Stablecoins are digital assets that aim to manage volatility by tracking the values of more stable assets, such as fiat currencies like the U.S. dollar. Though the name might imply otherwise, stablecoins are not without risks for investors. Here are three things to know about stablecoins.
1. Stablecoins were created to manage digital asset volatility by linking to more stable assets.
Stablecoins are designed to serve as a source of stored value within the distributed ledger technology (DLT, also known as blockchain) ecosystem, thereby reducing the need to convert digital assets into fiat currency, which typically involves both administrative burdens and significant fees. Stablecoins can also serve as a bridge between DLT markets and traditional financial systems by offering payment methods that are equivalent in both worlds, e.g., as a substitute for cash payments in transactions to buy or sell other digital assets. Several other potential use cases for stablecoins currently are being explored to facilitate payments and cash management within the traditional financial system.
Stablecoins achieve this functionality by linking their value to assets such as fiat currencies, commodities (e.g., gold), or a pool of digital assets. The applicable traditional or digital assets are then typically held in reserve to back the value of the stablecoin.
2. There are currently four main categories of stablecoins.
- Fiat-backed stablecoins are the most prevalent type of stablecoins in the digital asset marketplace. The issuer of a fiat-backed stablecoin holds one or more fiat currencies (e.g., U.S. dollars, Euros, Japanese Yen, etc.) in reserve, typically in a bank or other type of financial institution. The value of the stablecoins are then generally pegged 1:1 to the value of collateral held in reserve. However, it can be difficult, if not impossible, for the public to verify how much fiat currency the issuer actually holds or what percentage of stablecoins are backed by reserve assets.
- Commodity-backed stablecoins are tied to tangible assets, such as gold or other precious metals. These stablecoins may appeal to individuals seeking exposure to physical assets in a way that is more accessible and provides greater liquidity. For commodity-backed stablecoins, one coin is typically worth one predetermined unit of the referenced commodity (e.g., one ounce of gold or one barrel of oil). The applicable commodity is frequently held with a third party that stores these assets in reserve. Depending on how they are structured, commodity-backed stablecoins may be open to questions about the accuracy of the reserve holdings, which in turn may impact the value of the stablecoins themselves.
- Crypto-backed stablecoins may be pegged to a fiat currency, but collateral comes in the form of other digital currencies (such as bitcoin or ether). The amount of collateral is structured so that the value of reserves is larger than the value of the outstanding stablecoins. Such "over-backing" is done to limit the potential volatility of the stablecoin, but also requires individuals to tie up capital that could otherwise be used for other purposes. Again, it can be difficult for the public to confirm the extent of any over-backing.
- Algo-based stablecoins do not hold any form of collateral, and instead rely on smart contracts that use algorithms to adjust the supply of the stablecoins based on market demand in order to keep the value stable. These stablecoins are generally considered to be the most novel, complex and rare form of stablecoins. Risks that are central to algo-based stablecoins relate to the ability of the algorithm to accurately respond to changing market forces and ensuring that the algorithm cannot be manipulated.
3. There are risks to consider before transacting in stablecoins.
Stablecoins share many of the same risks associated with other cryptocurrencies, including those related to cybersecurity and regulatory uncertainty. In addition, certain stablecoins may present enhanced cybersecurity risks in comparison to traditional digital assets (for instance, when the safe storage of other digital assets creates the basis for the value of a stablecoin), as well as when algorithms are used to maintain the value of the stablecoin.
Moreover, stablecoins may also carry potential risks concerning how any reserve assets backing the stablecoin are held and maintained. Accordingly, it is worth doing some research about the company, its history and principals and, to the extent possible, find reliable information on how collateral associated with a stablecoin is held and what safeguards (e.g., auditing) are in place to verify a stablecoin's value.