Your guide to stablecoins

Stablecoins provide the freedom and accountability of cryptocurrencies without the volatility. So how do they work and what are their benefits?

Matthew Blenkarn, Content Marketing Manager

8 Sep 2022

Introduction

Awareness and adoption of cryptocurrencies is steadily growing. One in 10 people in the UK have held crypto, while two in five respondents to a 2021 Gemini survey said they were “crypto-curious.” Trading and fintech apps alike are taking note, competing with crypto exchanges to reach an expanding market.But cryptocurrencies’ price volatility remains a concern for businesses and people that hold them. It’s hard to cost things in crypto when their value can grow and fall dramatically. And that undermines their utility as a store of value or medium of exchange. Stablecoins are one answer. They provide the freedom and accountability of cryptocurrencies without the volatility. But what is a stablecoin? How do they work? And how do customers buy them?Read on to learn about the basics of stablecoin and see why it’s a useful asset for both consumers and businesses.

What is a stablecoin?

Stablecoins are cryptocurrencies whose prices are pegged to a fiat currency (eg USD Coin to the US dollar, Eurocoin for the euro, etc), a commodity (e.g Pax Gold to gold), or another cryptocurrency (eg DAI to Ether). The largest stablecoin is Tether (USDT) — it’s backed by collateral to the US dollar and has more than 72 billion coins in circulation as of August 2022. Stablecoins offer several advantages compared to other cryptocurrencies. They’re generally less volatile, and therefore provide more consistent and stable value. And since they’re often pegged to other assets, they’re easier to convert into fiat currency, providing a smooth onramp to crypto trading and ensuring liquidity.Compared to fiat currencies, stablecoins also offer better settlement times and foreign exchange rates in a trading environment. Traditional banking rails, with their slow settlement times, restrict when fiat payments and transfers can be executed. This imposes a barrier when commodities are in short supply and time is of the essence. Stablecoins run on blockchains that operate 24/7, allowing them to overcome this problem. Trading can take place around the clock, often with almost immediate settlement. This ensures that changing prices and foreign exchange rates don’t impact a trade.

How do stablecoins work?

Stablecoins work by matching the price of the asset to which it’s pegged. They adjust their price by maintaining stocks of that asset as collateral, or through algorithms that adjust to fluctuations in demand and supply. Generally, stablecoins fall into the following categories:

Collateral-backed stablecoins: cash or asset reserves act as collateral to prove that each coin is backed by its equivalent amount. These are also known as off-chain stablecoins
Crypto-backed stablecoins: cryptocurrency reserves function as collateral to ensure a stablecoin maintains a one-to-one value with an asset. These are also known as on-chain stablecoins
Algorithmic stablecoins: an algorithm maintains the peg between a stablecoin and an asset. It adds tokens to the supply if the price gets too high and removes them if the price falls below the peg

The latter category is more prone to ‘breaking its peg’ — having its value fall below a one-to-one ratio with its associated asset, as seen with the recent news surrounding TerraUSD. Instead of maintaining reserves to guarantee their price, these assets rely on algorithms and users to balance their value, making them more vulnerable to price fluctuations.

How do you buy and sell stablecoins?

Stablecoins can be bought on cryptocurrency exchanges such as Coinbase, Binance or FTX. Customers register an account with the exchange and undergo KYC and AML checks. They then deposit an amount of fiat currency with the platform, and execute a trade for a stablecoin. The exchange then takes a commission from the sale.Exchanges are the most popular way to buy and sell stablecoins. Though stablecoins are commonly bought with and sold for fiat, it is also possible to use other cryptocurrencies.

How do you store stablecoins?

You can store stablecoins on an exchange platform or transfer them to a crypto wallet. With the former, you don’t actually own the stablecoin — instead, the platform holds it ‘in custody’. It is only when you transfer the stablecoins off the exchange and into a ‘self-custody’ wallet that you take ownership. Both options have benefits and drawbacks. Storing stablecoins on an exchange is convenient, especially if you are trading regularly. But that is also a risk. Exchanges can be hacked, or they can go out of business. And because they’re not regulated, customers often have little recourse.That’s why many stablecoin owners prefer to hold their coins in private wallets. These include digital ‘soft’ wallets — software-based storage methods — or on a ‘hard’ wallet drive, which looks like a USB stick with a digital interface.

How can consumers benefit from stablecoins?

Stablecoins allow consumers to benefit from a better crypto trading experience, greater access to currencies and assets, and the ability to transfer money internationally.

Better crypto trading experience

With almost 20,000 cryptocurrencies available, consumers have plenty of opportunity to profit from trading digital currencies. But converting one form of crypto to fiat currency before using it to buy another can bog down this process. To transact on the blockchain, customers need to convert their fiat currencies into a vehicle that can be used in the crypto world.Stablecoins are the perfect solution for this. They keep customers in the cryptocurrency ecosystem and allow access to crypto capital markets. This reduces the time and costs of jumping back and forth between blockchain and fiat rails.

Access to currencies and assets

Currency markets are not freely available everywhere. Some countries ban the purchase of foreign currencies, especially if their own is losing value. This creates multiple problems for citizens. First, a currency suffering high inflation becomes increasingly untenable as a medium of exchange. Secondly, it also becomes futile as a long-term store of value. By swapping your money for a stablecoin pegged to a more reliable currency, a person can protect themselves from inflationary forces and still trade with merchants that accept the stablecoin. The same principle applies to purchasing assets. At a time of economic uncertainty, some assets like gold, oil and wheat can be relied on to hold their value. But commodity markets can be hard for people to access. Investing in a stablecoin pegged to a commodity will be an easier way to protect your wealth against inflation, and also easier to convert back to a fiat currency when the time is right.

