Trading and Investing

What Are Stablecoins?

Published
March 2, 2020
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Most people are familiar with Bitcoin, which has experienced a meteoric rise in popularity over the past decade. While speculators flocked to the cryptocurrency, there hasn't been widespread adoption among consumers due in part to the immense volatility. Few people want to hold a currency that might depreciate ten percent over the course of a week.

Stablecoins aim to reduce volatility by pegging their value to a stable asset or basket of assets. By physically holding these assets, the value of the stablecoin is "backed" by the aggregate value of its underlying assets. Any increase in the value of the cryptocurrency is usually accompanied by an increase in the value of the physical assets being held in reserve.

Let's take a closer look at why stablecoins have become popular, growing regulatory concerns, and the most popular options for traders, investors, and of course, consumers.

Nobody wants the money in their wallet to depreciate ten percent in a week — and that's what may happen with Bitcoin.

Why Use Stablecoins?

Most consumers agree that cryptocurrencies are too unstable for day-to-day use. Consumers want their purchasing power to remain the same week-to-week or month-to-month rather than risking a significant depreciation in value. After all, what's the point of a "savings" account if all of the savings could be wiped out in a bad week or month?

Stablecoins

Bitcoin Chart Since Inception - Source: CoinDesk

Stablecoins aim to significantly reduce volatility using the same concepts as physically-based exchange-traded funds (ETFs). For instance, physically-backed gold ETFs hold real gold reserves that are equivalent to the market capitalization of the ETF. The price of the ETF therefore mimics the price of gold very closely with minimal extra volatility.

Tether is the most popular stablecoin on the market today, but Facebook's Libra is the most promising upcoming project. The social media giant wants to enable peer-to-peer payments with a cryptocurrency whose value is tied to a basket of fiat currencies. In addition to reducing friction in online payments, the move could expand reliable banking access.

List of Popular Stablecoins

There are many different stablecoins that take different approaches to reducing volatility. While some of them have achieved low volatility, others have much greater volatility than conventional fiat currencies or commodity-based stores of value like gold. Therefore, it's important to conduct just as much due diligence on stablecoins as other cryptocurrencies.

The largest stablecoins by market capitalization, as of February 10, 2020, include:

  • Tether - $4.46B - Tether is the largest and best-known stablecoin that’s widely accepted by most exchanges, although it has its share of controversy.
  • USD Coin - $425.8M - The USD Coin is a stablecoin developed by Coinbase. Each coin is backed by one U.S. dollar held in a dedicated bank account.
  • Paxos Standard - $216.86M - The PAX token is pegged to the U.S. dollar and is regulated by the New York State Department of Financial Services.
  • TrueUSD - $138.2M - TrueUSD was built by TrustToken and is backed by a reserve of U.S. dollars held in an escrowed bank account.
  • Multi-Collateral DAI - $113.49M - The DAI is a stablecoin that’s pegged to the U.S. dollar rather than being backed by it, which means there’s a guaranteed ratio.

Facebook's Libra could capture a significantly larger market share in very short order if it's approved and released to the public. In addition to Facebook, the stablecoin has attracted a wide range of conventional banks and other financial institutions as partners that could increase liquidity and transform the cryptocurrency into a market standard.

Upcoming Regulations

Many regulators have turned a blind eye to Bitcoin and other cryptocurrencies, which have struggled to gain traction among consumers. Since most cryptocurrency holders are traders and investors, the majority of the regulations impacting the market have been issued by tax and securities authorities that are more interested in the investment angle.

Facebook's launch of Libra has drawn the ire of regulators due to the social media giant's sheer size. With billions of users, governments around the world are concerned that any stablecoin could create an overnight replacement for fiat currencies. Governments could then have trouble with everything from combating money laundering to collecting taxes.

A new bill called the Managed Stablecoins are Securities Act of 2019 would make Facebook's Libra a security under law. Regulators insist that the law ensures that they can audit the assets backing stablecoins to ensure their structural soundness, but critics argue that it's a thinly-veiled attempt to derail the project by introducing onerous regulatory requirements.

Risks & Other Concerns

Stablecoins could face near-term regulatory headwinds, but there are also many other risks to consider. Traders, investors and consumers should conduct the same level of due diligence on stablecoins that they do conventional cryptocurrencies to avoid investing in coins that they believe are stable — but may actually involve more risk than non-stablecoins.

Tether is perhaps the best example of these concerns. In New York, it's being sued for allegedly transferring $850 million to cover a loss experienced by its owner, the Bitfinex exchange, that it never disclosed to investors. The Hong Kong-based company has thus far refused to comply with the investigation saying that the NYAG doesn't have authority.

Other experts believe that many people may be holding Tether without knowing it. Since many crypto exchanges lack access to traditional financial services, they're forced to hold consumer deposits in Tether rather than U.S. dollars. These activities may not be fully disclosed to exchange users who may not appreciate the risks associated with Tether.

The Bottom Line

Stablecoins aim to reduce volatility by tying their value to stable assets, such as fiat currencies or commodities. Consumers looking for a stable hold of value may use these cryptocurrencies for online transactions more readily than highly-volatile cryptocurrencies, like Bitcoin, that often experience massive fluctuations over time.

While the goal is admirable, there are still several hurdles facing stablecoins that have made them anything but stable. Traders, investors and consumers should keep these risks in mind before using them. In the meantime, ZenLedger makes it easy to track capital gains and losses experienced using any crypto currencies — eliminating some of the challenges.

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