Ever wondered ‘how do stablecoins work?’ You’re in the right place. In this article, we’ll explain everything you need to know about stablecoins and whether they could be a smart addition to your portfolio.
When it comes to trading cryptocurrency, one of the sector’s biggest draws can also be a serious hazard: volatility. While fiat currencies typically have daily volatility levels of 0.5%, it’s not unusual for the price of cryptocurrencies to change by as much as 5% — and if prices consistently fall, this can result in huge losses for investors. (A fiat currency is one which is regulated by a government and has a fixed value, for example, the British pound or US dollar).
Although volatility can be a positive factor if traders know exactly when to buy and sell, it means that most cryptocurrencies are extremely risky investments. However, for those who want to access the decentralised benefits of crypto, but don’t want to worry about the unpredictable prices, there is an alternative solution: stablecoins.
If you’re wondering ‘how do stablecoins work’ or even ‘what are stablecoins’, you’re in the right place. In this article, we’ve put together the ultimate beginner’s guide to stablecoins. Whether you’re an existing crypto investor who wants to know more about these assets or someone who’s wary of Bitcoin and thinks stablecoins could be the answer, read on to discover why so many investors are adding stablecoins to their portfolio.
What Are Stablecoins?
As the name suggests, stablecoins are a particular type of cryptocurrency (or crypto token) that’s designed to be stable in nature. While currencies such as Bitcoin take their value from a range of factors — including supply and demand, investor confidence, and events such as the Bitcoin halving — stablecoins are pegged to a fixed external value.
Often, this is a fiat currency such as the US dollar, but it can also be a commodity such as gold, oil, or certain mineral exports. It can even be another cryptocurrency, as long as it’s one (or more) which isn’t subject to huge price swings.
The idea behind this is that the value of the underlying asset will be stable enough to keep the stablecoin in check. Because the stablecoin has the same value, it’s protected from the market volatility which affects standard cryptocurrencies. Although it will be affected by any fluctuations that occur to its pegged asset, these are likely to be far less dramatic than those which impact the price of Bitcoin, Ethereum, and other major cryptos.
What Is Volatility?
Volatility is one of the most important concepts in the cryptocurrency market. Before we answer the question ‘what are stablecoins used for?’, let’s recap exactly what the term ‘volatility’ means and how it can be measured in investments.
Volatility is the extent to which a cryptocurrency (or any other asset) fluctuates in value. It’s an important indicator for traders and investors, who can use this information to predict breakout investment opportunities. In fact, studying past price movements is one of the most important steps to take before adding a new crypto to your portfolio.
In cryptocurrency investing, these price movements are generally measured in pips. This stands for percentage in point (or price interest point) and is used to show even the smallest changes in value. Think of a pip as the fourth decimal place in a number — for example, $0.0001.
A highly volatile cryptocurrency is one that fluctuates wildly in value. Bitcoin is often cited as one of the world’s most volatile assets. In the three months between October 2017 and January 2018, for example, the currency hit a record volatility rate of 8% — while in June 2019, its price crashed by $1,000 in just 20 minutes!
Although no currency is completely free from volatility, it’s incredibly unusual for fiat currencies to experience this level of price movement in such a short time period. This means that stablecoins are far more resilient to the factors which can affect conventional cryptocurrency.
What Are The Different Types Of Stablecoin And What Are They Used For?
In order to understand what stablecoins are used for, we’ll need to explore the different types of stablecoin. These three types are:
- Fiat-backed stablecoins (otherwise known as peg stablecoins)
- Collateral stablecoins
- Algorithmic stablecoins
Each of these categories has different properties that make them suitable for a range of different purposes. Let’s take a closer look at how these types of stablecoin work.
What Are Fiat-Backed Stablecoins?
Fiat-backed stablecoins, or peg stablecoins, are pretty self-explanatory. These are crypto tokens that are tied in value to an underlying fiat currency. This could be the British pound, Japanese yen, Canadian dollar, Swiss franc — the possibilities are almost endless, but the most common is the US dollar.
