Stablecoins are digital assets whose value is linked to the value of another currency, commodity, or financial instrument. Stablecoins are designed to be an alternative to the excessive volatility of the most popular cryptocurrencies, such as Bitcoin (BTC), which has made such investments unsuitable for widespread use in transactions.
Though Bitcoin remains the most popular cryptocurrency, its price, or exchange rate, is notoriously volatile. For example, Bitcoin’s price surged from an intraday low of just over $4,000 in March 2020 to nearly $65,000 in April 2021 before plummeting nearly 50% in the next two months. Intraday swings can be extreme; the cryptocurrency frequently moves more than 10% in a few hours.
All of this volatility is excellent for traders, but it turns everyday purchases into a risky gamble for both the buyer and seller. Long-term cryptocurrency investors don’t want to make a name for themselves by paying 10,000 bitcoins for two pizzas. Meanwhile, most businesses don’t want to lose money if the value of a cryptocurrency drops after they’ve been paid for it.
A currency that isn’t legal tender must maintain relative stability in order to assure those who accept it that it will preserve purchasing power in the short run. Daily movements of even 1% in forex trading are uncommon among traditional fiat currencies. Stablecoins, as the name suggests, try to solve this problem by guaranteeing to keep the cryptocurrency’s value stable in a variety of methods.
Fiat-collateralized stablecoins keep a reserve of a fiat currency (or currencies) as collateral, such as the US dollar, to ensure the stablecoin’s value. Precious metals like gold and silver, as well as commodities like crude oil, can be used as collateral, however most fiat-collateralized stablecoins have reserves of US dollars.
Independent custodians manage these reserves, which are audited on a regular basis. Tether (USDT) and TrueUSD (TUSD) are two prominent stablecoins that are backed by US dollar reserves and are pegged to the US dollar.
Stablecoins that are crypto-collateralized are backed by other cryptocurrencies. Because the reserve cryptocurrency may be volatile, such stablecoins are over-collateralized, meaning that the value of the cryptocurrency held in reserves exceeds the value of the stablecoins produced.
Reserve assets may or may not be held by algorithmic stablecoins. The technique of keeping the stablecoin’s value stable by restricting its supply through an algorithm, which is effectively a computer software running a predefined calculation, is the main difference.
In some aspects, this is similar to central banks, which do not use a reserve asset to maintain the value of the currency they issue. The difference is that a central bank, such as the Federal Reserve, sets monetary policy publicly based on well-known parameters, and its standing as a legal tender issuer adds to its credibility.
In a crisis, algorithmic stablecoin issuers can not rely on such advantages. On May 11, 2022, the price of the TerraUSD (UST) algorithmic stablecoin plummeted by more than 60%, destroying its peg to the US dollar, while the price of the linked Luna token used to peg Terra plummeted by more than 80%.
Given the $130 billion market’s rapid growth and potential to disrupt the broader financial system, regulators continue to scrutinize Stablecoins. Stablecoins should be regulated as financial market infrastructure alongside payment systems and clearinghouses, according to the International Organization of Securities Commissions (IOSCO) in October 2021. The proposed restrictions target Stablecoins that authorities consider systemically important and have the ability to disrupt payment and settlement processes.
Furthermore, legislators have raised requests for Stablecoins legislation. Senator Cynthia Lummis (R-Wyoming) advocated for regular audits of Stablecoins issuers in September 2021, while others support bank-like rules for the sector.