A stablecoin is a type of cryptocurrency that is designed to maintain a fixed value over time. The value of a stablecoin is usually pegged to a specific real currency, often the US dollar. In this setting, one unit of cryptocurrency typically equals one unit of real currency. Unlike highly volatile cryptocurrencies such as Bitcoin, stablecoin prices are not meant to fluctuate.
However, events in the stablecoin market, such as the sharp decline in TerraUSD, have federal authorities keeping a close eye on the space. Treasury Secretary Janet Yellen cited the broader financial stability risks posed by stablecoins, while the Federal Reserve discussed the uncertainty of what actually backs stablecoins and the lack of oversight in their markets. A report was published.
Here we explain how stablecoins work, what risks there are, and how to know if a stablecoin is safe.
Stablecoins: What are stablecoins and how do they work?
A stablecoin is a cryptocurrency whose value is pegged to another asset, often a currency such as the US dollar or euro, but other assets are also possible. This type of crypto coin tracks the underlying asset and stabilizes its value over time, at least compared to fixed currencies. In effect, it is like the underlying asset has been digitized, like a digital dollar.
Since the purpose of stablecoins is to track assets, stablecoins are often backed by specific assets that are fixed. For example, organizations issuing stablecoins typically set up reserves with the financial institutions that hold the underlying assets. Therefore, a stablecoin can hold $100 million in reserves and issue 100 million coins with a fixed value of $1 per coin. If stablecoin owners want to cash out their coins, they can eventually withdraw real money from the reserves.
This structure is in contrast to most cryptocurrencies, such as Bitcoin and Ethereum, which are not backed by anything. Unlike stablecoins, these other cryptocurrencies are highly volatile as speculators drive their prices up and down as they trade for profits.
Many stablecoins are backed by hard assets, but some are not. Instead, these others use technical means (such as destroying a portion of the coin supply to create scarcity) to keep the price of a crypto coin at a fixed value. These are called algorithmic stablecoins and can be riskier than asset-backed stablecoins.
Why stablecoins are used for cryptocurrency trading
Stablecoins solve one of the key problems with many mainstream cryptocurrencies: their rapid volatility makes them difficult, if not impossible, to use in real-world transactions. Masu.
“Digital currencies like Bitcoin and Ethereum are so volatile that it’s very difficult to price them accordingly,” said Anthony Citrano, founder of NFT marketplace Acquicent. I say. “Stablecoins avoid this problem by pegging prices to a known reserve currency.”
Additionally, their stability allows many stablecoins to be used as functional currencies within cryptocurrency intermediaries. For example, a trader may convert Bitcoin to a stablecoin such as Tether rather than dollars. Stablecoins are available 24/7, making them more accessible than cash available through banking systems, which are closed at night and on weekends.
Stablecoins can also be used in smart contracts, which are a type of electronic contract that is automatically executed when conditions are met. The stability of digital currencies also helps avoid disagreements that can arise when dealing with more volatile cryptocurrencies.
Most popular stablecoins
Stablecoins typically don’t receive as much press (and hype) as other cryptocurrencies. Part of the reason is that stablecoins don’t offer the same kind of “get rich quick” opportunities. However, as of August 2024, the most popular cryptocurrencies by market capitalization include:
Tether (USDT): $116 billion USD Coin (USDC): $35 billion Dai (DAI): $5 billion
Of course, the size of these coins pales in comparison to the largest cryptocurrencies such as Bitcoin, which has a market cap of about $1.2 trillion, and Ethereum, which has a market cap of more than $320 billion.
TerraUSD, an algorithmic stablecoin, was also a popular choice, but lost its peg to the dollar in May 2022. This stablecoin used a sophisticated arbitrage system with other cryptocurrencies to maintain valuations at a 1:1 level. However, due to the decline in the cryptocurrency market and the subsequent loss of confidence in stablecoins, its price plummeted.
Stablecoin risks
At first glance, stablecoins may seem low risk. Those are facts compared to popular cryptocurrencies that are not backed by anything. But stablecoins also present some typical crypto risks and at least one unique risk.
