Is Stablecoin the Answer to All Cryptocurrency Problems?

Stablecoins are a newer breed of cryptocurrency gaining popularity for their commitment to minimize the price volatility that has limited the use of Bitcoin (BTC) and other digital currencies as a medium of exchange.

Since Tether (USDT) launched in 2014 as the first stablecoin, the list has grown to include Dai (DAI), USD Coin (USDC), True USD (USDT), Digix Gold, Havven's Nomin, Paxos Standard, and Binance USD (BUSD).

What Are Stablecoins?

Whether it's the U.S. dollar or Dogecoin, a currency is most useful as a medium of exchange and a store of value. Price stability is crucial to those functions. For that reason, policymakers aim to keep the price of traditional national currencies broadly stable. In forex trading of 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. More recently, it surged from under $5,000 in March 2020 to over $44,000 by August 2021. 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 characteristics 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.

Enter a new class of cryptocurrencies, called stablecoins, which aim to provide the price stability required to encourage wider use. Stablecoins promise cryptocurrency adherents the best of both worlds: stable value without the centralized control attributed to fiat.

How Stablecoins Maintain Valuations

Historically, some currencies were pegged to gold. None are today. Great Britain went off the gold standard in 1931 and the U.S. followed two years later.

The modern substitute for the gold standard is the reserve currency role of the U.S. dollar. At least 14 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 by backing the value of their tokens with liquid reserves of collateral. Stablecoins can be divided into three groups based on how they choose to pursue price stability.

Fiat-collateralized stablecoins: The value of these stablecoins is backed by fiat currency like the U.S. dollar. Collateral can also consist of precious metals like gold and silver and commodities like crude oil.

Collateral must be held by a custodian and audited regularly to guarantee redemption of the stablecoin tokens.

Tether and TrueUSD are popular stablecoins pegged at par to the U.S. dollar and are backed by dollar reserves.

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.

The Dai stablecoin uses a basket of crypto assets as collateral at a ratio of 150% to the value of its tokens. It is pegged to the U.S. dollar.

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 keeping 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 is somewhat akin to a central bank's role in increasing or decreasing interest rates to ensure stable prices. The difference is that central banks like the U.S. Federal Reserve set monetary policy based on widely understood parameters and back that policy with an unlimited supply of legal tender. Algorithmic stablecoins like Basis and TerraUSD lack such advantages.

The Stablecoin Potential

The increasing adoption of stablecoins could help popularize the use of cryptocurrencies as a medium of exchange for routine financial transactions, as well as for 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.

A volatile cryptocurrency is not suitable for those purposes, since the volatility presents a risk of loss for parties to the transaction.

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 a great deal, with the TerraUSD collapse strongly suggesting sufficient collateral in liquid form like U.S. dollars offers a much sturdier guarantee than the naked promise to maintain value by relying on an algorithm.

Investing in cryptocurrencies and Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns no cryptocurrencies.