International money transfer

Sending money abroad can be a costly and lengthy experience. Stablecoins overcome this because they do not rely on legacy banking rails and third parties to move money. What’s more, the immediacy of settlement means they are not subject to fluctuations in currency values from the time of sending to the time of receipt. That gives both parties confidence in the price validity of the transaction.

How can businesses benefit from stablecoins?

Stablecoins allow businesses to diversify their balance sheets, ensure steady cash flow and access new markets, both domestically and abroad.

Balance sheet diversification

Businesses continually need to adjust their balance sheets to hedge against currency risks and inflation that devalues cash holdings. Speed makes all the difference here. Delays between executing and settling a trade can wipe millions off the value of a balance sheet.Unfortunately, legacy infrastructure and cautious incumbents can make it hard for businesses to buy the assets and currencies they want in a timely manner. Stablecoins solve this by essentially creating a secondary market with more liquidity and less friction. Businesses can adjust the make-up of their balance sheet quickly and easily, maximising the value of their assets.

Cash flow

One of the biggest challenges for businesses is cash flow. Slow settlement plays a big role in this problem, especially when exchanges take place across multiple territories. Payments that cross borders take complex paths, often navigating their way through intermediary banks before they arrive. FX adds more time and cost before the payment clears. Since stablecoins aren’t encumbered by the blockages that exist when fiat money moves, they enable 24/7 settlement. This ensures the working capital needed to do business is available at the moment of need. That confidence makes it easier to plan and avoid cash flow crises.

International growth

Doing business in a new market can be a regulatory headache. A business will typically need to create a separate legal entity, open a bank account, and implement sales tax rules before it can accept payments. All of that takes time and cost.Retailing with stablecoins overcomes this barrier to growth because the underlying blockchains that run operate across borders and jurisdictions. As a result, merchants can move into new markets much faster.

What are the risks of stablecoins?

While stablecoins are generally less volatile than other cryptocurrencies, they do carry risks such as depegging, centralisation, the need for sustained adoption and more.

Depegging

Over the past few years, some stablecoins have broken their peg. Tether (USDT), the largest stablecoin by circulation, temporarily lost parity to the dollar for a few days in May 2022, falling as low as $0.9959. A month later it had slipped again to $0.9975. On both occasions, the peg was restored within a few days. But while these drops don’t seem large, they can have profound impacts on individual stablecoin prices and customer trust in cryptocurrencies as a whole.Algorithmic stablecoins present their own risks. They require regular inflows of new capital and are more prone to sell-offs when investors lose confidence. The TerraUSD stablecoin is one example. In May 2022, it became depegged from the dollar and lost almost all of its value.

Centralisation

While centralised stablecoins are generally less volatile than decentralised cryptocurrencies, they do carry their own disadvantages. Companies issuing centralised assets are not immune to attacks, so customers must trust those organisations to maintain high security standards.Censorship from central governments is another major concern. For example, recent sanctions from the US Treasury’s Office of Foreign Assets Control (OFAC) against cryptocurrency mixer Tornado Cash have raised questions about whether or not stablecoin providers should freeze certain accounts. For more on this, see the regulatory section below.

Adoption

While the crypto world has embraced stablecoins, traditional organisations are still in the early adoption stage. Questions of governance and security remain. There’s also ambiguity around stablecoin from an accounting standpoint. Should it be classed as cash, a highly-liquid asset, or an intangible asset? This creates uncertainty about an organisation’s liquidity ratios, which investors, creditors and ratings agencies use in their valuations.

Regulation

Like other decentralised assets, stablecoins are designed to sit outside of central regulations. Therefore, governments can’t tamper with or manipulate them to set damaging fiscal policy or control citizens. But stablecoins will increasingly fall under regulatory scrutiny as governments continue to evaluate their systemic risk.The implications could be profound. Lighter touch policies could include mandating stablecoin issuers to be registered and insured in the same way as banks and other financial institutions. Custodial wallet providers may need to share personal and transactional data about their users with authorities. Regulators could also enforce fiat payment standards around payment, clearing and settlement onto stablecoin transactions.As decentralised finance continues to gain mainstream acceptance, the call for regulation will only increase. Wherever centralised entities control an asset, regulatory oversight will likely play a key role. This could influence the way financial authorities treat stablecoins going forward.

What’s next for stablecoins

The stablecoin market has already come a long way in a short time. Of the world’s top 10 cryptocurrencies, three — Tether (USDT), USD Coin (USDC), Binance USD (BUSD) — are stablecoins. Collectively stablecoins account for around 17% of all cryptocurrencies in circulation.These numbers represent the critical mass needed to ensure the future of stablecoin. The next challenge is to present a compelling alternative to more traditional financial instruments. As retail and corporate familiarity in stablecoins increases, regulators take a proactive but reasonable approach, and junk coins find it harder to attract users, stablecoins could provide the solution to many problems. These could include providing a safe retreat from deflationary fiat currencies and enabling real-time, low-cost bank transfers across borders. In fact, many iconic institutions already see the promise of stablecoins. Banks such as JP Morgan, Australia and New Zealand Bank and other consortiums are starting to release their own products. And stablecoins remain foundational to the development of Central Bank Digital Currencies (CBDCs), government-backed digital versions of existing fiat assets. As companies and governments alike recognise their promise, expect to hear more about stablecoin in the near future.

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About the author

Matthew Blenkarn

Content Marketing Manager

Matthew Blenkarn is a Content Marketing Manager at TrueLayer, where he's responsible for blogs, case studies and a host of other open banking content.

27 Jul 2022