportunities.
• Earn Interest. Stablecoins pay high interest rates on some platforms, making them a great way to earn passive (crypto) income.

But stablecoins have also been known to collapse, leaving investors with nothing (see: UST). And governments are starting to crack down on stablecoins, with investigations into the collateral claims by stablecoins issuers.

Although stablecoins mimic real world assets and fiat currencies, they are not the same. And stablecoins, like any other crypto, should be treated as a speculative investment with the risk of total loss possible.

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Stablecoin FAQs

Stablecoins are immensely popular and act as a bridge between real-world currencies and cryptocurrencies. Here are some answers to some of the most common questions about stablecoins:

What’s the Difference Between Stablecoins & Digital Currencies?

Stablecoins are a type of digital currency, but they are typically backed by a fiat currency or other type of currency outside of the cryptocurrency ecosystem. Stablecoins are used for trading purposes or to make purchases on the blockchain. They are the equivalent of “holding cash” in crypto form, and their price is pegged to a real-world asset, such as the U.S. dollar.

Central Bank Digital Currencies (CBDCs) are a type of fiat currency issued by a nation’s central bank, which is regulated by governing authorities of that nation. CBDCs are a form of legal tender used to exchange goods and services. CBDCs are the new digital equivalent of paper currency, and are designed to replace the modern “cash” currency used as legal tender within a nation. CBDCs are used just like any other fiat currency, with the ability to make purchases and investments within a supported jurisdiction.

What Are the Most Popular Stablecoins?

Currently the most popular stablecoins by market capitalization are:

• Tether (USDT)
• USD Coin (USDC)
• Binance USD (BUSD)
• Dai (DAI)

As mentioned earlier, the TerraUSD (UST) coin used to be one of the most popular until the collapse of the Terra ecosystem.

How Do You Use Stablecoins?

Stablecoins can be used in a variety of ways, from trading with other cryptocurrencies to making purchases online. Stablecoins were designed as a more stable currency than other cryptos, and are commonly used in online transactions.

Although many retailers don’t accept stablecoins as payment for items, there are a few crypto debit cards that allow you to spend cryptocurrency on regular purchases. For example, the Crypto.com card allows you to spend Tether (USDT) on regular purchases and converts it to fiat currency automatically for you.

Stablecoins can also be used for transferring funds in a peer-to-peer (P2P) fashion, similar to apps like Venmo or PayPal. Stablecoins can be transferred globally and on a 24/7 basis between user wallets, making them a more flexible currency than most fiat currencies.

How Are Stablecoins Regulated?

Stablecoins are currently unregulated in most jurisdictions, although there is a lot more scrutiny surrounding stablecoins after the collapse of Terra. 

Stablecoins have been under regulatory debate for some time, and in 2021 the President’s Working Group on Financial Markets (PWG) created a report on stablecoins and called for further investigation and regulation from the Securities and Exchange Commission (SEC). 

Although stablecoins are not regulated in most countries, there may be regulation coming soon from the U.S. government.

Final Word

Stablecoins have become some of the most popular cryptocurrencies to hold for crypto investors, with three of the top 10 cryptocurrencies by market cap being U.S. dollar stablecoins. Stablecoins make it easy to transfer funds between parties and to maintain the value of crypto assets you hold for trading.

Stablecoins are on the hot seat, though, with governmental authorities like Janet Yellen demanding regulation to help protect consumers from the risks of stablecoins. And there are risks. A lack of transparency about collateral reserves and the fact that coins can de-peg and lose value make them a riskier investment than holding cash.

But even with impending regulation, stablecoins seem poised to be a mainstay of the cryptocurrency market. Just make sure you understand what you are holding when you invest in them.