What is a stablecoin?

Bitcoin and nearly all other cryptocurrencies are infamously volatile, capable of experiencing double-digit price swings in less than 24 hours. While this is an attractive feature for speculators looking to profit from price movements, it also remains one of the biggest barriers to the widespread adoption and legitimacy of cryptocurrency.

Enter stablecoins. These fixed-price digital currencies provide stability and a much wider range of everyday use cases than cryptocurrencies currently enjoy, and there are now more than 50 stablecoin projects being developed around the world.

Keep reading to find out how stablecoins work, the benefits they offer and why they’re important.

What are stablecoins?

A stablecoin is a cryptocurrency with a fixed price. While the price of most cryptocurrencies is determined by supply and demand, stablecoins are designed to achieve a constant, stable price.

The most common method stablecoins use to achieve price stability is to peg the value of their coin to a real-world asset, for example gold or the US dollar. However, there are also a couple of other approaches for designing stablecoins, and we’ll explore all the options in detail a little further down the page.

Compare stablecoins side-by-side

How do stablecoins work?

How do stablecoin creators achieve the price stability they desire? There are three different types of stablecoins, each with its own approach for ensuring minimal price fluctuations.

• Fiat-collateralized stablecoins

  This is the simplest method of creating a stablecoin and is used by Tether (USDT), one of the best-known stablecoins in existence today. Fiat-collateralized stablecoins are backed by a real-world asset, most commonly the US dollar or some other fiat currency or also a traditional asset such as gold. That asset is owned and held by a central entity, with each unit of the stablecoin backed by a corresponding unit of the fiat currency.

  For example, a stablecoin issuer accepts deposits in USD and issues one unit of stablecoin for every dollar it receives – the digital currency is effectively an IOU issued on that asset. If you decide you want to cash out 1,000 units of stablecoin, the coin issuer transfers you US$1,000 and “burns” 1,000 stablecoins.

  While this method is reasonably easy to understand and implement, its main downside is that it requires a high level of trust in the central entity that controls USD deposits and issues the stablecoin.

  And trust can be hard to come by in the crypto world. For example, Tether has long been the subject of accusations that not only is it used to prop up the price of bitcoin, but also that the company behind the currency (Tether Limited) doesn’t have sufficient USD reserves to back up the supply of Tether. At the time of writing in October 2018, rumours of Tether’s insolvency continue to circulate online.

  As an example of how a fiat-backed stablecoin works, check out the Tether price graph relative to the value of the USD below.

  

  Pros and cons of fiat-collateralized stablecoins

  Pros

  • Easy to understand
  • Stablecoin’s value should match the value of a real-world asset

  Cons

  • Required trust in third party to hold sufficient fiat collateral
  • Auditing required to make sure appropriate amount of collateral is being held – this can be slow and expensive
  • Uses a centralized structure that somewhat negates one of the key principles of cryptocurrency – decentralization
  • Relies on traditional fiat currency payment systems, which are slower and more expensive than cryptocurrency

• Crypto-collateralized stablecoins

  The concept of crypto-collateralized stablecoins is fairly similar to that of fiat-collateralized stablecoins, but with the obvious difference that they’re backed by digital currency (or a basket of digital currencies).

  They also need to account for the volatility of the cryptocurrency being offered as collateral. So while fiat-collateralized coins are backed on a 1:1 ratio by fiat deposits, crypto-backed stablecoin issuers hold crypto deposits of a ratio higher than 1:1. For example, you may need to deposit $500 worth of Ether (ETH) to access $250 worth of a stablecoin.

  Because crypto-backed coins can be managed on-chain, there’s no need to worry about entrusting your deposit to a third party. However, the biggest concern is the volatility of the underlying collateral, so the coin issuer must hold a substantial amount of collateral to protect against significant price drops.

  Pros and cons of crypto-collateralized stablecoins

  Pros

  • You don’t have to entrust custody of your collateral to a third party – instead, collateral is locked up in a smart contract on the blockchain
  • Conducted on-chain, which ensures transparency and removes the need for third-party auditing that fiat-backed coins have

  Cons

  • Requires extra collateral to be secure against cryptocurrency volatility
  • Risk of the asset collateralizing the stablecoin, experiencing a significant decline in value
  • If backed by a basket of cryptocurrencies, selecting the right currencies to ensure price stability can be difficult

• Seigniorage shares

  These stablecoins are controlled by an algorithm designed to match supply with demand in order to achieve price stability. Using smart contracts, supply is increased when the coin’s price goes up and decreased when it goes down, thereby maintaining the price at a steady level.

  For example, if the price of the stablecoin is trading at above $1 per unit, the algorithm issues additional units to increase overall supply until the price returns to $1. The profits collected in this process are known as seigniorage.

