Stablecoins have been all over the crypto news cycle lately, but what exactly are they? And how do stablecoins work? You ask, Boardroom has answers.
You may have heard the term “stablecoin” in passing over the last few days and wondered what exactly the term means. Quite simply, a stablecoin is a digital currency whose value is pegged to another asset or currency. Stablecoins are meant to maintain a fixed value over time, so unlike other cryptocurrencies, these coins don’t want their prices to fluctuate.
Stablecoins can manage crypto volatility, save assets, make international payments, and earn interest, among other uses. They are also an alternative and safer investment asset than a typical cryptocurrency like Bitcoin, whose value is subject to wild fluctuations.. While stablecoins may be a safer investment option, they aren’t the best if you are trying to make a quick dollar based on the volatile crypto market, since their prices aren’t supposed to change. Some of the most common and most-used stablecoins are UST, USD Coin, and Binance USD.
One stablecoin that has been in the news lately is Terra’s algorithmic stablecoin, TerraUSD, because its price dropped significantly below its dollar threshold. This event caused a widespread crypto crash that affected Bitcoin, NFTs, and more.
Types of stablecoins
Here are the three types of stablecoins on the market.
- Algorithmic stablecoin: This stablecoin’s value stays stagnant when a computer program running a preset formula is used. Algorithmic stablecoins like TerraUSD achieve price stability by pegging to a reserve asset like gold, a foreign currency, or even USD. Algorithmic stablecoins are designed to help balance the supply and demand of the asset in circulation. These coins also may or may not have reserve assets behind them.
- Crypto-collateralized stablecoin: This is a stablecoin backed by collateral held in reserve. This collateral is often another cryptocurrency that fluctuates in price and may exceed the value of the stabelcoins it supports. The Tether cryptocurrency, which is pegged to the $1, is a good example of this type of stablecoin since it has a $5 billion reserve.
- Fiat-collateralized stablecoin: This stablecoin is backed by sovereign currency, which means that “to issue a certain number of tokens of a given cryptocurrency, the issuer must offer dollar reserves worth the same amount as collateral,” Corporate Finance Institute explains. These stablecoins are often maintained by an independent issuer who is audited for compliance. An example of this type of stablecoin is TrueUSD.
Are Stablecoins Safe?
Like most cryptocurrencies, stablecoins have to be held in a crypto wallet. But unlike most cryptocurrencies, stablecoins aren’t decentralized because there are banks holding reserves for them.
Trusting in stablecoin reserves, in general, is a significant risk.
Before investing in stablecoins, it’s essential to know which type it is and to look into the reserve reports to see how collateral is handled. Sometimes these reports are released regularly, and sometimes you have to dig for them. Either way, know what’s backing a stablecoin before investing in it, and if you can’t find those reserve reports, that may help you decide if that stablecoin is right for you.
It’s important to note that unless a stablecoin has a reserve that’s 100% cash, there’s no guarantee that every coin in circulation is supported and can be redeemed for cash if something fails.
While stablecoins provide more stability than most cryptocurrencies and seem like they have fewer risks, there are still some things to consider before investing in them.