It is ironic that for many, their first encounter with the term “stablecoin” was news coverage about a profoundly unstable situation. But a deeper dive into the world of stablecoins will make clear that not every stablecoin is created equal.
What Are Stablecoins?
Put simply, stablecoins are cryptocurrencies designed to avoid volatility. In most cases, this means the value of the stablecoin is pegged to a reference asset. For instance, if a stablecoin is pegged to the U.S. dollar, the stablecoin should always be worth $1 (within a margin of error).
Stablecoins first arrived in 2014, and since then a few of them have achieved widespread popularity among cryptocurrency enthusiasts. At this writing, two of them — Tether and USD Coin — are among the top five largest cryptocurrencies of any type by market capitalization, in the company of major players Bitcoin, Ethereum and BNB Chain.
Types Of Stablecoins
Stablecoins typically maintain their stability in one of two ways. Some maintain a pool of reserve assets to use as collateral. Others use an algorithm to directly control the supply of the coin, thus adjusting its price.
Collateralized stablecoins, sometimes also called “reserve-backed” stablecoins, are those that maintain value via reserve assets. When a coinholder wants to cash out, the corresponding assets are taken from the stablecoin’s reserves. In cases where the reserves are mostly in the form of the reference asset itself, the stablecoin’s value is unlikely to drop below the underlying asset’s value.
These reserve pools are under the management of some central entity which regularly audits the funds. These entities also generally work directly with regulators to ensure compliance, and individuals who want to buy these stablecoins often have to go through “Know Your Customer” and “Anti-Money Laundering” checks similar to those governing other cryptocurrency exchanges.
Within collateralized stablecoins, you can further differentiate based on the type of reserves underpinning the coin’s value.
Currency-backed, or fiat-backed, stablecoins are — as their name suggests — backed by a currency issued by a central bank. Many, though not all, currency-backed stablecoins are pegged to the U.S. dollar at a fixed ratio. This reflects that maintaining the stablecoin’s value carries some costs: legal compliance, transaction fees to maintain the reserve pool, and so on. The stablecoin’s value may also fluctuate slightly in response to market conditions, since actions to bring it back in line with its target may not always take immediate effect. But generally, a stablecoin pegged to the dollar should always be worth approximately $1.
Currency-backed stablecoins were the first stablecoins available, and they remain the most common type. USD Coin and Tether, the two most popular stablecoins by market capitalization, are both currency-backed offerings. USD Coin, which is notable in that it periodically discloses its precise reserves and stablecoin liabilities, holds its collateral in a mix of cash and U.S. Treasuries. Tether, in contrast, has faced some increased scrutiny and pressure from regulators to prove that its reserve pool is sufficient to cover all possible redemptions, given its more opaque operating methods. Tether maintains that it has the assets it needs to back the tokens in circulation; as of this writing, it has never failed to meet a redemption request.
Commodity-backed stablecoins function the way currency-backed coins do, but their reserve assets are commodities such as gold rather than fiat currency. Their value can be fixed to one or more commodity types. In addition to the costs associated with currency-backed stablecoins, commodity-backed tokens may face additional overhead in order to store and protect the commodity reserves.
Crypto-backed stablecoins come in two flavors. In one, the stablecoin is pegged to a reserve asset but the collateral is held in the form of a cryptocurrency. For example, a stablecoin may be pegged to the U.S. dollar, but instead of maintaining a pool of cash, the token is backed by Ethereum in a corresponding amount. These stablecoins are usually meant to be overcollateralized — that is, their reserves are worth more than the value of the circulating stablecoins — to ensure they can maintain their target value even during periods of high market volatility.
The other type of crypto-backed stablecoin tracks an underlying cryptocurrency’s value directly. Wrapped Bitcoin operates this way. These stablecoins are, by design, more likely to fluctuate in value than other types of collateralized stablecoins.
Both types of crypto-backed stablecoins are generally more decentralized than fiat- or commodity-backed offerings. They can be created using smart contracts and don’t always require a centralized controlling entity. In theory, their value is meant to stay steady, but in practice, they are somewhat more volatile than other collateralized stablecoins.
Given their compatibility with smart contracts, some crypto-backed stablecoins allow users to take out a loan by locking up their collateral, making it more appealing to pay off their debt if the stablecoin’s value drops. The smart contracts prevent sudden crashes by requiring users who take out such loans to liquidate if their collateral dips too close to the value of their withdrawal.
All of the collateralized stablecoins are more alike than they are different, especially in contrast to noncollateralized stablecoins. These are often referred to as “algorithmic” or “seigniorage”-style stablecoins. (Note that, as I’ve mentioned, some collateralized stablecoins also use algorithms to manage their value; to avoid confusion, in this article, “algorithmic” will only refer to noncollateralized stablecoins.)
Instead of maintaining a pool of assets to keep their value stable, noncollateralized stablecoins control the supply of coins directly. Similar to a central bank’s ability to print or destroy currency, algorithmic stablecoins create (or “mint”) more coins to bring the price down and destroy (or “burn”) coins to bring the price up. These adjustments are controlled by code, rather than individual human decisions.