Security: Like other cryptocurrencies, stablecoins need to be held somewhere, whether it’s in your own digital wallet or at a broker or exchange. And this comes with risks, as a particular trading platform may not be secure enough or may have some vulnerabilities. Counterparty risk: While cryptocurrencies may appear to be highly decentralized, they actually involve multiple parties in a transaction, such as banks holding reserves and organizations issuing stablecoins. You will be trading. They must be doing the right things (security, proper preparation, etc.) to maintain the value of the currency. Reserve Risk: A key element of the stablecoin ecosystem is the reserves that back stablecoins. These reserves are the final backstop to the value of the stablecoin. Without these, coin issuers cannot guarantee the value of their stablecoins with complete confidence. Lack of confidence: If a stablecoin is not well-backed by physical assets, especially cash, it can suffer a crash and lose its peg to the underlying currency. This is effectively the same thing that happened to the algorithmic stablecoin TerraUSD in May 2022. This is because it was backstopped by other cryptocurrencies rather than cash. Stablecoin prices collapsed and fell as traders lost confidence in their ability to maintain their pegs.
“The main risk with stablecoins is that they are not fully backed by the reserve currency they claim to be,” Citrano says. “In an ideal situation, a stablecoin issuer would have sufficient currency reserves (cash or other liquid and secure investments) to fully support the stablecoin. 100 If it is less than %, there is a risk.”
How safe are stablecoins?
So how do you know if a stablecoin is safe? You need to read the fine print in the issuer’s statement. And Citrano says it’s absolutely essential to do just that.
“Check the issuer’s reserve report,” he says. “If they don’t provide a preliminary report, be very wary.”
Still, stablecoin owners need to pay attention to exactly what is backing their coins. Stablecoin Tether has come under fire for disclosing its reserves. And those who think that cryptocurrencies are fully secured by physical dollars should be careful.
The company indicated in its provision report dated March 31, 2021 that it had more provisions than liabilities. Things look good on the surface, but the devil is in the details.
Approximately 76% of reserves are held as cash or cash equivalents (the majority of which is short-term debt, also known as commercial paper). Almost 13% are secured loans. Corporate bonds, funds, and precious metals account for nearly 10%.
These other assets often act like physical cash, but they are not physical cash.
If you look closely, less than 4% is actually cash, with the majority held in short-term corporate bonds. This commercial paper is not the same as cash, especially in an emergency. When markets decline, the value of those assets (and other non-cash assets) can fall quickly, leaving Tether coins completely unsecured when they are needed most.
Unless a stablecoin commits to holding 100 percent (or more) of its reserves in cash, there is no guarantee that that cash will be available to redeem the coins. In this case, the value of the stablecoin may turn out to be much lower than the stablecoin. Holders of stablecoins may end up losing out on old-fashioned attachments, a surprising fate for a technology that touts itself as very modern.
Since then, Tether has reduced its holdings in several of these non-cash assets.
In 2021, the U.S. Commodity Futures Trading Commission fined Tether $41 million for falsely stating that its stablecoin was 100 percent backed by real currency. Since the March 2021 report, Tether has reduced its holdings in commercial paper, and the company said it will continue to reduce its reliance on this capital.
As of the June 30, 2024 reserve report, Tether still had more reserves than debt and had switched its reserve composition.
Approximately 84 percent of our reserves are held in cash or cash equivalents, and approximately 80 percent of that amount is in U.S. Treasury securities. Approximately 6% are secured loans. About 10% are precious metals, Bitcoin, and “other investments.”
Although Tether has more than enough reserves to back its stablecoins, some of its investments (Bitcoin and precious metals) can be volatile. And it’s not really clear what “other investments” consist of, just that the investments here don’t fit into any other category. As such, its reserves (substantially all of which are not cash) can still take a big hit in tough times.
Finally, the best way to ensure the security of a currency is for people to widely accept it in exchange for goods and services. And the only widely accepted currency in the United States, in fact, the only price a product will ultimately be listed at, is the dollar.
conclusion
Stablecoins provide some of the stability that most cryptocurrencies lack. However, those who use stablecoins should understand the risks they take when owning them. While stablecoins appear to have limited risk most of the time, they can be most risky in times of crisis when owning a stablecoin is supposed to be the safest.
Editorial Disclaimer: All investors are encouraged to conduct their own independent research on any investment strategy before making any investment decisions. Additionally, investors should note that past performance of an investment product does not guarantee future price appreciation.
