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What Is a Stablecoin and Are They Really Stable?

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What Is a Stablecoin and Are They Really Stable?

Incredibly popular but highly controversial, stablecoins are among the most talked-about topics in the cryptocurrency world. They offer a great way to further the adoption of digital currency, they’re ideal for payments or as value stores, and as the name implies, they’re capable of avoiding the immense volatility risks of the cryptocurrency market. So what is a stablecoin? What makes it “stable,” and therefore capable of accomplishing what other coins and tokens can’t?

In this guide, we explain what a stablecoin is and how it works. We also take a closer look at some of the most popular stablecoins, including some promising new entrants into the space. Finally, we ask the all-important question: Are stablecoins really stable?

What Is A Stablecoin and Why Do They Matter?

What Is a Stablecoin and Are They Really Stable?

Let’s start with the basics, the “textbook” definition. This definition explains what stablecoins should ideally be. As we’ll see later on, however, the real-world reality doesn’t always hold up to the ideal.

Stability vs. Volatility

At this point, even non-investors have heard about cryptocurrency’s extreme volatility. Capable of, and even prone to massive price and market cap fluctuations, cryptocurrency is still a risky asset class. Put simply, this volatility has been a major deterrent for many investors, but especially institutional investors. Volatility has slowed the wider adoption of cryptocurrency, restricting the market’s expansion as investors struggle with Bitcoin price analysis.

So what is a stablecoin going to do about the simple fact of cryptocurrency’s volatility? What solution do they offer? They are, by their very design, intended to introduce some degree of stability into the cryptocurrency market. So whereas the price of traditional coins or tokens can vary dramatically, the price of a stablecoin stays, well, stable.

They’re Fixed or “Pegged” to Another Asset

When you hear talk about stablecoins, you’re going to hear the word “peg” thrown around quite a bit. That’s because the defining feature of a stablecoin is its “peg,” the fixed value asset to which the coin is paired and that gives it its stability.

So what are they fixed to? These days, the most common way to peg a stablecoin is to a fiat currency, i.e. the U.S. dollar. By definition, a peg represents the fixed, 1:1 price ratio between the coin and the asset underpinning it.

As such, a stablecoin is essentially a cryptocurrency version of a fiat currency—its digital stand-in. And the idea is that it’s price is always identical to the value of one USD.

For this reason, you’ll notice ticker symbols for stablecoins all look pretty similar: “USD” with either a prefix or a suffix with the initial of the coin. There is Tether (USDT), TrueUSD (TUSD), Gemini (GUSD), and Coinbase’s new coin, USDC.

Those symbols indicate what those cryptos are “pegged” to, in this case, USD. The worst thing a stablecoin can do is break its peg. What is a stablecoin that breaks its peg? An asset people will rush to offload. So how do stablecoins attempt to prevent this from happening?

How Do Stablecoins Work?

What Is a Stablecoin and Are They Really Stable?

Now you can reply to anyone who asks, “what is a stablecoin,” with a simple answer. But do you know how they work? How they actually stay stable?

There are generally two different ways of keeping the price fixed. And it’s the pros and cons of these different approaches, and how issuers leverage them, that distinguish one stablecoin from the next.

IOU Issuance Models

In the first place, there’s the IOU issuance model and its variations. In this model, stablecoins are held against a stable asset that remains on deposit while the issuer issues tokens. The tokens serve as a claim on that deposit.

If this sounds like the way central banks do businesses, that’s because it is. But whereas banks use the funds on deposit to make investments—something that works because people trust the bank will be able to honor claims on its deposits and the bank trusts that people won’t all demand their claims at once—stablecoin issuers tend to keep the funds underlying their tokens on deposit at all times. And the reason for that is simple: trust. The IOU issuance model typically involves fiat currencies or other physical assets, such as gold.

Sometimes, however, stablecoins are backed by other decentralized currencies. This is the crypto asset-collateralized model. Typically using Ether (ETH) on the Ethereum blockchain, this model involves overcollateralizing the stablecoins. This means that more cryptocurrency is held than the number of stablecoins created. Overcollateralization makes it possible for the stablecoin to absorb price fluctuations without breaking its peg.

Stablecoins Use Seigniorage Shares Model

A unique and, at this point, rarer way to keep them stable is the seigniorage shares method. In this method, nothing else backs a stablecoin. In other words, there’s nothing to “peg” its value to in a 1:1 ratio. Instead, cryptographic algorithms control the supply of the stablecoin using smart contracts. Supply is expanded or contracted using smart contracts based on supply and demand for the token, much the way central banks determine monetary supply by controlling how much is in circulation.

Without a fixed peg outside the blockchain, however, these types of stablecoins are choice prey for bot attacks attempting to break the peg and make off with the gains of the inevitable selloff.

Why Are Stablecoins Cool?

What Is a Stablecoin and Are They Really Stable?

What is a stablecoin going to offer that conventional coins and tokens don’t? Essentially, the advantages of stablecoins all derive from their stable, fixed price relative to fiat currency or other physical assets. That stability makes them attractive products to a number of investors, and especially institutional investors. And that’s because stablecoins offer a way to adopt cryptocurrency while hedging risks.

