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 aims 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 what are stablecoins, why they have become popular, their growing regulatory concerns, and the best options for traders, investors, and of course, consumers.
What Are 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?
Bitcoin Chart Since Inception - Source: CoinDesk
Stablecoins aims 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.
Types Of Stablecoins
Stablecoins can be categorized into four types:
- Fiat collateralized
- Commodity collateralized
- Crypto collateralized
Fiat Collateralized Stablecoins
The most simple among all stablecoins types is fiat collateralized stablecoins, which means stablecoins that are backed by fiat currency. The simplicity helps in easier understanding among newcomers in the crypto space that helps in the promotion of the latest technology. There is a 1:1 ratio in fiat collateralized stablecoins—1 unit of currency (U.S. Dollar, EUR, or GBP) will be equal to 1 stablecoin. Thus for each fiat-backed stablecoins, there is the backup of real currency.
Commodity Collateralized Stablecoins
Owners of commodity-collateralized stablecoins have tangible assets, like precious metals, as collateral. The value of these commodities can appreciate over time, that'll help gain more incentive. The most popular collateral commodity is gold. Other examples are precious metals, real estate, and oil. Stablecoins have also brought about new opportunities to individuals around the world:
- Digix Gold (DGX) is backed by gold in a 1:1 ratio where 1 gram of physical gold is represented by 1 DGX. It is based on the Ethereum blockchain.
- Tiberius Coin (TCX) holds a combination of 7 precious metals that are used in technical hardware as collateral.
- SwissRealCoin (SRC) is backed by Swiss real estate.
Crypto Collateralized Stablecoins
Stablecoins that are backed by cryptocurrencies are more decentralized than those backed by fiat currency, as crypto-backed stablecoins are based on blockchain technology. As the crypto market is highly volatile, these stablecoins are over-collateralized so that they can absorb the dramatic fluctuations of the crypto market.
The most independent and decentralized stablecoin is the one that isn't collateralized to any asset. Unlike collateralized stablecoins, non-collateralized stablecoins used the seigniorage share model, where stablecoins are governed by algorithms that control their supply.
Popular Stablecoins List: 5 Best Stablecoins
Many different stablecoins take different approaches to reduce 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 September 9, 2021, 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 Stablecoin 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 security under the 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 Tethers 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 aims 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, which 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 cryptocurrencies — eliminating some of the challenges.