What Are Stablecoins?

By Kirsty Moreland

Wondering what stablecoins are? And need to find out more about that so-called non-volatile crypto asset? We’ve got you covered!

Cryptocurrencies are known for many reasons, including their decentralized nature of providing fast and low-cost international transfers. Another thing cryptocurrencies such as Bitcoin are well known for is their price volatility.

Sure enough, the price of Bitcoin has gone from $1.000 to almost $20.000 in 2017 alone, after which it corrected all the way back to nearly $3.000 in 2018. While this volatility can be highly profitable for traders and holders, it can also cause losses.

As a result, many traders were looking for a less volatile crypto asset to hold. That’s where stablecoins come in.

What Are Stablecoins?

Unlike traditional crypto assets, stablecoins have their value pegged to a certain currency or commodity. A stablecoin could be pegged to any currency, such as the Euro, Yen or Pound Sterling.

However, most stablecoins are pegged to the US Dollar. For example, Tether (USDT) is the biggest stablecoin in terms of market capitalization. 1 Tether USD tends to remain worth exactly 1 US dollar.

There are also stablecoins pegged to commodities such as the price of gold. Since they are bound to the value of real-world assets, stablecoins remain mostly unaffected by crypto market swings.

Why Stablecoins?

So you know what stablecoins are, but do you know why you might want to use them? Well, there are two main reasons why someone might want to use stablecoins:

Trading

Firstly, traders may swap their traditional cryptocurrencies into stablecoins if they expect a decrease in price. By exchanging their potentially volatile crypto assets for stablecoins, the plummeting price wouldn’t affect them so much. That said, if you time it badly, you can easily incur losses. Trading crypto is always risky, thus doing your own research is imperative.

Financial independence

Crypto also offers users financial independence. To explain, since the blockchain is decentralized, users can take control of their own funds. Since crypto offers self-custody in a way traditional banks do not, users have freedom of choice over their assets. Furthermore, they don’t have to keep an eye on price swings. Using stablecoins allows users to treat their crypto wallet much like the bank account they are familiar with.

Types of Stablecoins

The main way to classify stablecoins is by how they are backed. To explain, some are backed one-to-one by whatever they are representing. Others use algorithms to keep the price stable. Each of these methods has its advantages and disadvantages. So, let’s explore the different types.

Fiat Collateralized stablecoins

Fiat collateralized stablecoins are backed by fiat currencies, such as Euros and dollars. Issuers of these coins claim to have a reserve of that currency, to collateralize the on-chain stablecoin. These coins are pegged to the value of the currency in reserve. You can also collateralize stablecoins with precious metals such as gold or silver, but US dollars are by far the most popular.

A great example of a fiat-backed stable is Tether (USDT). Tether claims they have one US dollar in reserve for each USDT coin they have created. Some other examples include USDC and TrueUSD (TUSD).

Crypto Collateralized Stablecoins

Some issuers opt to collateralize their stablecoins with cryptocurrencies instead. This is possible, but a little tricky, as cryptocurrencies can be extremely volatile. To ensure they have enough liquidity to cover withdrawals, issuers over-collateralize. This allows the currency to drop in value while leaving a sort of insurance amount to cover assets as needed.

A good example of a Crypto Collateralized stablecoin is MakerDAO token DAI. While this coin is pegged to the US dollar, DAI is actually backed by Ether and some other cryptocurrencies.

Algorithmic Stablecoins

Algorithmic Stablecoins use computer programs to keep the price consistent. This means they may not hold real reserves. Essentially they work much as traditional banks do: Instead of actually holding the asset, an algorithm controls the supply, which in turn controls the price.

However, it’s not always so easy. While banks have control over what happens on their network, the blockchain is decentralized. That means if the programming is bad, there’s no single entity that can help restore the price peg.

Risks and Criticisms

Actually, there are a number of concerns regarding interacting with stablecoins. While they may seem just like digital dollars, they are actually much more complicated than that. Before using them, it’s important to understand the risks that come with them.

So what could go wrong? How can we be aware of their limitations?

Centralization Concerns with Fiat-Backed Stablecoins

While some issuers may claim their token is fully backed one-to-one with fiat currencies, where are their reserves stored? Unfortunately, keeping access to those kinds of funds is almost impossible without using the traditional banking system. And that’s exactly what stablecoin issuers do. In fact, many coins backed by fiat have their reserves sitting in the very banks we’re trying to avoid. That means if the bank goes bust, your stablecoins’ value goes along with it. Yes, even though that goes against the very ethos of blockchain technology!

Risk of failure with crypto-collateralized stablecoins

Crypto-collateralized stablecoins don’t have to worry about banks failing. Instead, they have the crypto market to worry about. As previously mentioned, if they are backed by crypto, these coins are usually over-collateralized in order to overcompensate for potential volatility. However, if a cryptocurrency decreases in price significantly, this can pose a problem.

Regulatory Uncertainty

Right now, stablecoins are getting a lot of attention. Mainly, crypto users are noticing that they aren’t all as secure as others. But that means governing bodies are noticing too. As a result, around the world governments are calling for tightened regulation on these types of coins. In 2022 the SEC showed interest in regulating stablecoins, however, there has been no law passed just yet.

If you want to stay up to date, make sure to check out the Ledger Academy article on crypto regulation.

Future of stablecoins

For now, it’s unsure how the stablecoins will play out. While regulation is still so unclear, it’s impossible to know what the future holds. That said, stablecoins offer a real tangible solution for beginners using cryptocurrencies. If you want to transfer value in a decentralized and secure way without using banks or having to watch cryptocurrency price fluctuations, then stablecoins are a good option.

Not only are they simple to understand for beginners, but they may also offer some benefits to traditional finance too.

Potential adoption by mainstream financial institutions

In essence, stablecoins have all of the benefits of the asset they represent but they also benefit from the way the blockchain works. Since the blockchain is unhackable, this is a huge plus point for some financial services. Believe it or not, TradFi firms get hacked all the time, and stablecoins could offer them a welcome solution.

Managing your Stablecoins Securely

As mentioned previously, most stablecoins operate as tokens on blockchains belonging to a different cryptocurrency. By far most of these are on the Ethereum network (being ERC-20 tokens such as USDT, USDC, DAI or TrueUSD), but they can equally be found on others like the Tron blockchain (using TRC20 standard). At all rates, it is important to keep all of your digital assets secure and out of reach from anyone that would want to steal your hard-earned money.

That’s where Ledger comes in.

At Ledger, our mission is to provide top-notch security for your critical digital assets. Our hardware wallets keep the key to unlocking your crypto wealth offline, away from online hacks. It’d even be protected against a wide array of physical attacks against your hardware wallet since Ledger uses cutting-edge Secure Element chips to keep access to your crypto secure.

Not only do we provide security, but you can also manage a plethora of different coins directly in our all-in-one software solution: Ledger Live. 

Keep learning! If you enjoy getting to grips with crypto and blockchain, check out our School of Block video Alt Coins or Different Coins on the Block