Stablecoins also provided a relatively stable entry and exit point for fiat-to-crypto transactions. That makes them useful as a form of payment and exchange, as well as short-term value stores.

What Are Their Drawbacks?

For many crypto enthusiasts, the volatility that turns off would-be investors is everything that’s so exciting and seductive about digital money like Bitcoin (BTC). Volatility can cause great losses, yes, but also great gains. Without that volatility, you won’t just safeguard yourself against losses, you’ll also prevent yourself from realizing significant gains.

In other words, they’re never going to generate gains. They won’t grow in value like other coins, because of their link to the value of something else. As such, they’re kind of a necessary evil, a temporary solution that’s nonetheless essential for cryptocurrency’s continuing viability.

And the drawbacks and shortcomings have been on full display recently, as headline-grabbing news of broken pegs and insurgent alt-stablecoins show a shakeup is underway.

Are Stablecoins Really Stable?

What Is a Stablecoin and Are They Really Stable?

Stablecoins should have a fixed—pegged—1:1 ratio to the USD or some other asset. In short, they’re supposed to be stable. But are they really? Recent upheavals have shown that sometimes, they’re not. And what is a stablecoin without its stability?

Tether’s Downfall Shows Trust Is Everything

Last week, the cryptocurrency market exploded with news when Tether (USDT), the most popular stablecoin, broke its 1:1 peg with the USD. On October 15, Tether’s price dropped to an 18-month low, down to $0.85. 24 hours later, the price had yet to fully recover, hovering around $0.95 on most exchanges.

What happened to break Tether’s peg is an interesting case in the psychology of stablecoins. Wall Street had had a rough couple of weeks. And declining trust in the market, or fear winning out over greed, prompted suspicion over the stability of Tether. Then, rumors began circulating that Tether didn’t actually have all of its tokens backed with U.S. dollars, that liabilities exceeded assets. Fear and mistrust combined to spark a massive sell-off, with investors cashing in their Tether for fiat.

The Rise of Gemini and the Increasing Demand for Alternatives

As Tether worked to weather bad publicity, restoring its peg with the USD and winning some trust back, other coin offerings surged into the space, hoping to capitalize on increasing demand for alternatives.

Amid the increasing competition among coin offerings, the Winkelvoss’ Gemini stablecoin (GUSD) saw its price break the 1:1 USD peg in the opposite direction.

As investors looked for alternatives, many hopped over to GUSD, sending the price to a new high of $1.09 as trading volume nearly doubled. Tether is still older, better established and has a higher volume and market cap. Gemini, on the other hand, is barely a month old. But its advantage is its approval as a trust company from the New York State Department of Financial Services.

Besides Tether, Is There Another Stablecoin to Watch?

What Is a Stablecoin and Are They Really Stable?

With increasing demand for stablecoins, the crypto market has seen a number of new entries. Each offers its own tweak to the Tether model, hoping to increase trust, security and transaction volume.

One alternative to watch is TrueUSD (TUSD). TUSD is part of the TrustToken asset tokenization platform. It’s a blockchain-based stable coin similar in many respects to Tether. But the key difference is that TUSD holds USD in bank accounts with multiple trust companies that have signed escrow agreements. Tether, by contrast, holds assets in an account only it controls.

Dai (DAI) and Maker (MKR) are an alternative based on the crypto assett-collateralized model. Maker is a smart contract. It controls and sells DAI tokens via the decentralized and trustless Maker platform. Maker is a volatile token that governs the platform, and stabilizes the value of Dai, which is essentially an ERC20 token with a 1:1 USD peg. So far, it’s only on small exchanges, but growing in popularity.

Another one to watch is the Paxos Standard Token (PAX), which just listed on the major exchange Binance. Paxos is another NYS-approved trust company. It’s entire supply of Ethereum-based tokens is backed by USD held in dedicated omnibus cash accounts at FDIC-insured U.S. banks.

The cryptocurrency exchange Huobi is taking another innovative approach by launching its own “all-in-one” stablecoin HUSD. Huobi says HUSD lets investors deposit or withdraw and deposit any of four others—excluding Tether—with no conversion fees.

Final Thoughts About Stablecoins

Stablecoins are an innovative solution for a volatile cryptocurrency market.

But in order for that to work, they need to be and remain stable—otherwise, they have no point. Different platforms and exchanges are still figuring out the best way to achieve this stability, so that stablecoins can maintain their 1:1 peg. That’s the computer science aspect of the problem.

But ultimately, what is a crypto without investor trust? They must rely on trust, or at least their ability to eliminate the problem of trust in the first place. For that reason, stablecoins need to take extra steps toward transparency and security. Indeed, many major stablecoins submit their holdings to monthly audits and provide investors with daily updates. Does a stablecoin actually have the money it claims to? Will it withstand economic fluctuations and lost confidence? Is it transparent? Solvent?

These are the problems stablecoins will have to solve as they fill a crucial gap in today’s cryptocurrency market.