Stablecoins are a new class of cryptocurrencies where the price is designed to be pegged to a cryptocurrency, fiat money or an exchange-traded commodity. Stablecoins have gained some popularity recently, as they offer the best of both worlds.

One plus factor is the instant processing and security or privacy of cryptocurrency payments, and the second is the volatility-free, stable valuation of fiat currencies. The dozens of existing stablecoins use the USD as their benchmark asset, but on the other hand, many stablecoins are pegged to other fiat currencies issued by governments, such as the euro and the yen. This, in turn, means the fluctuations in the price of stablecoins are very limited, compared to high-profile cryptocurrencies, like Bitcoin and ETH, that tend to rise and fall unexpectedly.

The very first stablecoin, Tether, was created in 2014. Thereafter, many other stablecoins were launched. Users typically receive one token for every dollar they deposit. The tokens can be converted back into the original currency at any time, also at a one-to-one exchange rate.
On July 28, 2021, Tether had a market capitalization of $62 billion, or slightly more than half of the $117 billion market capitalization of all stablecoins worldwide. The next biggest stablecoin is called USD Coin. It has a market cap of around $27 billion.

Stablecoins are supported by various sources, including fiat currency (i.e. popular currencies like the USD in your bank account), other cryptocurrencies, gold and algorithmic functions. However, the risk level of a backing source for a crypto can also change.

At the same time, the fiat-backed stablecoin may be more stable because it is linked to a centralized financial system with an authority figure (like a central bank) that can step in and control prices when the market faces volatility. Bitcoin-backed stablecoin may face quick rises or drops because no regulating body controls the currencies to which stablecoins are pegged.

Fiat-backed Stablecoins

These stablecoins are described as an IOU — you use your USD or other fiat currency to purchase stablecoins that you can redeem later for your original currency. Unlike other cryptos, fiat-backed stablecoins tend to have very small price fluctuations, with a value that can fluctuate uncontrollably.

However, it is not to say that stablecoins are a completely safe bet. They are still almost new, with a limited track record and unknown risks, which is why we should be investing in them with caution. The cryptocurrency exchange, Coinbase, offers a fiat-backed stablecoin called the USD coin, which can be exchanged at a 1-to-1 ratio for one US dollar.

Crypto-backed Stablecoins

These stablecoins are supported by other crypto assets. Since the backing asset can be volatile, crypto-backed stablecoins are overcollateralized to secure the price of the stablecoin. By way of example, a $1 crypto-backed stablecoin could be attributed to an underlying crypto asset meriting $2, so if the underlying crypto dumps in terms of value, the stablecoin has a built-in cushion and can remain at $1.

Furthermore, these stablecoins are less stable than fiat-backed stablecoins, and it is a good idea to keep tabs on how the underlying crypto asset behind your stablecoin is performing. One crypto-backed stablecoin is dai, which is pegged to the US dollar and runs on the Ethereum blockchain.

Precious metal-backed Stablecoins

These stablecoins use gold and other valuable metals to help maintain their value. They are centralized, which some members of the crypto community may see as a drawback, but it also protects them from crypto volatility. The yellow metal is seen as a hedge against volatility and inflation of the stock market, which makes it an attractive supplement to portfolios in fluctuating markets.

Digix is a stablecoin backed by gold, that provides investors with the capacity to invest in valuable metals without the hassle of transporting and storing them.

Algorithmic Stablecoins

These stablecoins are not supported by any asset. This is why the biggest challenge is understanding why they are called stablecoins. These stablecoins use a computer algorithm to maintain the value of the coin, and prevent it from fluctuating too much.

If the algorithmic stablecoin price is pegged to $1, but the stablecoin climbs higher, the algorithm automatically issues more tokens into the supply, in order to lower the price. On the flip side, if it falls below $1, the algorithm will cut the supply to bring the price back up. One algorithmic stablecoin is AMPL, which its authors say is better equipped to handle shocks in terms of demand.

Stablecoins are relatively safe, by comparison, as their level of risk is lower than investing in the stock market. One of the most significant differentiators regarding the risks related to stablecoins is that their level of risk is comparatively well-known. We can compare this to standard investments, where much of the information on reserve accounts, backing banks and shadow parties is widely researched.

Furthermore, the United States Office of the Comptroller has accepted the use of stablecoins by banks, which possibly means that more laws will be introduced. This, in turn, improves the safety and reliability of stablecoins. Furthermore, the crypto-backed stablecoin employs smart contracts to ensure that the contractual obligations are met. The ability of stablecoins to reduce risk may be aided by embedded restrictions. However, meeting those obligations, even when assets are missing, could be disastrous and force the onus back onto the obligated bank.

Coin buyers can decrease the risk by investing wisely, as stablecoins are becoming more regulated in the US federal regulatory system. Stablecoins can enhance the efficiency of the provision of financial services. However, they may also generate risks to financial stability, especially if they are adopted on a huge scale. Some stablecoins are riskier than they may appear.

Stablecoins may carry risks in terms of asset contagion, collateral and accountability. Neither should we ignore the risks that stablecoins potentially pose to the financial system, in terms of systemic risks, whereby sovereign currencies are undermined.