a cryptocurrency that is pegged to another asset to achieve greater stability
What are stablecoins?
Stablecoins are a type of cryptocurrency that aim to deliver price stability by having their value pegged to another asset. Most commonly, these coins are backed by a fiat currency such as the US dollar, which means $1 is kept in reserve for every unit of a stablecoin in circulation. Stablecoins can also be pegged to cryptocurrencies and precious metals like gold.
How they work
Stablecoins can generally be categorized in three ways, depending on the type of asset they have been pegged to (a process known as collateralization.)
Fiat: Stablecoins that are collateralized by old-fashioned money need to ensure there are adequate supplies of their pegged currency held in reserve. If a coin is worth $1 and there are 100,000 units in circulation, $100,000 should be kept in a secure account. To reassure customers, independent audits are often carried out to ensure reserves are maintained properly. Stablecoins can also be backed by other major currencies such as euros or pounds, or a combination of them.
Precious metals: Assets such as gold have long been regarded as a good store of value. As a result, some stablecoins have chosen this method of collateralization. One unit of a stablecoin may be pegged to the value of one gram of gold, and as with fiat, enough precious metal to back every coin must be held securely in a vault.
Other cryptocurrencies: Critics argue this approach might not be practical because of the measures needed to prevent volatility. Crypto-backed stablecoins often rely on over-collateralization – meaning $2 is held in reserve for every $1 of crypto in circulation. As you can imagine, this could start to get expensive.
What stablecoins are for
Cryptocurrencies like bitcoin can be subject to extreme price volatility, making them impractical for everyday use. Stablecoins aim to tackle this by having their value linked to assets that are less prone to wild fluctuations. As a result, consumers can have confidence when making a purchase that prices aren’t suddenly going to be considerably higher than they were expecting. Stablecoins can also be a safe haven for investors when unpegged cryptocurrencies are entering into a downwards spiral.
There are downsides to stablecoins that need to be taken into account. As well as the risk that some of these digital currencies may not be properly collateralized, some critics argue that they undermine what crypto has been trying to achieve: moving the global economy away from fiat currencies controlled by governments.
Dozens of stablecoins have been launched in recent years, and the value of the market is continually rising. Some of the best-known providers include Tether, Paxos and Gemini.
Mainstream institutions have also been getting involved in the action. The US financial giant JP Morgan recently unveiled a stablecoin designed to enable instantaneous payments to be made between its clients. Meanwhile, Facebook has unveiled plans for Libra, and hopes the cryptocurrency will reach millions of people who don’t have access to basic financial services.