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The short version:

  • Stablecoins are different than most other types of crypto as they are pegged to the market value of an external reference point – like the US dollar.
  • These tokens are stabilized in different ways: fiat-collateralized coins are backed by fiat currency; crypto-collateralized currency is backed by another cryptocurrency, and non-collateralized currencies rely on an algorithm to control the coin's supply.
  • While stablecoins are generally safer than other types of cryptocurrency, there are still risks involved with investing in them due to a lack of regulation and other factors.
  • Non-collateralized stablecoins can be especially risky as was made painfully apparent during the recent blowup of the TerraUSD algorithmic stablecoin.

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What are stablecoins?

One of the significant drawbacks of cryptocurrencies is how volatile they can be. For example, it's not uncommon for Bitcoin to rise or fall by over 50% within one year's time. This represents a much higher risk level compared to other places to keep your wealth, like traditional investments or even cash.

This volatility means it’s no surprise that the average investor might think twice about moving a portion of their portfolio into crypto. After all, would you be comfortable investing in a currency that might half or zero out your investment with no warning?

Enter stablecoins.

Stablecoins are cryptocurrency coins that attempt to reduce the natural volatility inherent in cryptocurrencies. They can achieve this predictability by pegging their market value to an external reference point like a fiat currency (for example, Tether has pegged to the U.S. dollar) or a commodity like gold.

How do stablecoins work?

So how exactly does that work? After all, isn’t a currency's price influenced by supply and demand?

Depending on the type of stablecoin, the issuer uses one of several methods to guarantee its stability. One of those methods is controlling the supply of coins. Another is setting up a reserve where it stores the asset that backs the currency.

For example, if an issuer plans to issue one million coins pegged to the U.S. dollar, they’ll need to keep a reserve of $1 million to back up the units.

Keeping a reserve is one of several different strategies issuers use to stabilize stablecoins. There are three main strategies used to collateralize stablecoins.

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The 3 types of stablecoins

Stablecoins can be a great place to hold capital between purchases of other cryptocurrencies or a quick way to transfer money between exchanges.

But it’s essential to research which type of stablecoin is a good fit for you.

Stablecoins are classified by the method used to stabilize (or collateralize) the coins. There are three primary types of stablecoins.

Fiat-collateralized

Fiat-collateralized stablecoins use a fiat currency like the U.S. dollar as collateral for the coin’s value. As we outlined above, a common way for fiat-backed stablecoins is to set up a reserve equal to the number of coins the issuer makes available for purchase. A third-party custodian usually maintains these reserves. The biggest stablecoin on coinmarketcap.com, Tether, is collateralized in this way and is worth more than $72 billion.

Crypto-collateralized

If fiat-collateralized stablecoins are backed by a fiat currency, crypto-collateralized stablecoins are backed by other cryptocurrencies. In these cases, the value of the reserves may be quite a bit higher to account for the volatility.

For example, a cryptocurrency reserve may hold $2 million in cryptocurrency to collateralize $1 million in stablecoins. A 50% drop in the value of the reserve currency will still leave enough in reserve to cover the value of the stablecoins issued.

An example of a cryptocurrency-backed stablecoin is Dai, which is backed by Ethereum and other cryptocurrencies at a rate of 150% of the value of Dai in circulation.

Learn More>>Ethereum 101: Everything You Need to Know About Investing in ETH

Non-collateralized

Some stablecoins aren’t backed by an asset and are instead stabilized by algorithms that control the coin’s supply. While this might sound a little unreliable, it’s very similar to how most nations manage their own currencies. For example, the Federal Reserve doesn’t rely on a reserve asset to back the U.S. dollar. Instead, they set monetary policy to influence the value of this fiat currency.

That said, fiat currencies have the advantage of longstanding existence. And more importantly — people can use them in everyday life to buy things, making them inherently more stable. Non-collateralized stablecoins can’t rely on these factors to help stabilize the currency, which is why they are considered the least stable of all stablecoins.

Not only that, non-collateralized stablecoins can still dip dramatically in value, often overnight.

Insert Info Box

An example of this happened recently when the algorithm-backed TerraUSD collapsed on May 11, 2022. While the name of the coin would suggest it was pegged to the US dollar, it was actually using the Luna token to peg Terra — and when that token crashed, so did Terra. Now the SEC is conducting an investigation of TerraForm Labs, the company behind the TerraUSD stablecoin according to a Bloomberg report.

End Info Box

What are stablecoins used for?

So, what can stablecoins be used for if they purport to be as stable as some fiat currencies? Stablecoins are mostly used for trading, lending, and borrowing other digital assets. Worth noting is that their value in the real world is still mostly theoretical, as very few retailers will accept stablecoins. Most won’t even accept Bitcoin.

The creators of stablecoins suggest they could be used widely by households, businesses, and even governments and institutions. In fact, in a recent executive order addressing the rise of crypto, President Biden outlined steps the government would take to create a Central Bank Digital Currency (CBDC).

What are the risks of stablecoins?

The main concern most people have of investing in a stablecoin is similar to investing in a cryptocurrency: Is it safe? Most stablecoins claim to be backed by a reserve. But it can be difficult to verify that the issuer actually has the collateral to secure the coin that it claims to have.

Remember that cryptocurrencies aren't regulated by any governing body, although some are calling for that to change. There is no protection or verification process to make sure these coins are stable.

That said, many stablecoins are still less risky than other forms of cryptocurrency. If you really want to hold coins, stablecoins would be an excellent way to prevent the possibility of dramatic overnight drops in value.

Why Washington worries about stablecoins

The stablecoin market has grown to over $130 billion in assets and has drawn scrutiny from Washington officials and influencers. And the demands for more regulation in the space have only grown louder over time.

These calls are prompted by the fact that stablecoins are (in theory) used mainly as payment systems. This means that a large drop in value could cause significant disruption for banks and governments.

In a Bloomberg interview, former Treasury Secretary Mnuchin said that crypto stablecoins shouldn't be like “casino chips.”  And he's been very vocal regarding his opinion that all stablecoins should be held in regulated banks and backed by real dollars.

The bottom line

There are many different types of coins under the cryptocurrency umbrella, including stablecoins, memecoins, and gaming coins.

Each category of coin (and even each coin itself) comes with its own risk profile. However, if you’re looking for a less volatile coin to invest in, you may want to look at stablecoins backed by fiat currency.

Depending on the coin, they can be a good option to temporarily hold value or transfer capital between exchanges. If you’re interested in building a cryptocurrency portfolio, stablecoins can be a good place to start.

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Jordann Brown Freelance Contributor

Jordann Brown is a millennial money expert and personal finance blogger based in Nova Scotia, Canada.

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