What are stablecoins and how do they affect the cryptocurrency market?

A stablecoin is a type of cryptocurrency designed to maintain a fixed value over time. The value of a stablecoin is usually pegged to a specific unit of real currency, usually the US dollar. In this setup, one unit of the cryptocurrency is usually equal to one unit of real currency. Unlike highly volatile cryptocurrencies like Bitcoin, the price of stablecoins is not designed to fluctuate.

However, events in the stablecoin market (like the fall of TerraUSD) have led federal officials to closely examine the space. Treasury Secretary Janet Yellen has spoken of risks to broader financial stability from stablecoins, while the Federal Reserve has released a report addressing the lack of oversight and uncertainty surrounding what actually underpins stablecoins.

Here’s how stablecoins work, what risks they pose, and how to check if a stablecoin is safe.

Stablecoins: What are they and how do they work?

A stablecoin is a cryptocurrency whose value is pegged to another asset, usually a currency like the US dollar or the euro, although other assets are possible. Such cryptocurrencies track the underlying asset, stabilizing their value over time, at least relative to the currency to which it is pegged. In effect, it is as if the underlying asset has become electronic, like a digital dollar.

Since their purpose is to track an asset, stablecoins are usually backed by the specific assets they are tied to. For example, the issuer of the stablecoin will usually create a reserve with a financial institution that holds the underlying asset. So, a stablecoin might hold $100 million in reserves and issue 100 million coins at a fixed value of $1 per coin. If the owner of a stablecoin were to cash out the coin, the actual money could eventually be taken from the reserve.

This structure is in contrast to most cryptocurrencies, such as Bitcoin and Ethereum, which are not backed by anything. Unlike stablecoins, these other cryptocurrencies fluctuate greatly as speculators push their prices up and down as they trade for profit.

While many stablecoins are backed by hard assets, others are not. Instead, these others use technical tools (for example, destroying part of the coin supply to create scarcity) to keep the price of the cryptocurrency stable. These are called algorithmic stablecoins, and they can be riskier than stablecoins backed by assets.

Why use stablecoins in crypto trading?

Stablecoins solve one of the fundamental problems with most mainstream cryptocurrencies; namely, their large volatility makes them difficult or even impossible to use in real transactions.

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“Digital currencies like Bitcoin and Ethereum are extremely volatile, which makes it very difficult to price things on their own terms,” says Anthony Citrano, founder of Acquicent, a marketplace for NFTs. “Stablecoins avoid this problem by pegging their price to a known reserve currency.”

Additionally, their stability allows many stablecoins to be used as a functional currency in a crypto brokerage firm. For example, instead of exchanging Bitcoin for dollars, traders can convert it into a stablecoin like Tether. Stablecoins are available 24/7, making them more accessible than cash obtained through the banking system, which is closed overnight and on weekends.

Stablecoins can also be used with smart contracts, a type of electronic contract that is automatically executed when its terms are met. The stability of digital currency also helps prevent disputes that can arise when dealing with more volatile cryptocurrencies.

Most popular stablecoins

Stablecoins don’t typically get the same press (and hype) as other cryptocurrencies, in part because they don’t offer the same kind of “get rich quick” opportunity. However, a few are among the most popular cryptocurrencies by market cap as of August 2024:

Of course, the size of these cryptocurrencies pales in comparison to the largest cryptocurrencies, such as Bitcoin, which has a market value of around $1.2 trillion, and Ethereum, whose value exceeds $320 billion.

TerraUSD, an algorithmic stablecoin, was another popular option but lost its peg to the dollar in May 2022. This stablecoin used other cryptocurrencies and a complex arbitrage system to keep its valuation at 1:1. However, the decline in crypto markets and the subsequent loss of confidence in the stablecoin caused its price to fall.

Risks of stablecoins

At first glance, stablecoins may seem low-risk. Compared to popular cryptocurrencies that are not backed by anything, they are. However, stablecoins also present some typical crypto risks and at least some of their own kind of risk:

Security: Like other cryptocurrencies, stablecoins must be held somewhere, whether it’s in your own digital wallet or at a broker or exchange. And this presents risks as a particular trading platform may not be secure enough or may have some vulnerabilities.

