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What Are Stablecoins?
Stablecoins are virtual currencies that aim to provide a price of 1 token to 1 dollar, yen, rupee, or other fiat currency. The ultimate goal of stablecoins is to encourage wider use through price stability and safety.
At one time, stablecoins promised cryptocurrency adherents the best of both worlds: stable value without the centralized control attributed to fiat. Do they still?
- Stablecoins are tokens designed to provide stable value.
- Stable tokens and currencies are more useful as a store of value and medium of exchange.
- Stablecoins minimize typical cryptocurrency volatility by maintaining collateral in reserves, often U.S. dollars.
- Commodity-backed stablecoins are backed by gold, silver, or other commodities.
- Algorithmic stablecoins were a type that aimed to provide steady value by adjusting supply based on pre-set rules and pairs of tokens.
Stablecoin Purposes
Whether it’s the U.S. dollar or Dogecoin, a currency is the most useful as a medium of exchange and a store of value. Price stability is crucial to those functions. For those reasons, policymakers aim to keep the price of traditional national currencies broadly stable. In forex trading (fiat currencies), a 2% move in a day is a landslide.
Not so in the world of cryptocurrency. The world’s most popular cryptocurrency, Bitcoin, shot from less than $6,000 to more than $19,000 between mid-November and mid-December of 2017, then fell to about $6,900 by early February 2018. It surged from under $5,000 in March 2020 to over $44,000 by August 2021. Bitcoin opened 2022 with a value of $44,733. However, in the roller-coaster years since, it traded between $24,000 and nearly $74,000. Even on an intraday basis, it is not uncommon to see cryptocurrencies jump or fall by 10% in a 24-hour period.
Swings of this magnitude are not characteristic of a stable currency. They have more in common with the volatility of speculative trading instruments like derivatives. This has led to serious questions about whether popular cryptocurrencies have a function beyond speculation.
How Stablecoins Maintain Valuations
Historically, some currencies were pegged to gold, but none are today. The U.K. stopped using the gold standard in the 1930s, and the U.S. ceased using it in the 1970s.
The modern substitute for the gold standard is the reserve currency role of the U.S. dollar. Many currencies are pegged to the dollar. The nations that issue them rely on the dollar peg to limit currency volatility that might otherwise disrupt their economies.
Similarly, some stablecoins seek to tame volatility by pegging their price to the U.S. dollar and backing the value of their tokens with liquid collateral reserves. Based on how they choose to pursue price stability, stablecoins can be divided into four groups.
Fiat-Collateralized Stablecoins
The value of these stablecoins is backed by fiat currency like the U.S. dollar, debt instruments like U.S. Treasuries, or other cash equivalents. The collateral must be held by a custodian and audited regularly to guarantee redemption of the stablecoin tokens.
Tether is the most popular stablecoin, pegged at par to the U.S. dollar and backed by dollar reserves.
Commodity-Collateralized Stablecoins
In these stablecoins, collateral consists of precious metals like gold and silver or commodities like crude oil.
Most of these tokens are not very convincing in their approaches and rely on third-party custodians and external auditors to verify their holdings. In most cases, the auditors never actually saw the commodities; they only verified the paperwork sent to them by the custodians. Essentially, there has not been proof that the holdings existed. For instance, Paxos Gold is one of the more popular commodity-backed tokens, but the gold has apparently not been seen by the auditors who published their results for the company:
…while we did obtain confirmation of gold balances from the third-party custodians, our procedures did not include the observation of gold held by these custodians and did not include any validation of the quality of gold held by these custodian(s) on behalf of the Company and the PAXG token holders. We believe that the evidence we obtained is sufficient and appropriate to provide a reasonable basis for our opinion.
It is important to remember that an auditor puts their professional reputation on the line when publishing these reports, so generally, if they are from a reputable firm, they can be relied on. That said, it’s critical to validate the holdings any stablecoin purports to have to ensure they are valid and not simply a token representing a value without any backing.
Crypto-Collateralized Stablecoins
Crypto-collateralized stablecoins are similar to those backed by fiat, except that their underlying collateral is another cryptocurrency or basket of cryptocurrencies instead of a fiat currency or a commodity. To accommodate the adverse impact of the collateral cryptocurrency’s volatility, stablecoins backed by other cryptocurrencies tend to be “over-collateralized,” meaning the value of the collateral exceeds that of the tokens issued by a predefined ratio.
For instance, a reserve of Bitcoin worth $1 million might be required to issue $500,000 of that stablecoin. That way, even if Bitcoin were to lose 30% of its value, the stablecoin would have sufficient collateral for full redemption. More frequent audits and regular top-ups for any shortfalls in collateral value can keep the crypto-backed stablecoins covered.
It’s not a perfect system. If the collateral cryptocurrency goes completely bust, or there are procedural issues with the audit process or demands for additional top-ups of collateral are not met in time, the stablecoin’s valuation will plummet, defeating its purpose.
Algorithmic Stablecoins
Whether collateralized or not, algorithmic stablecoins rely on an algorithm, or a set of rules, to control the supply of tokens, thereby attempting to keep the value stable.
For example, an algorithmic stablecoin may rely on a rule that requires changes in token supply sufficient to maintain the stablecoin’s value. This resembles a central bank’s role in increasing or decreasing interest rates and money supply to ensure price stability and control the inflation rate.
The Stablecoin Potential
The increasing popularity of stablecoins could make cryptocurrencies a more common medium of exchange for routine financial transactions and other applications.
Such applications may include using stablecoins to trade goods and services over blockchain networks, in decentralized insurance solutions, derivatives contracts, financial applications like consumer loans, and prediction markets.
Stablecoin Regulations
Regulators in most jurisdictions have decided that stablecoins need to be regulated with collateral enforcement to prevent collapses such as TerraUSD, which wiped out billions of dollars in the cryptocurrency markets. The European Union’s Markets in Crypto Assets regulation governs stablecoins, and in the U.S., existing regulations require that issuances require approval.
So, do stablecoins provide an avenue for price stability and no centralized control? Prices appear to be stabilizing for these tokens, but they must be issued following specific laws and monitored by regulatory agencies in most jurisdictions.
What Is a Stablecoin in Crypto?
A stablecoin is a blockchain token backed by a reserve quantity of another asset to attempt to stabilize its price.
Is Stablecoin Better Than Bitcoin?
Stablecoins are different than Bitcoin in that Bitcoin is a payment network with a token that has become popular with speculators. Bitcoins have much more market value than stablecoins, which are tokens backed by collateral that make them equal in value to that collateral.
Is PayPal a Stablecoin?
PayPal is a money service provider that created a stablecoin called PayPalUSD (PYUSD). It is purportedly backed by dollars, U.S. Treasuries, and other cash equivalents.
The Bottom Line
Stablecoins combine the decentralization of cryptocurrencies with the promise of stability akin to that offered by fiat. How they attempt to deliver on that promise matters greatly, as the TerraUSD collapse strongly suggests that sufficient collateral in liquid form, like U.S. dollars, offers a much sturdier guarantee than the promise of maintaining value by relying on an algorithm.