What Is a Stablecoin? The Benefits and Drawbacks of Stablecoins

As the popularity of cryptocurrencies grows, so are the asset class’s products and services. One increasingly common example is stablecoin. It’s a version of cryptocurrency that’s increasingly available on crypto exchanges, but it’s different from regular crypto because its value doesn’t fluctuate.

That might reduce your ability to make the kinds of big gains investors hope to get on cryptos, but stablecoins provide other very important benefits.

Table of Contents
  1. What Is a Stablecoin?
  2. How Does Stablecoin Work?
  3. Why Stablecoins Matter
  4. The Benefits of Stablecoins
  5. The Drawbacks of Stablecoins
  6. What are the Most Popular Stablecoins?
  7. The Bottom Line

What Is a Stablecoin?

By its very nature, cryptocurrency floats in value. Because it’s a decentralized asset, the market establishes the value entirely. That is, what one party is willing to pay another in exchange for the crypto involved in the transaction. 

Though that arrangement has led to massive profits, crypto is highly unpredictable and can lead to significant losses.

The crypto industry has responded by creating a digital asset version that maintains a constant value – it’s where the very name stablecoin comes from.

How Does Stablecoin Work?

Cryptocurrency exchanges maintain the value of stablecoin by tying its value to a recognized fiat currency. Most commonly – and certainly for investors in the US – that’s the US dollar. One stablecoin is typically equal to $1. For investors in Europe, stablecoin may be tied to the euro, and the yen in Japan. 

In this way, a stablecoin becomes something like a digital dollar, digital euro, or digital yen. Even so, it’s important to understand that the stability of the crypto in no way implies backing by any government, including those issuing the fiat currency the stablecoin is tied to.

Each stablecoin maintains a certain level of reserves to help keep its value. If a stablecoin is linked to the US dollar, the issuing exchange may have a certain amount of US dollars as reserves to back its stablecoin. But they may hold additional reserves in other fiat currencies, cryptocurrencies, and precious metals.

Why Stablecoins Matter

An essential purpose of stablecoins is to give crypto investors a safe investment option. Similar to money market funds with investment brokerages, crypto investors can move money out of free-floating cryptocurrencies during times of market instability and park them in stablecoins until they’re prepared to get back into the market.

If you’re an active trader, you may like the option to hold your funds in between crypto surges. Since stablecoins aren’t subject to the fluctuations of other cryptos, you’ll be able to “keep your powder dry” until new opportunities arise. 

You can readily use Stablecoin to purchase traditional cryptocurrencies or even other assets. We’ll cover the many potential uses for stablecoins in the next section.

The Benefits of Stablecoins

Stablecoins provide several significant benefits for crypto investors:

  • A place to park your funds in between crypto investments. If you just made a big score on a run-up in the price of one or more cryptos, or if you want to exit your positions due to market instability, you can sell your other cryptos and move the money in a stablecoin.
  • Some stablecoins pay interest. This is becoming an increasingly common arrangement, with the interest paid on stablecoins being many times higher than that paid on bank accounts. It’s not unusual to see interest rates in the 8% to 9% range.
  • Move money back into US dollar assets. Since the value of stablecoins are tied to the value of the US dollar, it can be very easy to transfer funds from your crypto exchange into your bank account. For all the same reasons, stablecoins can be used to easily make payments internationally.
  • Inexpensive transfers. The cost of transferring funds using stablecoins can be surprisingly affordable, especially on large amounts.
  • Jump back into cryptos without needing to transfer funds from your bank. Stablecoins add liquidity to a crypto exchange account. With funds sitting in stablecoins, you’ll have ready cash available to purchase additional crypto. Because stablecoins are also crypto, they can easily be converted into other cryptocurrencies.
  • Diversification. While it is recommended that you have other assets in addition to cryptocurrencies, it’s not a bad idea to have some diversification within your crypto holdings. A diversification of 10% to 20% of your crypto account into stablecoins can lower volatility and improve long-term performance.

The Drawbacks of Stablecoins

Though you might perceive stablecoins as a safer version of cryptocurrencies, that’s not necessarily the case. There are specific risks involved with this type of digital asset.

First, stablecoins are precisely what the name implies – crypto with a stable value. That means they won’t increase in value, the way more popular cryptos like Bitcoin and Ethereum will. What’s more, any funds you have tied up in stablecoins won’t be available for price growth the way other cryptos are. Stablecoins can produce an opportunity cost in this way, which is why you shouldn’t have too much money tied up in them.

The second drawback is a lack of security. The term “stablecoin” should in no way imply guaranteed value. They may be stable relative to free-floating cryptos, but they are no safer. There’s no FDIC or SIPC insurance to cover your losses should the exchange or broker fail or if it’s somehow compromised and your holdings are lost.

Third, even though stablecoins are backed by reserves, the digital asset’s value could drop if the reserves prove insufficient to provide full backing for the coin. This could occur if investors began liquidating their positions in stablecoin en masse.

In short, the “stable” aspect of stablecoins refers only to its price. Otherwise, it’s no safer than other types of cryptocurrencies.

According to the website CoinMarketCap, the largest stablecoins, including their market capitalization as of January 14, 2022, are as follows:

  1. Tether (USDT), 78,435,693, 261
  2. USD Coin(USDC), $45, 437,346,757
  3. TerraUSD (UST), $10,689,342,963
  4. Dai (DAI), $9,614,220,727
  5. TrueUSD (TUSD), $1,441,940,204
  6. Pax Dollar (USDP), $945,622,888
  7. Neutrino USD (USDN), $529,781,543
  8. Fei USD (FEI), $423,776,405
  9. 10.Reserve Rights (RSR), $352,440,064

Note that at least eight of the ten largest stablecoins are tied to the US dollar. You can also see that the two largest stablecoins, Tether and USD Coin, have market capitalizations well into the tens of billions. But after the top two, capitalization levels fall off dramatically. The last four on the list have total market capitalizations under $1 billion.

You can say the same for cryptocurrencies in general, where Bitcoin and Ethereum are the most dominant cryptos. In contrast, the thousands of others are much smaller, with many having barely any market capitalization at all.

The Bottom Line

No doubt, most people who invest in cryptocurrencies do so in the hope of earning massive returns on the next surge in Bitcoin, Ethereum, or some other popular crypto. For that reason, moving some of your crypto account balance into stablecoins may not seem attractive.

But suppose you’re a long-term crypto investor, and you’re looking to add all the benefits stablecoins provide, including diversification and liquidity. In that case, you should seriously consider taking and maintaining a position in stablecoins on an ongoing basis. 

Think of it as cash held in an online brokerage account, except stable coins pay much higher interest on your balance.

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About Kevin Mercadante

Since 2009, Kevin Mercadante has been sharing his journey from a washed-up mortgage loan officer emerging from the Financial Meltdown as a contract/self-employed "slash worker" – accountant/blogger/freelance blog writer – on OutofYourRut.com. He offers career strategies, from dealing with under-employment to transitioning into self-employment, and provides "Alt-retirement strategies" for the vast majority who won’t retire to the beach as millionaires.

He also frequently discusses the big-picture trends that are putting the squeeze on the bottom 90%, offering workarounds and expense cutting tips to help readers carve out more money to save in their budgets – a.k.a., breaking the "savings barrier" and transitioning from debtor to saver.

Kevin has a B.S. in Accounting and Finance from Montclair State University.

Opinions expressed here are the author's alone, not those of any bank or financial institution. This content has not been reviewed, approved or otherwise endorsed by any of these entities.

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