What are stablecoins?

Stablecoins are cryptocurrencies whose price is pegged to the value of a reserve asset, such as a fiat currency or commodity price. The idea is to reduce volatility by tying a cryptocurrency’s price to another asset.

Many investors appreciate the decentralised cryptocurrencies, but their widely fluctuating prices can make them difficult to use for everyday transactions. Unlike most cryptocurrencies that operate in a decentralised environment, stablecoins are overseen by a central authority that is required to maintain value and provide liquidity if needed.

The latest report on stablecoins from the US President's Working Group on Financial Markets (PWG) defined stablecoins as follows: “Stablecoins are digital assets that are designed to maintain a stable value relative to a national currency or other reference assets. Today, stablecoins are primarily used in the United States to facilitate trading, lending, or borrowing of other digital assets, predominantly on or through digital asset trading platforms.”

What does stablecoin mean?

Stable cryptocurrency attempts to bring together the best features of crypto and traditional fiat currencies. By operating on blockchains, stablecoins benefit from the best aspects of cryptocurrencies by offering efficient, secure transactions that investors can make around the clock from all over the world. But they also maintain stable prices that are typical of traditional fiat currencies.

Stablecoins are mainly used to buy other cryptos and for facilitating smart contracts. The low volatility of a stablecoin means that many purchasers use them to bridge the gap between traditional and cryptocurrencies. Buyers first deposit fiat currency into the stablecoin, then use the stablecoin to purchase other cryptos.

These crypto-to-crypto transactions are significantly faster compared to the original fiat deposit, which minimises the chance of significant price movements during the processing time. Active traders also benefit from reduced or non-existent transaction fees on high-volume trading by avoiding frequent bank deposits and withdrawals that typically charge a percentage per transaction.

Similarly, contracts made in most cryptos, such as bitcoin, would not be practical. The price could change dramatically before the contract was completed. Stablecoins mitigate the chance of significant changes in the value of the contract during execution and, in the case of international business, eliminate potential losses due to currency exchange fees.

According to the European Central Bank (ECB), “The market capitalisation of stablecoins has risen from $5bn to $120bn since 2020 and they are serving increasingly different functions in the crypto-asset ecosystem … Despite their recent growth, stablecoins still only account for around 6% of the estimated $2trn total market capitalisation of crypto-assets, though interlinkages between stablecoins and crypto assets imply a correlation of risks between these market segments.”

The ECB report identified several major stablecoins use cases:

Stablecoins can serve as a bridge between fiat currencies and crypto assets, acting as a safe haven from crypto volatility.
They are used for trading. In September 2021, almost 75% of trading volume on crypto platforms involved a stablecoin.
Low price volatility contributes to stablecoins’ popularity as collateral in crypto-asset derivative transactions or decentralised finance (DeFi) projects.

Types of stablecoins

The stablecoins definition presupposes some alternate asset represents a cryptocurrency’s price. Most stable cryptocurrencies are backed up by a reserve of the asset the crypto represents.

According to the CB Insights report, there are four types of stablecoins: fiat-collateralised, commodity-collateralised, crypto-collateralised, and non-collateralised stablecoins.

Types of stablecoins

A fiat-collateralised example would be a stablecoin mimicking the price of US dollars. For every 1 stablecoin in circulation, there is $1 in traditional fiat held securely in a bank or trust. When users decide to trade their crypto holding, funds held in reserve are used for payment.

At the time of writing, on 18 January 2022, the most popular stablecoin was Tether (USDT), with CoinMarketCap ranking it as the third-largest cryptocurrency by market capitalisation.

Other assets, such as gold, can also back Stablecoins. An example of commodity-collateralised stablecoin is Digix Gold (DGX), an ERC-20 token running on the Ethereum network and backed by physical gold. 1 DGX represents 1 gram of gold.

Crypto-collateralised stablecoins secure reserve value by utilising the purchaser’s assets in other cryptocurrencies and issuing tokens equal to the value. The newly issued stablecoins can then be used to execute contracts or perform transactions through a relatively low volatility crypto. One of the crypto-collateralised stablecoin examples is DAI. The stablecoin is created by MakerDAO and has a face value pegged to USD, but is actually backed by ETH that is locked up in smart contracts.

Non-collateralised stablecoin examples utilise algorithms to maintain a constant value, relative to another asset such as gold or the USD, by constantly creating and destroying the supply of the stablecoin to increase or decrease its value. In theory, the prices of such stablecoins remain stable as they are driven by supply and demand.