What are stablecoins and how do they work?

Over the past few years, the popularity of cryptocurrency (like Bitcoin) has exploded amongst those in the share trading world. However, the volatility of many digital currencies has forced investors to look for more stable ways to purchase crypto. 

Stablecoins are a type of cryptocurrency whose value is ‘pegged’ to another currency, commodity or financial instrument, like US dollars, gold, and in some cases, other cryptocurrencies. 

The term ‘stablecoins’ comes from its relative stability compared to high-volatility crypto like Bitcoin, and is seen as a more useful way to make everyday transactions using digital currencies. 

The basic idea of a stablecoin is that it should largely be able to maintain its purchasing power and avoid excessive inflation, whilst offering the stability of fiat currencies. 

Stablecoins are thought to be stable because they are backed by a reserve asset that helps to keep the price steady, negating the volatile nature of cryptocurrencies, like Bitcoin, whose value comes mainly from supply and demand. 

Some stablecoins are backed by reserve assets of fiat currency, some are tied to other cryptocurrencies, and some can even have no reserve assets – instead, they’re controlled by algorithms.

You can put stablecoins into three main categories, depending on the way they operate. These types of stablecoins are fiat-collateralised stablecoins, crypto-collateralised stablecoins and algorithmic stablecoins. 

Fiat-collateralised stablecoins

Fiat-collateralised stablecoins are cryptocurrencies that have their value pegged to government-issued fiat currency (e.g. USD and AUD) in order to stabilise the coin’s value. 

These sorts of stablecoins may also hold reserve assets like gold, silver, and crude oil as collateral. 

Crypto-collateralised stablecoins

Crypto-collateralised stablecoins are actually backed by reserves of other cryptocurrencies, despite the volatility of these traditional crypto assets. 

Issuers of crypto-backed stablecoins will keep far larger reserves of crypto than the number of stablecoins that they issue to consumers, as a way of balancing out volatility. 

Algorithmic stablecoins

Algorithmic stablecoins sometimes aren’t pegged to a reserve asset at all. Instead, they use computer algorithms to control the supply of their stablecoins, similar to the way that central banks control fiat currency.

While stablecoins are considered a safer alternative to other forms of cryptocurrency, they are not without their risks. 

It comes down to several factors, like how they are backed (e.g. with a fiat currency like the USD, or controlled by a computer algorithm), who the issuer is, and whether future government regulations could impact its value negatively. 

The Reserve Bank of Australia released a bulletin in December 2022, highlighting some of the risks associated with stablecoins. These risks can include: 

• Stablecoins can be vulnerable to runs, meaning a mass withdrawal of funds by investors, leading to an extreme drop in value (especially for algorithmic stablecoins that are not backed by reserve assets).   
• The reserve assets that a stablecoin uses as collateral may be affected by market, credit, and liquidity risks. 
• Issuers of stablecoins may not be held responsible for lost or stolen crypto-assets, due to being unregulated, the crypto ecosystem’s complexity, and legal grey areas surrounding the redemption rights of consumers.

As stablecoins are asset-backed, the value of the asset can play a role in how much a stablecoin is worth. 

For example, if a stablecoin is pegged to the value of gold, any price movement of gold will cause the stablecoin to either increase or decrease in value accordingly. 

And it’s the same for stablecoins tied to fiat currencies, like USD or AUD. Some stablecoins, like TrueUSD (TUSD) and Tether (USDT), are denominated almost dollar-for-dollar with USD. 

Again, if a stablecoin is pegged to a fiat currency that loses value, then your stablecoin will lose value too.

As stablecoins are asset-backed by reserves, the safest kind of stablecoin will be one that is tied to the safest kind of asset. Many consider this to be the US dollar, due to its relative strength compared to other fiat currencies. 

For example, a stablecoin tied to a reserve asset like USD will likely be safer than one tied to a cryptocurrency like Bitcoin. 

But you will also need to consider how trustworthy the issuer of a stablecoin is. If a stablecoin issuer has its reserves regularly audited and has a proven track record of transparency, then it may be a safe bet to invest in its coin.

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