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A stablecoin is a cryptocurrency tied to a reserve asset that is considered stable, like the U.S. dollar. Stablecoins were created to offer a stable crypto option for investors to stash cash in or exchange for other cryptocurrencies.
If you're new to cryptocurrency investments, it's a good idea to understand what stablecoins are, how they work and when to add them to your wallet. Here's what you should know.
How Stablecoins Work
Stablecoins are a type of cryptocurrency with a value that's intended to remain stable. The price of a stablecoin is linked to the value of a particular asset, which means its value should fluctuate very little compared with other types of cryptocurrency.
This stability offers several uses. Perhaps you are just getting ready to buy crypto and want to add money to your crypto wallet to prepare for trades. You can start by buying a stablecoin with a value equal to a dollar to keep things simple. When you decide to make a purchase, owning a stablecoin means you won't have to worry about the added delay and hassle of converting cash to crypto.
Or perhaps you have been holding Bitcoin and are tired of the rollercoaster of volatility. If you need a break, trading your Bitcoin for a stablecoin is a good way to keep your money in cryptocurrency while maintaining its current value and subverting volatility.
If you're familiar with popular cryptocurrencies like Bitcoin and Ether, then you are already familiar with the concept of blockchain, on which stablecoins also operate. Blockchain is a public, unalterable ledger kept across a decentralized network of computers that records cryptocurrency transactions.
But while they all use blockchain technology, cryptocurrencies like Bitcoin and Ether are prone to huge swings in value because consumers buy and trade them in a way similar to stock trading that affects their price. Stablecoins are built to avoid this sort of fluctuation.
Types of Stablecoins
There are two main categories of stablecoins based on how they maintain their asset peg, algorithmic or collateralized, and among these categories there are many different types of stablecoins run by different issuers and on different blockchains.
Collateralized
For collateralized stablecoins, an asset is held to back collateralized stablecoins. This may be a fiat currency or some type of commodity.
Collateralized stablecoins can be backed by a variety of assets, but there are three general types:
- Fiat-backed: These are backed by a fiat currency, such as the U.S. dollar. The issuer can keep distributing stablecoins as long as they have the assets to back them up.
- Crypto-backed: These are backed by another cryptocurrency. Your collateral may need to be worth more than the value of the crypto you are purchasing in order to protect against fluctuations in price.
- Commodity-backed: The price of these is pegged to a particular commodity, such as gold. These may experience more volatility than other backing options due to fluctuating commodity values.
Examples include: Tether (USDT) and USD Coin (USDC).
Algorithmic Stablecoins
Algorithmic stablecoins don't use collateral. Instead, the issuer of algorithmic stablecoins grows or shrinks the number of available tokens to keep the price stable and pegged to the value of an external asset.
Examples include: TerraUSD (UST) and Magic Internet Money (MIM).
Benefits of Investing in Stablecoins
There are several potential benefits to buying or trading for stablecoins. These include:
- Low volatility: Investors may purchase stablecoins when they are hoping to keep a steady value for their investments.
- Usability: Investors who want to have a cryptocurrency in their wallet they can use for everyday purchases opt for stablecoins. They are also easier and less expensive to use for buying and selling other cryptocurrencies compared to transferring fiat currency for each trade.
- No time limits: Like all cryptocurrencies, stablecoins can be traded at any point. This is a contrast to assets like stocks that typically need to be traded during approved hours.
- Low fees: Fees for trading or sending stablecoins—even large amounts or international trades—can be low, especially compared to more traditional transfer methods.
Drawbacks of Investing in Stablecoins
For the very reason stablecoins are attractive—their intended stability—they aren't where you should look if your goal is to make money with an investment. These are the drawbacks:
- No—or very low—gains: Stablecoins are inherently designed to not experience the kind of volatility which offers big gains in other cryptos, so they are not a great investment to expect gains from.
- Unexpected crashes: Stablecoins do occasionally experience some sudden volatility. For example, in 2022 a stablecoin called TerraUSD lost its peg to the U.S. dollar. This occurred when the Terra blockchain experienced a high level of selling which affected its operation and the algorithms designed to maintain the dollar peg. Values of the cryptocurrencies on the chain sank to pennies on the dollar, losing billions for investors. Because investors choose stablecoins for their stability and may have stashed cash they couldn't afford to lose in them, unexpected crashes can be much more devastating.
The Bottom Line
It may be best to think of stablecoins as a trading tool for investments. You can more safely store value in stablecoins and trade between a variety of currencies.
Stablecoins may not reap gains, but they can help facilitate better trades or easier purchases while using cryptocurrency. The deeper you get into crypto investing and spending, the more stablecoins will find a place in your digital wallet.