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Anyone who has looked at the price graph of any cryptocurrency knows just how volatile they can be. It’s not uncommon to see daily fluctuations in the 20–40 percent range. While many day traders see this as a feature of cryptocurrency, those who wish to use cryptocurrency in a daily capacity see it as a bug. The stablecoin is an effort to combat this volatility by pegging the value of the coin to something of value that exists outside of the blockchain ecosystem. While this has been done with varying degrees of success, some stablecoins have garnered substantial attention and buy-in.
Stablecoins are generally tied to the value of fiat currencies but can also be tied to precious metals like gold and other assets. A stablecoin can function in one of three different ways. First, a stablecoin may be fixed, unit for unity, to a currency such that one stablecoin equals precisely one unit of currency. In this way, stablecoins often function as proxies for the fiat currency they represent and allow transactions to be realized as if they were the real currency. Second, crypto-collateralized stablecoins may be backed by other cryptocurrencies. This backing strategy may or may not be a good idea since other cryptocurrencies can be volatile and could destabilize the “stablecoin.” Finally, there are algorithmic stablecoins. These stablecoins use algorithms that decide when to create and when to destroy cryptocurrency issued by the central institution. This last sort of stablecoin has drawn much scrutiny because of the potentially specious backing mechanism. At the end of the day, cryptocurrencies backed by algorithms and other cryptocurrencies may end up being stablecoins only nominally.
Stablecoins like USDT (Tether) are backed with a one-to-one reserve of a given currency. In the case of USDT, the coin is directly linked to the value of one U.S. dollar. The issuing organization is said to hold liquid assets in the same amount they have issued USDT assets. For example, if an investor purchased $30,000 of USDT, then the issuing organization would need to increase its stock of U.S. dollars, all else being the same. A real-time algorithm takes care of the rapid sale and purchase of U.S. dollars so that the price of Tether is always within a few one-thousands of the value of the U.S. dollar.
Other coins like the now-defunct Luna and Terra were purported to be “stablecoins” and were advertised to be linked to the U.S. dollar. However, these coins were only tangentially linked to the U.S. dollar and were only backed by other cryptocurrencies, making the price relatively volatile. This extra degree of separation from the USD allowed tragedy to strike in May 2022 when the price of Luna and Terra plummeted to zero.
It’s important to note that anytime large amounts of money are involved, unscrupulous people are standing by to make dishonest gains — take Enron, for example. This, however, is not indicative of the underlying fundamentals of the market nor the legitimacy of blockchain. The best way to avoid making poor financial decisions is to learn as much as possible about the asset, the market, and first-principles economics.
The cryptocurrency market can be scary and off-putting to investors and daily users who need a baseline level of confidence. For people who wish to transact in cryptocurrencies on a daily basis, stablecoins offer the opportunity to maintain asset value as items and other cryptocurrencies are bought and sold. For example, if person A wished to pay person B in Bitcoin for services rendered, it may be hard to pinpoint how much Bitcoin should be transferred. This discrepancy comes from a lack of certainty that the Bitcoin will be worth as much at the end of the transaction as it was at the beginning.
Remittances can be quickly sent and received with stablecoins. Because blockchain and stablecoins largely operate within permissionless systems, workers can send money back to their families that live in different countries with little red tape and regulatory barriers. There’s also the assurance that whatever value was sent will indeed arrive intact and undamaged by any market volatility.
Stablecoins can potentially eliminate the need for third-party verification on different transactions. Because funding information is readily available and accessible on the blockchain, there is no need for institutions to verify fund availability — an activity that generates an additional transaction fee. Widespread use of stablecoins could lower transaction costs for all parties involved.
One of the main trends for stablecoins is the regulations that are looming on the horizon. An executive order by President Biden in early 2022 pushed for an investigation into stablecoins (among other assets). Stablecoins, like Tether, have the potential to decentralize power over some aspects of monetary policy, which could be a thorn in a government’s side.
Another trend of stablecoins, and the community developed around them, is a keen interest in the assets that back the coin. The collapse of a leading algorithmic stablecoin (UST) in May 2022 has made many take a second look at the collateral behind stablecoins and their issuing institutions.
Stablecoins bring a much-needed reprieve from the volatility of the traditional crypto market. Their use is highlighted by their ability to ensure that the amount of value sent to a recipient is the amount of value received. Looking forward, it’s likely that stablecoins and their analogs will continue to gain traction within markets and transform how we purchase and transfer money. The Wharton School developed the Economics of Blockchain and Digital Assets program to help professionals navigate the burgeoning world of blockchain and stablecoins. To learn more about Wharton’s course or to enroll, please visit our homepage for next steps.
This article is for marketing purposes only and does not intend to represent the opinions of the program.
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