The most famous fiat-backed stablecoin is Tether (USDT) which was launched in 2014. This was actually the world’s first stablecoin, so it’s something of a trend-setter. Tether appealed to investors who were intrigued by the decentralised nature of crypto, but found the prospect of Bitcoin’s dramatic price swings too alarming. And this appeal has paid off. Tether is currently not just the most popular stablecoin, but also the third biggest cryptocurrency by market cap. At the time of writing, its market cap is $17,473,086,836 and it has the highest 24-hour trading volume of any digital asset on the market ($41,067,765,107).
Tether takes its name from the fact it’s ‘tethered’ to the US dollar. This means that 1USDT is equal to 1USD. Other examples of US-backed stablecoins are:
- USD Coin
- Gemini Dollar
One of the most important uses for fiat-backed stablecoins is as an intermediary between fiat and cryptocurrency. On exchanges, it’s often treated as a digital dollar. If an investor can’t make a direct USD transaction, using Tether tokens can be a great alternative. Because 1USDT will (in theory) always value 1USD, many investors choose to convert their funds to Tether as a way of storing them in digital wallets without having to worry about their value going down over time.
What’s more, lots of exchanges don’t offer investors the opportunity to buy and sell crypto using fiat currency. As a result, converting crypto funds to fiat can be quite tricky — but converting crypto to Tether, and then Tether to USD, is pretty straightforward.
What Are Collateral Stablecoins?
Collateral stablecoins work using the same principle as fiat-backed stablecoins. However, instead of being tied to USD, GBP, or EUR, they are tied in value to another cryptocurrency.
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In fact, most collateral stablecoins are tied to a selection of different cryptocurrencies. (This is sometimes referred to as a basket of assets). You may think that tying a stablecoin to one or more cryptocurrencies defeats the object of a stablecoin. After all, if its underlying assets aren’t stable, how can a stablecoin live up to its name?
This is a valid concern. Collateral stablecoins such as the Maker coin (DAI) are much less stable than those which are backed by a fiat currency. But they do have one major advantage over both the peg and centralised stablecoins: they can be fully hosted on the blockchain. This means that they are completely decentralised, unlike those which rely on government-issued assets.
Most investors use collateral stablecoins as a hedging tool to counterweigh more volatile currencies in their portfolio. Although they are the most volatile form of stablecoin, they can still be an effective form of risk management, weathering some of the storms which can cause huge price movements in more major cryptos.
What Are Algorithmic Stablecoins?
Unlike fiat-backed or collateral stablecoins, algorithmic stablecoins are not tied to an underlying asset. Instead, the circulating supply is controlled in response to its performance.
For example, if a coin is supposed to be roughly equal in value to the US dollar and is starting to fall below this amount, an algorithm will automatically reduce the supply in order to drive the price back up. Similarly, if the price is starting to exceed $1, the algorithm will increase the circulating supply to help bring the price lower.
Algorithmic stablecoins are based on the quantity theory of money. This states that the price of a good or service is directly proportional to the amount of money that’s in circulation. It’s the same practice which most banks use to regulate inflation or deflation.
An example of an algorithmic stablecoin is Basis. Founded by three graduates from Princeton University in April 2018, Basis raised an impressive $133 million in its most recent investment round, showing that a lot of people can see the potential for algorithmic stablecoins. Its system is described as an ‘algorithmic central bank’ — but what advantages does it have over fiat-backed or collateral stablecoins?
Unlike stablecoins such as Tether, Basis does not require its founders to hold reserves of US dollars. This is because the coin is pegged to 1USD in value, but isn’t actively backed by physical reserves. This enables it to be truly decentralised from fiat banks in a way that most fiat-backed cryptocurrencies cannot be.
The algorithmic approach is also more exact than being tied to a selection of cryptocurrencies. The algorithm isn’t dependent on external market factors, whereas a widespread hit to the cryptocurrency sector (such as the coronavirus pandemic, which affected investments of all kinds to such an extent that it’s now known as the ‘coronavirus crash’) is likely to bring the value of a collateral stablecoin crashing down.
What Are The Advantages Of Stablecoins?
Now we’ve answered the question ‘what are stablecoins’, let’s weigh up the different advantages of this type of crypto to help you decide whether stablecoins are a good investment in 2020 and beyond.
