Stablecoins: What They Are, How They Work and Why They Are Freaking Out Crypto Investors
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Bitcoin and other cryptocurrencies are extremely volatile, especially compared with conventional financial instruments like stocks and bonds. That volatility plays a central role in crypto’s appeal for investors. Sure, you can lose all your money on any coin or token — or you could?become a millionaire overnight. There is, however, a subset of cryptocurrencies designed to hold steady, to provide a value that?doesn’t?fluctuate. They’re called stablecoins, and they’re playing an important role in cryptocurrency markets.
At the moment, a number of stablecoins — specifically terraUSD and tether — are making headlines for their respective failures to deliver stability. Terra has now lost nearly 100% of its value?and tether, the largest and most popular stablecoin, is showing signs of fragility.?
Stablecoins have become central to the crypto ecosystem, serving important functions for investors and speculators. Below, we’ll run through what makes a stablecoin one — in theory, anyway — how they’re different from other cryptocurrencies and how people are using them today.
Are stablecoins cryptocurrency?
A stablecoin is cryptocurrency with a twist. Instead of being “mined” by an open, distributed network of computers performing a combination of math and recordkeeping, a stablecoin derives its price from the value of another asset. In short, a stablecoin is pegged to another underlying asset.
What are the leading stablecoins?
The most prominent stablecoins are the ones used for trading on crypto exchanges. These include?tether, the most popular stablecoin, which is usually in the top-five highest market caps for cryptocurrencies;?USD coin, or USDC, an?open-source project?run by a consortium called Centre; and?binance?USD, a stablecoin issued by?Binance, the world’s largest crypto exchange.?
What can you do with a stablecoin?
The primary use for a stablecoin is facilitating trades on crypto exchanges. Instead of buying bitcoin directly with fiat currency, like the US dollar, traders often exchange fiat for a stablecoin — and then execute a trade with the stablecoin for another cryptocurrency like bitcoin or ether.?
In this way, stablecoins are sort of like poker chips for crypto exchanges. The most widely traded stablecoins are each associated with a specific exchange: tether with Bitfinex; USD coin with Coinbase; binance USD with Binance.
Though advanced crypto traders may use stablecoins for a variety of purposes, including staking and lending, most beginners use them to mitigate trading fees. That’s because many exchanges don’t charge for exchanging US dollars for a stablecoin. Coinbase, for example,?doesn’t charge any fees?on USDC to US dollar transfers. If you’re looking to quickly liquidate bitcoin at a certain price, you can transfer it into a less volatile entity like USD coin or tether.?
In fact, tether currently accounts for more than half of all bitcoin traded into fiat or stablecoin, according to CryptoCompare, a global cryptocurrency market data provider.
Another use for stablecoins is remittances; that is, transferring funds across international borders. Sol Digital, a stablecoin that’s pegged to Peru’s sol national currency, launched on the Stellar blockchain in September. It can be exchanged between individuals in different countries without incurring the considerable fees exacted by third parties for cross-border money transfers.
And it’s within this use case that lies the seed of one of bitcoin’s more grandiose potential goals — namely, to give relief to populations that are subject to rapid inflation and could benefit from transferring funds out of a distressed local currency into a stablecoin. (As long as the stablecoin isn’t tied to that local currency, it would theoretically be insulated from the regional inflation.)?
Are all stablecoins pegged to a national currency?
Similar to how the US dollar serves as a reserve currency for countries around the world, the most popular stablecoins are currently pegged to the US dollar. A single unit of tether, USD coin or binance USD is each worth approximately $1.
But the underlying asset doesn’t have to be a national currency. The asset could be a commodity like gold (as with kitco gold), an algorithm (dai) or even another cryptocurrency like bitcoin (bitUSD).
How are stablecoins different from traditional cryptocurrencies?
A traditional cryptocurrency has no central control; it’s governed by the masses. A stablecoin is different in that it’s issued and governed by a central authority. When you buy one, you accept that the issuer of that coin has a sufficient amount of the asset it’s pegged to.?
The asset reserve, which gives a stablecoin its value, also serves as collateral. As long as the value of the assets is stable, the price of the stablecoin is stable. But since there are?no US regulations?in place to monitor stablecoin reserves, this equation is based on trust: You’re trusting that the reserve exists and is valued correctly.
And sometimes that trust is broken. In February 2021, Tether (the company issuing the tether stablecoin), along with affiliated exchange Bitfinex, paid $18.5 million in fines after New York Attorney General Letitia James ruled against them in a case involving the cover-up of $850 million that went missing. Tether and Bitfinex neither admitted nor denied wrongdoing in the civil settlement.
“Bitfinex and Tether recklessly and unlawfully covered up massive financial losses to keep their scheme going and protect their bottom lines,” said James. “Tether’s claims that its virtual currency was fully backed by U.S. dollars at all times was a lie. These companies obscured the true risk investors faced and were operated by unlicensed and unregulated individuals and entities dealing in the darkest corners of the financial system.”
Do I need a special bank account or crypto wallet to buy stablecoins?
You don’t need a special bank account to buy stablecoins, and that alone could make them attractive to unbanked and underbanked populations. But you do need a crypto wallet?to buy, sell, trade and store stablecoins, just like you do for other cryptocurrencies. And not all wallets support every coin (this is all software, after all). The trick here is making sure the crypto wallet you choose supports the stablecoins you want. For example, Trezor’s and Ledger’s latest wallets both support tether.?