Stablecoins have gained popularity in recent years as they are deemed to offer the security, instant processing and privacy of cryptocurrencies with the stable valuations of fiat currencies.
Generally considered as less volatile than other cryptocurrencies such as Bitcoin, Stablecoins are often pegged to a currency such as the US Dollar or to a commodity’s price such as gold. This helps protect Stablecoins from wild swings in their valuations and makes it a less risky investment option for investors and traders.
How Stablecoin works
Stablecoins can be backed by multiple sources including fiat currencies, other cryptocurrencies, commodities such as precious metals and algorithmic functions. The level of stability of a Stablecoin is usually determined by the asset it is backed against.
For example, fiat-backed Stablecoins are considered the most stable and therefore the less risky as they are linked to a centralized financial system such as the US Dollar and the central bank can intervene to control prices when valuations are volatile.
On the opposite end of the scale would be crypto-backed Stablecoins such as those that are backed by Bitcoin. These are seen as higher risk as there is no regulatory body controlling the asset that the Stablecoin is linked to.
Let’s take a more detailed look at each of the sources that can be pegged to Stablecoin:
Fiat-backed Stablecoins: Backed by a fiat currency such as the US Dollar. Investors use Dollars to buy Stablecoins that can be redeemed in the future for the original currency. Fiat-backed Stablecoins aim to have very small price fluctuations.
Crypto-backed Stablecoins: These are backed by other cryptocurrencies such as Bitcoin or Ethereum. It’s worth noting that these can be more volatile due to the volatility of the asset they are backed by.
Precious metal-backed Stablecoins: Gold, silver and other precious metals can be used to back these types of Stablecoins. This type of Stablecoin protects against volatility but are considered centralized which can be a drawback for some investors and traders.
Algorithmic Stablecoins: These are not technically backed by an asset, but instead use a computer algorithm to keep the coin’s value from fluctuating too much. The algorithm is designed to control the number of coins available to help manage the price. For example, if the price rises too high more coins are released, but if it drops too low the supply is restricted.
Advantages of Stablecoins
The advantages of Stablecoins include:
Less risky cryptocurrency
Choosing to invest in a fiat currency-backed or precious metal-backed Stablecoin can help investors limit their exposure to risk. However, as with all investments, an element of risk will still exist and if the cryptocurrency market collapses investors could experience huge losses.
Decentralized investment instrument
As many Stablecoins are decentralized they are an attractive option for investors looking to diversify their portfolio with a mix of centralized and decentralized investments. The processing and transaction fees for decentralized investments are often lower than centralized ones.
Disadvantages of Stablecoin
The disadvantages of Stablecoins include:
Lack of transparency
Stablecoins have come under scrutiny from regulators and demands for more transparency and control. In October 2021, the International Organization of Securities Commissions (IOSCO) stated that Stablecoins should be regulated as financial market infrastructure such as payment systems and clearing houses.
Not all Stablecoins are decentralized
Fiat currency-backed and precious metal-backed Stablecoins are technically centralized as the asset they are pegged to is centralized. This can be a concern for some investors, particularly those looking to diversify their portfolios with decentralized investments.