Counterparty risk: Cryptocurrency may seem fairly decentralized, but in reality you’re dealing with multiple parties in a transaction, including the bank that holds the reserves and the stablecoin issuer. They need to do the right things (security, proper reserve holding, etc.) for the currency to retain its value.

Reserve risk: A key element of the stablecoin ecosystem is the reserves that back a stablecoin. These reserves are the final safeguard on the value of a stablecoin. Without them, the coin issuer cannot guarantee the value of a stablecoin with full confidence.

Lack of confidence: If a stablecoin is not sufficiently backed by hard assets, especially cash, it can experience a run and lose its peg to the target currency. This is what happened to the algorithmic stablecoin TerraUSD in May 2022, as it was backed by other cryptocurrencies, not cash. The stablecoin’s price fell and spiraled downward as traders lost confidence in its ability to maintain the peg.

“The primary risk of stablecoins is that they are not fully backed by the reserve currencies they say they are,” Citrano says. “In an ideal situation, the issuer of the stablecoin has enough currency reserves (cash or other highly liquid, safe investments) to fully back the stablecoin. Less than 100 percent introduces risk.”

How safe are stablecoins?

So how do you know if a stablecoin is safe? You need to read the fine print in the issuer’s disclosures. And it’s absolutely essential that you do that, Citrano says.

“Check the issuer’s reserve reports,” he says. “If they don’t provide any reserve reports, be extremely cautious.”

And even then, stablecoin holders should be careful about what’s backing their coins. Stablecoin Tether has come under fire for its statements about reserves. And those who think the cryptocurrency is fully backed by real dollars should be careful.

The company showed that it had more reserves than liabilities in its March 31, 2021, reserve report. That’s fine on the surface, but the devil is in the details:

Approximately 76 percent of its reserves are held as cash or cash equivalents (the vast majority of which is short-term corporate debt, also known as commercial paper).

Approximately 13 percent consists of secured loans.

About 10 percent consists of corporate bonds, funds and precious metals.

These other assets can often act like real cash, but they are not real cash.

If you look closely, less than 4% is actual cash, while most of it is held in short-term corporate debt. This commercial paper is not the same as cash, especially in emergencies. If markets fall, these assets (and other non-cash assets) can lose value rapidly, leaving Tether coins under-reserved exactly when they are needed most.

Unless a stablecoin commits to holding 100 percent (or more) of its reserves in cash, there’s no guarantee the cash will be there to buy it back. In that case, the value of the stablecoins could be much lower than the stablecoins themselves. Stablecoin holders could end up on the losing end of an old-fashioned bank run, a surprising fate for a technology that markets itself as cutting-edge.

Since then, Tether has reduced the share of some of these non-cash assets in its portfolio.

In 2021, the U.S. Commodity Futures Trading Commission fined Tether $41 million for making false statements that its stablecoin was 100% backed by fiat currency. Since the March 2021 report, Tether has reduced its holdings in commercial paper, and the company said it would continue to reduce its reliance on that funding.

According to the reserve report dated June 30, 2024, Tether’s reserves were greater than its liabilities and changed the composition of its reserves:

Approximately 84 percent of its reserves are held as cash or cash equivalents, with approximately 80 percent of that amount in U.S. Treasury bonds.

Approximately 6 percent consists of secured loans.

About 10 percent is in precious metals, Bitcoin and “other investments.”

While Tether has more than its fair share of the reserves backing the stablecoin, many of its investments — in Bitcoin and precious metals — can be volatile. And it’s not really clear what constitutes “other investments,” just that the investments here don’t fit into any other categories. So its reserves — which are almost all non-cash — could still take a hit in tough times.

Finally, the best guarantee of a currency’s security is that people widely accept it for goods and services. And in the United States, the only currency that is widely accepted—indeed, the only price at which products are ultimately called—is the dollar.

Conclusion

Stablecoins provide some of the stability that most cryptocurrencies lack. However, those who use stablecoins should be aware of the risks they take when they own them. While stablecoins appear to have limited risk in most periods, in a crisis, stablecoins can become the riskiest when they should be the safest to own.

Editorial Disclaimer: All investors are advised to conduct their own independent research on investment strategies before making any investment decision. Investors are also advised that past investment product performance is no guarantee of future price appreciation.