✅ The main benefit of investing in stablecoins is that they can be an effective form of risk management. As a hedging tool, stablecoins can help to regulate your portfolio and act as a form of insurance to counterweigh more risky investments
✅ Stablecoins can be easily converted into fiat currency, which makes them a convenient intermediary between fiat and crypto
✅ Stablecoins require very little monitoring by investors, thanks to their incredibly low levels of volatility
✅ They can be used to transfer large amounts of funds to offshore accounts without having to worry about unfavourable exchange rates or cross-border fees
✅ Stablecoins are also less vulnerable to being hacked than conventional cryptocurrencies, since the blockchain doesn’t actually store its collateral
✅ Stablecoins are highly scalable, as there are no fixed reserves
What Are The Disadvantages Of Stablecoins?
Stablecoins might come with a whole host of advantages, but that doesn’t mean they are flawless. Far from it, in fact! These are the key disadvantages to consider before deciding whether to invest in any type of stablecoin.
❌ While stablecoins can be a good hedging tool, they are not themselves good investments. This is because their value over time will never increase — it will always be equal to 1 unit of its underlying base asset
❌ Many stablecoins require a custodian or auditor to monitor their performance and ensure the value is pegged. This requires investors to put their trust in someone and means there can be potential for human error
❌ Some people have likened algorithmic stablecoins to a pyramid scheme. The low price of tokens such as Basis ($1) means the growth must inevitably be subsidised by new investors buying into ‘the scheme’
❌ There can be a lack of transparency surrounding fiat-backed stablecoins. For example, Tether has repeatedly come under fire for supposedly not owning enough reserves of USD to support its claims that for every Tether token it issues, it holds $1 in the bank
- Stablecoins were developed to bypass the volatility which makes the crypto market so risky
- Stablecoins often act as the intersection between fiat and cryptocurrency
- The volatility of a typical cryptocurrency can be around 5%, as opposed to 0.5% for a typical fiat currency
- There are three main types of stablecoin: fiat-backed, collateral, and algorithmic
- The majority of fiat-backed stablecoins are pegged to the US dollar
- Major stablecoins include Tether, DAI Coin, and Basis
- Algorithmic stablecoins are based on the quantity theory of money
- Stablecoins can be an effective hedging tool to manage risk in a diversified portfolio
- However, they are not themselves an investment which will increase in value over time
If you’ve been wondering ‘what are stablecoins’, we hope this beginner’s guide has given you an introduction to this unique type of cryptocurrency. As wider interest in stablecoins starts to grow, now could be the time to pay close attention to stablecoins and monitor their usage in the wider market. In fact, a report by the cryptocurrency exchange Binance revealed that interest in USD-collateralised stablecoins increased dramatically between May 2018 and May 2019, with the 24-hour quote asset volumes driven by stablecoins rising from 35.78% to 60.55%.
Thinking about adding stablecoins to your portfolio? Despite their low volatility, it’s still important to remember that any form of cryptocurrency is a risky investment. Always carry out your due diligence before buying into a fiat-backed, collateral, or algorithmic stablecoin.
A Beginner’s Guide To Stablecoins — FAQs
How many stablecoins are there?
There are currently more than 200 stablecoins on the cryptocurrency market. Since there are over 6,000 cryptocurrencies in total, this represents a relatively small share.
What is the most popular stablecoin?
The most popular stablecoin is Tether. It was the first stablecoin to be launched, so is often considered the Bitcoin of stablecoins!
Are stablecoins actually stable?
The answer to this question isn’t straightforward. While stablecoins are usually much more stable than conventional cryptocurrencies, they’re only ever as stable as the underlying asset to which they are pegged. This means that they aren’t completely free from volatility (almost no currency is).
Why are stablecoins popular?
Stablecoins are popular because they bypass much of the volatility which makes Bitcoin and other cryptos so risky. They have also become increasingly popular as a way of converting crypto funds to fiat.
What’s the future of stablecoins?
As stablecoins grow in popularity, many experts believe we could see them start to encourage the mass adoption of cryptocurrency. In the future, stablecoins could be a convenient form of making online or contactless payments, as well as transferring funds between digital wallets.