Updated: Dec 6, 2021
Many people are still trying to understand crypto currency, such as bitcoin and ethereum. Now we have another type of crypto - called stablecoin.
An easy way to understand stablecoins and their purpose is by thinking of traditional finance: You own stocks and bonds for the long term, and you have cash in the bank for short term, regular purchases.
The cryptocurrency environment follows a very similar pattern.
Some investors may own a cryptocurrency, such as bitcoin, as a long-term investment. Since the prices are very volatile, the asset isn’t suited for regular purchases or transactions.
Stablecoins, like the name implies, were designed to help stabilize prices and be a medium of exchange, like the dollar is used for transactions.
What is it and What’s The Purpose?
A stablecoin is a type of cryptocurrency whose value is usually tied to an external asset. This is what helps make them more ‘stable’ over time, compared to other cryptos that have no correlation to an existing asset. Many existing stablecoins peg their value to the dollar and the result is a digital currency with similar stability to the dollar.
Some stablecoins provide 1:1 backing, so for every unit of standard currency invested, you get one token. In theory, you could cash out the digital currency at any time and receive fiat (cash) back at the same 1:1 rate. This is an example of a fiat-collateralized stablecoin.
For a basic example, some stablecoins can be viewed like the US dollar - and there is one coin, USDC (US Dollar Coin), that is known to be backed 1:1 by the US Dollar in its reserve.
Also, there are crypto-collateralized stablecoins. It's the same concept, except rather than being backed by fiat currency, they’re backed by other cryptocurrencies. And while some stable coins take this extra step of backing their coins, not all do.
Given their $100 billion+ market cap, stablecoins are getting a closer look from regulators. While some issuers have state regulations and requirements they must meet, overall, there’s minimal regulatory oversight.
As the use of stablecoins increase, we'll likely see more laws and more clarity around that space. Some changes that are possible could be regular audits of the issuing company, or more bank-like operating and reporting procedures.
One of the most popular, and scrutinized, stablecoins is Tether. They've claimed that every coin is backed 1:1 with the US dollar. An investigation found that only 76% of its reserves are backed by cash/cash equivalents, and of that, only 4% was actually held in cash1. The remainder was held mostly in short-term debts and commercial papers.
In this scenario, you can imagine the risk of investing in a stablecoin that has a market decline without proper reserve backing. If investors start cashing out, liquid reserves may not be available to handle all the requests, potentially causing a sharp decline in price.
pros and cons of Stablecoins
If you want to invest in crypto without the heavy volatility, stablecoins could provide an alternative place to park some cash. Just be aware of its safety and legitimacy by reading the issuer’s statements and their reserve report.
Stablecoins are mainly used by people who already invest and transact in crypto as a way for easier conversions and transfers.
Stablecoins shouldn’t be viewed as a way to make significant gains since their role is to provide price stability. However, some coins give the ability to earn interest much like a high-yield savings account.
Regulatory risk: Regulatory risk is the most prominent risk as there is currently minimal oversight or regulation around the space.
Reserve risk: Depending on how a stablecoin is structured, its reserve may or may not be able to withstand a market sell-off.
Security risk: All cryptocurrencies must be held or stored in some sort of digital location - whether it be a custodial or non-custodial wallet - and because of this, security risk is present.
Stablecoins aim to provide stability in a market infamous for volatility - so it can be more easily used as a true currency. Even though it appears to be lower risk, it is still an unregulated investment, so be sure to understand the risks.
John Piershale, CFP®, AEP®
1. Lopatto, Elizabeth. The Tether Controversy, Explained. The Verge. August 16, 2021.
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