A stablecoin is referred to as “pegged cryptocurrency” because its price is fixed in terms of another asset. While cryptocurrencies like Bitcoin and Ether can sometimes fluctuate wildly in fiat money—like the U.S. dollar—stablecoins are designed to maintain a stable value relative to other assets.
As new forms of blockchain-based money continue to be developed and adopted rapidly, stablecoins are becoming increasingly popular and getting attention from some heavy hitters in the crypto world.
For example, Tether (USDT), created in 2014 by two developers who wanted to enable people to move money across borders quickly and anonymously using BTC, has grown into the second-highest market capitalization among cryptocurrencies today.
Since its inception, hundreds of millions of USDT have been issued—all backed by fiat currency reserves held in a bank account in Taiwan with assets totaling $2 billion as of October 2017.
Importance of Stablecoins
In the past year, Bitcoin has fallen from above $15,000 to below $6,000 before rallying again over the past few months. The erratic movement of the market comes from several factors that may include changes in the overall demand for Bitcoins and other cryptocurrencies and their supply.
These vast increases and decreases are partly due to Bitcoin’s relatively small market size. The total value of all Bitcoins is less than 60% of Apple’s current market cap. A small amount of money flowing into or out of the market can still significantly impact price.
This fact is compounded by its ease of use as a payment mechanism. Investors who might not otherwise be interested in trading stocks or bonds can use their existing accounts to buy and trade Bitcoin. This activity creates feedback loops between investors and markets, leading to price volatility.
Types of Stablecoins
Stablecoins are cryptocurrencies that are backed by collateral. It means that the value of stablecoins is tied to the value of the collateral.
Fiat-collateralized stablecoins are a type of cryptocurrency whose value is maintained by holding reserves of traditional money, such as the U.S. dollar, in an account. This collateral assures that the price will remain stable relative to the underlying digital currency used as collateral and the fiat currency whose value it maintains. The most common form of a fiat-collateralized stablecoin is a U.S.-dollar-backed version, but other forms of reserve currencies can also be used.
This way, fiat-collateralized stablecoins serve as intermediaries between cryptocurrencies and traditional currencies. Anyone can use stablecoins as an alternative to trading one cryptocurrency for another. Users can move money into or out of a cryptocurrency market without fearing losing value due to volatility.
Stablecoins having crypto as collateral are a bet on the stability of the cryptocurrency pegged to their value. They’re a bet that the crypto-collateralized stablecoin will be able to attract enough investment to weather adverse price movements of its reserve cryptocurrency. And they may have to endure some very adverse price movements.
One of the most common solutions is to hold reserves of other cryptocurrencies worth 150% of the total amount of stablecoins in circulation. When a new cryptocurrency is released, it’s not just a way of transferring money to someone—it can also be a way to hold value. Cryptocurrencies like Bitcoin (BTC), Ethereum (ETH), and Zcash (ZEC) are volatile, and their value changes rapidly.
Algorithmic stablecoins are getting much attention lately, but most people don’t understand what makes them different from their non-algorithmic counterparts. Some stablecoins have a reserve asset that backs up their value, and some do not. The main difference is the method used to stabilize the coin’s value.
Most central banks use monetary policy to manipulate the supply of legal tender they issue. Monetary policy is a set of rules that dictate how much money is released into circulation. Central banks like the U.S. Federal Reserve make these policies public and having the legal authority to issue currency gives their monetary policy credibility in the markets.
Unfortunately, this also means that central banks are vulnerable to political pressure that can sway policy decisions in ways that might destabilize the economy. Just look at how President Trump has been publicly attacking the Fed for raising interest rates, which directly impacts how much money is available in circulation and thus affects inflation and the currency’s value.
The Process Of Stablecoins
Stablecoins hold their market value by pegging themselves to an external reference, like the U.S. dollar or gold. You can think of them as a cryptocurrency version of the dollar; you can use them as currency, but they are still tied to the dollar in some way, so their value doesn’t fluctuate wildly.
They’re more valuable than regular cryptocurrencies because they aren’t as susceptible to market volatility; they maintain their purchasing power over time. If you were to buy a stablecoin for $100 and then spend it a week later, you’d be able to buy the same amount of goods with it that you could have purchased before.