Stablecoins: What They Are and How They Work

Stablecoins are built to not fluctuate in price while still giving users the benefits of crypto.
Alana BensonSep 24, 2021

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Gambling can be a good time, but bitcoin’s more than 50% drop in value in just a few months? That kind of gamble isn’t for everyone. Enter stablecoins: They have technology similar to traditional cryptocurrencies but are backed by real-world assets, making them less prone to significant drops in value compared with their highly volatile cousins.

Stablecoins are a type of cryptocurrency that is built to offer more stability than other cryptos because it is backed by assets like the U.S. dollar or gold. Other cryptos, such as bitcoin, aren’t pegged to a stable asset; their value is derived from a combination of peer-to-peer technology and software-driven cryptography.

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These are the 10 largest trading stablecoins by market capitalization as tracked by CoinMarketCap, a cryptocurrency data and analytics provider.

Data current as of Sep. 24, 2021.

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Stablecoins are backed by multiple sources, including fiat currency (meaning traditional currencies like the U.S. dollars in your bank account), other cryptocurrencies, precious metals and algorithmic functions. But a crypto’s backing source can impact its risk level: A fiat-backed stablecoin, for instance, may be more stable because it is linked to a centralized financial system, which has an authority figure (like a central bank) that can step in and control prices when valuations are volatile. Stablecoins that aren't linked to centralized financial systems, like a bitcoin-backed stablecoin, may change drastically and quickly in part because there is no regulating body controlling what the stablecoin is pegged to.

Fiat-backed stablecoins are described as an IOU — you use your dollars (or other fiat currency) to buy stablecoins that you can redeem later for your original currency. Unlike other cryptos, with value that can fluctuate wildly, fiat-backed stablecoins aim to have very small price fluctuations. But that’s not to say stablecoins are a totally safe bet — they are still relatively new with a limited track record and unknown risks, and should be invested in with caution. The cryptocurrency exchange Coinbase offers a fiat-backed stablecoin called USD coin, which can be exchanged on a 1-to-1 ratio for one U.S. dollar.

Crypto-backed stablecoins are backed by other crypto assets. Because the backing asset can be volatile, crypto-backed stablecoins are overcollateralized to ensure the stablecoin’s value. For example, a $1 crypto-backed stablecoin may be tied to an underlying crypto asset worth $2, so if the underlying crypto loses value, the stablecoin has a built-in cushion and can remain at $1. These assets are less stable than fiat-backed stablecoins, and it is a good idea to keep tabs on how the underlying crypto asset behind your stablecoin is performing. One crypto-backed stablecoin is dai, which is pegged to the U.S. dollar and runs on the Ethereum blockchain.

Precious metal-backed stablecoins use gold and other precious metals to help maintain their value. These stablecoins are centralized, which parts of the crypto community may see as a drawback, but it also protects them from crypto volatility. Gold has long been seen as a hedge against stock market volatility and inflation, making it an attractive addition to portfolios in fluctuating markets. Digix is a stablecoin backed by gold that gives investors the ability to invest in the precious metal without the difficulties of transporting and storing it.

Algorithmic stablecoins aren't backed by any asset — perhaps making them the stablecoin that is hardest to understand. These stablecoins use a computer algorithm to keep the coin’s value from fluctuating too much. If the price of an algorithmic stablecoin is pegged to $1 USD, but the stablecoin rises higher, the algorithm would automatically release more tokens into the supply to bring the price down. If it falls below $1, it would cut the supply to bring the price back up. How many tokens you own will change, but they will still reflect your share. One algorithmic stablecoin is AMPL, which its creators say is better equipped to handle shocks in demand.

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The interest in stablecoins is that they are built to withstand volatility in a way that other cryptocurrencies aren't, but still offer mobility and accessibility. A more stable cryptocurrency that is decentralized, meaning it isn't beholden to the rules and regulations of a centralized system, is attractive for other reasons: Faster money transfers, access to financial services without applications, keeping financial data private and avoiding financial service fees. Centralized stablecoins provide a digital option with the backing of a traditional currency.

Stablecoins may not be the investment that other cryptos are: They are inherently built to keep their prices stable, not soar in value. For example, the USD coin has barely strayed from its $1 value for its entire existence. Meanwhile, at the start of 2019, bitcoin floated close to $4,000, but in May 2021, it was over $60,000. Stablecoins may be better used as a form of digital cash rather than a speculative investment.

To buy stablecoins you’ll need an account with a crypto exchange or a digital wallet where you can buy crypto directly. Some services may not be available in all locations, so be sure to check whether the options you want are available where you live. Exchanges like Coinbase may offer some stablecoins, but such centralized exchanges may list fiat-backed versions only. For more options, you could use a decentralized exchange to swap any existing tokens for most stablecoins.

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Despite the fact that stablecoins may be safer than other forms of crypto, they are still using newer technology. If you’re planning on putting your savings into crypto in the hopes you’ll make millions, that could be a very dangerous bet, particularly because stablecoins are built to stay stable. Instead, if you’re curious about stablecoins, think about setting aside some  “fun money” — those dollars left over after you’ve built your savings and paid for essential expenses — to use, in addition to creating a well-diversified portfolio. If you’re looking to add some riskier assets to your portfolio, individual stocks can fill that void with less risk than crypto.

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Disclosure: The author held no positions in the aforementioned securities at the original time of publication.

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