Noncollateralized stablecoins remain rarer than their collateralized alternatives. Given the demonstrated risks, which I’ll discuss later in this article, they are likely to remain a niche product, at least for now.
Uses For Stablecoins
Stablecoin owners buy the tokens for a variety of reasons, but the primary one is to gain access to blockchains with less volatility than they would face if they bought traditional cryptocurrencies. Many applications and marketplaces in the crypto ecosystem won’t simply let you pay in dollars, much less in gold, so stablecoins offer a relatively safe way to conduct business in these settings.
Part of the reason that traditional cryptocurrencies have not gained widespread use as currencies is that they have failed to be reliable stores of value, mediums of exchange, or both. Stablecoins pegged to fiat currency, or even commodities, can allow users a less volatile way to buy or sell things on the blockchain. For example, some investors may want to buy nonfungible tokens, or NFTs, offered on a marketplace that doesn’t accept U.S. dollars. A dollar-pegged stablecoin is a reasonable solution.
Even if stablecoin users don’t have their eye on cryptocurrencies or NFTs, they may find blockchain applications useful for other reasons. International transfers can happen much more quickly and cheaply via stablecoin. Traditionally, an international bank transfer would require multiple intermediaries and often could take a few days to complete. A stablecoin transfer is essentially instant, and usually involves lower fees, or occasionally no fees at all. And, unlike traditional cryptocurrency transactions, with stablecoin transfers the recipient has some assurance that the value agreed to in advance will more or less match the value received.
Collaborators or contractors outside the United States may also find stablecoins appealing because they allow those individuals to essentially invest in the U.S. dollar, which may be stronger than their local currency. Individuals who live in countries with higher inflation, for instance, may find it appealing to store part of their savings in an asset pegged to a more stable currency.
Because stablecoins run on code, they can interact with blockchain-based applications such as smart contracts. Currency-backed stablecoins, especially, are essentially a way to use cash in applications that once would have required you to convert that cash into Bitcoin, Ethereum or another more volatile asset. And in some cases, you can use crypto-backed stablecoins to bridge one cryptocurrency to a different cryptocurrency’s blockchain. Wrapped Bitcoin is designed to let users essentially track the value of Bitcoin on the Ethereum blockchain, for instance.
Finally, in some cases, stablecoin owners have the option to earn interest by lending their assets to others or to take out cryptocurrency-backed loans. This, however, is the most dangerous application of stablecoins. Unlike loans from traditional financial institutions, decentralized finance loans do not provide any government-backed insurance. These arrangements can also put stablecoin owners in an uncomfortable spot when something goes wrong — as it did, earlier this year, for holders of TerraUSD.
A Cautionary Tale: TerraUSD
Stablecoins aren’t always as stable as investors might hope.
In early 2022, TerraUSD was the biggest algorithmic stablecoin by market capitalization, reaching a market cap of more than $18.7 billion by early May. The mechanism for controlling TerraUSD’s price was an underlying cryptocurrency called LUNA; the algorithm would mint or burn units of LUNA to keep TerraUSD’s price pegged to the U.S. dollar. How much LUNA it needed to make or destroy would vary with LUNA’s price.
In May, TerraUSD’s price began to slip relative to the dollar. That triggered smart contracts to automatically create more LUNA tokens. Selling the new tokens was meant to bring TerraUSD’s value up to $1. Unfortunately for TerraUSD’s coinholders, the drop in value was so rapid it triggered a death spiral. So much new LUNA entered the market that LUNA’s price crashed too, making it less and less useful for propping up TerraUSD’s value. TerraUSD fell to 10 cents, and LUNA crashed to “virtually zero,” from its peak of $119.51. The collapse of both the stablecoin and the underlying cryptocurrency over a few days wiped out nearly $45 billion of market capitalization.
Contributing to the death spiral was a protocol on the Terra network that let TerraUSD holders lock up their stablecoins by lending them to others. In exchange for this inflexibility, coinholders received an annual return of 20%. Since TerraUSD is a stablecoin, this arrangement was marketed as essentially safe. However, during TerraUSD’s crash, these users couldn’t withdraw their holdings. Many of them were mostly or fully wiped out.
Terra Classic, the remnant of this crash, is still trading. At this writing, the price is $0.00022.
The two major takeaways from the TerraUSD implosion aren’t radical, but they are worth remembering. First, when something — like a 20% annual return on a stablecoin pegged to the dollar — seems too good to be true, it probably is. And second, putting your faith in an asset without fully understanding the risks involved is a recipe for disaster. “Stable” in an asset’s name is not a guarantee against misfortune.
What happened to TerraUSD’s coinholders wasn’t inevitable, but it is a useful reminder that even if stablecoins are designed to be less volatile than other cryptocurrencies, they are not without downsides. Before purchasing stablecoins, you should be aware of some potential tripwires.
Like other elements of decentralized finance, stablecoins are relatively new, and regulators are scrambling to catch up.