  If the price falls below the $1 mark, the algorithm is designed to use seigniorage to buy up some of the coins, thereby decreasing supply and pushing the price back up to $1. If the price is still below $1 and there are no more profits left to buy more of the coin’s supply, seigniorage shares are issued. These are basically bonds that raise funds for the coin issuer and promise future seigniorage profits to buyers.

  Pros and cons of seigniorage shares

  Pros

  • No collateral required
  • Theoretically protected against the volatility of other cryptocurrencies (however, a wider market downturn could lead to decreased demand for seigniorage shares)

  Cons

  • More complicated than other structures
  • Relies on future growth in demand for the stablecoin in order to be successful – if there is no seigniorage left and seigniorage shares can’t be sold to raise funds, the price of the stablecoin could plummet
  • Largely unproven

Why are stablecoins important?

While Satoshi Nakamoto’s vision for bitcoin was as a form of electronic cash, the world’s biggest cryptocurrency is rarely used as a medium of exchange on a day-to-day basis. Rather, its volatility and high fees mean that bitcoin is impractical for everyday transactions, and is instead used more as a store of value.

The same can be said for most other digital currencies. Because prices fluctuate significantly from one day to the next, holding and using crypto in the same way you do Canadian dollars (getting paid a salary, paying for groceries, buying a coffee etc.) simply isn’t viable. Think about it – why would a business accept bitcoin as payment when 1 BTC might be worth $10,000 today, but tomorrow its value could have dropped to $9,000?

And this is, in theory at least, where stablecoins offer a key advantage. Not only do they offer all the benefits of cryptocurrency, including cryptographic security and the ability to transfer value digitally, but they’re designed to have the low volatility for which fiat currency is famous. The end result is a digital currency that can theoretically be used as a daily medium of exchange in the real world.

Stablecoin uses

What can stablecoins be used for? A price-stable cryptocurrency could potentially have a wide range of purposes, including:

• Medium of exchange. A successful stablecoin could be used as a medium of exchange for everyday spending in the same way we currently use Canadian dollars.
• Protection against market volatility. When the crypto market is experiencing a downturn, shifting your money out of traditional digital currencies and into a stablecoin can help hedge against market volatility. This can be particularly useful if you use a crypto exchange that doesn’t support fiat currency.
• Financial products. Stablecoins could potentially form the basis for a new financial ecosystem, including everything from crypto-backed loans and global remittances to insurance, as they provide the long-term stability required for many financial functions.
• Prediction markets. If you place a bet on the outcome of an event with a long timeframe, using a stablecoin allows you to minimize the impact of market volatility.
• Global access to a stable currency. In countries where the local currency is plagued by hyperinflation, holding a decentralized stablecoin could allow people to protect their wealth.

Bottom line

There’s little doubt that a working, trusted stablecoin is a key stepping stone on cryptocurrency’s path to mainstream acceptance. However, this goal is still some way off.

There have been numerous examples in recent years of stablecoin projects that have simply failed to stand the test of time. Even Tether, the world’s largest (in terms of market cap) stablecoin and one that’s been around since 2015, has been plagued by accusations that it doesn’t have sufficient US dollar reserves to back up the amount of USDT in circulation.

In The State of Stablecoins, a report from wallet provider Blockchain released in September 2018, the authors summed up the current situation in the stablecoin market by saying:

“While there is a great deal of excitement surrounding stablecoins, the technology is still nascent and it is highly unlikely that the perfect stablecoin design exists at present; further experimentation (and innovation) is expected.”

While some stablecoins have been able to demonstrate short-term stability, only time will tell whether they’ve got the goods to provide long-term reliability. Until that happens, don’t assume that any cryptocurrency will be able to provide the same stability as good old-fashioned fiat currency. And if you’re thinking of putting any of your hard-earned cash into a stablecoin project, make sure you thoroughly research it first.

FAQs

• Where can I buy stablecoins?

  This depends on the coin you want to buy. While well-known stablecoins like Tether and Dai are listed on a wide range of cryptocurrency exchanges, many other coins are less widely available. Do your research to find out where you can buy your chosen currency.

• How and where can I buy Tether?

  You can find step-by-step instructions on this in our guide to how to buy USDT.

Picture: Shutterstock

Disclosure: At the time of writing, the author holds ADA, ICX, IOTA, POWR and XLM.

Written by

Tim Falk

Writer

Tim Falk is a freelance writer for Finder. Over the course of his 15-year writing career, he has reported on a wide range of personal finance topics. Whether you're investing in stocks and ETFs, comparing savings accounts or choosing a credit card, Tim wants to make it easier for you to understand. When he’s not staring at his computer, you can usually find him exploring the great outdoors. See full bio