By providing a crypto alternative with reduced volatility, stablecoins aspire to offer a more consistent medium of exchange capable of fulfilling daily transactional needs. These digital currencies are designed to fill the gap between the fluctuating nature of popular cryptocurrencies like Bitcoin and the necessary stability for everyday financial dealings. They achieve this by linking their value to fiat currencies, commodities, or other financial instruments.

Their purpose is to maintain a stable value relative to traditional currencies or commodities. To achieve this, stablecoins connect to various assets like fiat currencies, commodities, or other financial tools. There exist four fundamental types of stablecoins, each using distinct methods to maintain price equilibrium: fiat-collateralized, commodity-backed, crypto-collateralized, and algorithmic.

Despite their promise, investors must remain cautious, as stablecoins necessitate third-party auditors for reserve verification, introducing a risk element into a system structured to reduce third-party involvement. With burgeoning market influence, stablecoins are meeting stringent regulatory examination globally. This has prompted numerous jurisdictions to implement protocols ensuring these digital currencies have sufficient reserve backing. The most widespread stablecoin, Tether (USDT), maintains a 1:1 peg to the U.S. dollar and frequently ranks among the leading cryptocurrencies by market capitalization.

Although Bitcoin captures the spotlight as the leading cryptocurrency, its price fluctuations are infamous. From under $5,000 in March 2020, Bitcoin soared to over $63,000 in April 2021, only to plunge nearly 50% within months. It’s not uncommon for Bitcoin’s price to vary by more than 10% in mere hours.

This level of volatility may entice traders but poses risks for everyday commercial transactions. Investors eyeing long-term cryptocurrency value appreciation are wary of becoming unwitting poster examples by making purchases. Likewise, most merchants are hesitant to face potential losses if cryptocurrency values dive post-receipt. A medium of exchange not recognized as legal tender must maintain relative stability to guarantee short-term purchasing power, a standard wherein even 1% daily fluctuations are atypical in fiat exchange.

As their name suggests, stablecoins endeavor to resolve this volatility issue by assuring steady cryptocurrency value through various methods.

Understanding the Types of Stablecoins

One essential type of stablecoin involves commodities as collateral, known as commodity-backed stablecoins. These digital currencies connect to assets like gold or oil, usually holding commodities through third-party custodians or associated ventures. A prominent example within this category is Tether Gold (XAUt), a cryptocurrency supported by gold reserves. Despite the custodian remaining anonymous, it is assumed that the gold resides in Switzerland, as outlined in the service terms:

The holder of a Gold Token, upon successful redemption, may choose to receive physical gold delivery at a mutually reasonable location in Switzerland, subject to fee payments per the prevailing Gold Token Fee Schedule at the transaction time.

In contrast, crypto-collateralized stablecoins derive backing from other cryptocurrencies. Notably, DAI is linked to the U.S. dollar but backed by Ethereum (ETH) and additional cryptocurrencies valued at approximately 155% of the DAI stablecoin in circulation.

Algorithmic stablecoins diverge with their distinctive asset reserve strategy or lack thereof. The foremost differentiation lies in stabilizing the coin’s value by utilizing algorithms—computer programs executing pre-set formulas—to regulate supply.

In certain respects, this approach resembles central banks, which likewise do not depend on reserves to stabilize the currency they issue. Nonetheless, central banks, such as the U.S. Federal Reserve, embrace public transparency and legal tender status, lending credence to their monetary policies.

Regulatory Challenges and Developments

Should algorithmic stablecoin issuers face turmoil, they lack such support mechanisms. A notable incident occurred on May 11, 2022, when TerraUSD (UST) plummeted over 60%, severing its peg to the U.S. dollar. The International Organization of Securities Commissions (IOSCO) proposed that stablecoins align with financial market infrastructure regulations, akin to payment systems and clearinghouses. Its guidelines emphasize systemically significant stablecoins—those capable of disrupting payment and settlement processes.

Additionally, U.S. political figures call for heightened stablecoin regulation. In November 2021, Senator Cynthia Lummis advocated regular audits for stablecoin issuers, while some policymakers suggest bank-like regulations for the industry. By 2024, Senators Lummis and Kirsten Gillibrand introduced a bill delineating a stablecoin regulatory framework. This proposal prohibits stablecoin issuance without registration as a non-depository trust or an authorized depository institution.

Europe, under the Markets in Crypto Assets Regulation enacted in 2023, effectively bans algorithmic stablecoins, mandating third-party custody for all other assets. Reserves must remain liquid, maintaining a 1:1 asset-to-coin ratio.

Stablecoins Versus Bitcoins

Stablecoins are distinct from bitcoins. They serve as a solution for the high volatility associated with mainstream cryptocurrencies, thereby increasing their viability for routine transactions. Attempting to anchor their market value to external references like fiat currencies, stablecoins offer greater transactional utility compared to volatile cryptocurrencies. They may link to currencies such as the U.S. dollar, commodities like gold, or employ algorithms to regulate supply.

The most distinguished stablecoin by market capitalization is Tether (USDT), which holds a consistent 1:1 U.S. dollar peg and is supported by reserves. Tether frequently ranks among the top five cryptocurrencies in market cap. It is accessible on renowned crypto exchanges, including Binance and Coinbase.

Cryptocurrencies like stablecoins connect to reserve assets, including fiat currency or commodities. Their primary aim is to create a crypto asset with diminished price volatility, rendering them more practical for transactions.

In the light of previous attempts to establish stable coins and corresponding challenges, various jurisdictions are adopting regulatory measures. These frameworks aim to manage inherent instabilities and losses. Opinions and analysis presented are solely for informational purposes. For additional details, please refer to our terms of use. As of this writing, the author holds no cryptocurrency ownership.