As I mentioned earlier, many stablecoins, especially currency-backed tokens, already must comply with a variety of regulations around licensing and transparency. But some regulators have loudly pushed for a more formal regulatory framework, especially following TerraUSD’s collapse.
In October 2021, Tether paid $41 million to resolve charges from the U.S. Commodity Futures Trading Commission that it allegedly “misrepresented to customers and the market that Tether maintained sufficient U.S. dollar reserves to back every USDT in circulation with the ‘equivalent amount of corresponding fiat currency.’” Tether maintains that its reserves are sufficient for the tokens in circulation, and it neither admitted nor denied the findings as part of the settlement.
In addition to potentially greater regulation, currency-backed coins could face a direct competitor in the government itself. A recent press release from the White House discussed the possibility of a digital form of the U.S. dollar, tentatively called U.S. CBDC. A digital currency directly from the U.S. government could essentially make a certain class of stablecoins obsolete, assuming the virtual currency could interact with smart contracts and other blockchain applications. While this development will take some time, stablecoin buyers should be aware that the possibility is on the horizon.
The central entities issuing stablecoins do not, as a rule, intervene in transactions once the tokens have been minted. This is one of the ostensible selling points of decentralized cryptocurrencies; anyone can send and receive stablecoins once they’re in circulation. However, central entities can, and have, frozen stablecoins to assist law enforcement in investigations. Issuers can freeze tokens over investigations into money laundering, terrorism financing, theft or other illegal activity. In a recent example, USD Coin’s issuer froze more than 75,000 tokens in response to sanctions from the U.S. Office of Foreign Assets Control. The risk for coinholders is that the nature of blockchains means stablecoins can be frozen or blacklisted due to an investigation into a previous owner’s activity, not only the actions of the current owner. While coinholders who haven’t committed any violations should eventually be made whole, they can lose the ability to sell or trade their holdings freely for as long as the stablecoins remain frozen.
Apart from the involvement by government agencies, counterparty risk is arguably the biggest disadvantage associated with stablecoins. Counterparty risk is the likelihood that someone involved in an agreement might not hold up their end of the deal. In the case of stablecoins, it usually refers to an issuer who is unable or unwilling to meet a request to redeem tokens for cash or other reserve assets.
Collateralized stablecoins should, in theory, have sufficient resources to meet any redemption requests. They are, however, subject to the same volatility and risk that applies to the assets in their reserves. If the holdings are principally in safe assets, decentralized assets or — ideally — both, they are relatively safe. But assets held in a central vault are vulnerable to theft or a loss of confidence, and volatile assets like Bitcoin are subject to market forces.
Further, stablecoins that rely on central entities and auditors (as opposed to algorithms) are subject to human error. Audits can fail to spot problems or inaccuracies. Currency-backed stablecoins often hold short-term unsecured debt, which also introduces the possibility that the company issuing the debt could default. This is part of why it’s important to understand exactly how a given stablecoin works. Understanding what underpins a given stablecoin and how its reserves are held is key to accurately assessing the associated risks.
A recent illustration of another form of counterparty risk is the downfall of FTX, a major cryptocurrency exchange. Stablecoin owners whose tokens were on the exchange, like other exchange participants, now find themselves part of a long line of clients and creditors hoping to be made whole as FTX faces bankruptcy. Many stablecoin holders routinely leave their tokens in exchanges for convenience, as moving assets to a personal digital wallet can be complex and transferring them back and forth from that wallet to conduct transactions can be cumbersome. Others were drawn to FTX specifically by attractive promised rates for lending out their tokens on the platform. FTX’s crash, however, illustrates the truth of the adage “not your keys, not your crypto.” Letting an exchange hold your tokens, whether out of convenience or in pursuit of lucrative returns on a loan, exposes you to the risk that the entity could fail and take your assets with it.
Algorithmic Stablecoin Risks
As I mentioned, algorithmic stablecoins are especially risky for investors, as the TerraUSD crash illustrated. They tend to be particularly opaque and complex in their operations, making it hard for prospective buyers to understand their operating mechanisms. And because noncollateralized stablecoins don’t hold asset reserves, keeping the stablecoin’s price steady relies on the market to have an unbounded appetite when responding to shifts in the token’s supply. At worst, algorithmic stablecoins can essentially become Ponzi schemes: New users deposit collateral to create new coins, but no one else wants them. If new users stop coming, the entire edifice can collapse. Most investors would do best to steer clear of noncollateralized stablecoins, absent any major changes in their structure.
If stablecoins seem to meet a specific need for you, or even if you just find them interesting, these risks are not a reason to stay away from them entirely. But despite their name, not all stablecoins are equally stable. Before you buy, take the time to perform due diligence and be sure you understand how a given offering works. And, as always, it is wise to keep an eye on your broader long-term financial plan, which should incorporate thoughtful diversification. Putting all your eggs in one basket is never a good idea; sinking more assets than you can afford to lose into a class that is still relatively unregulated, without much of a safety net, is a way to ensure your finances are distinctly unstable.
EDITOR’S NOTE: This article was updated on Nov. 15, 2022 to address the developing situation with FTX.