The second part of my Digital Currency series looks at stablecoins. These are a cryptocurrency that usually have some type of backing to remove most volatility and provide price stability. The goal is for stablecoins to provide a link between cryptocurrencies and fiat currencies.
Stablecoins fall into three categories, the first being fiat-collateralized. The collateral for these coins ranges from fiat currencies, such as the U.S. dollar, to gold, silver, oil, or other commodities. The reserves are typically maintained by independent custodians. Two of the more popular stablecoins in the United States are Tether and TrueUSD. Both are backed by U.S. dollar deposits within the exchanges offering them.
The second type of stablecoin is crypto-collateralized. As the term implies, these coins are backed by one or more cryptocurrencies. Crypto can be very volatile, leading to the need to over-collateralize for this type of stablecoin. As an example, a crypto backed stablecoin may have a reserve of $1000 for issue of $500. This accommodates up to a 50% swing in value.
The third type of stablecoin is non-collateralized. Instead of collateralization they use a consensus mechanism or algorithm to control the supply of the coin. This is a similar idea to central banks adding or removing currency from circulation to control fiat currency value. For example, to stabilize the price of a coin, the managing protocol may automatically increase the amount of tokens within investors’ wallets when the coin’s price increases in order to maintain a relative percentage of ownership. If the price of the coin drops, the protocol would re-purchase tokens from the market.
Stablecoins often offer interest rates to investors. It is not unusual to see an APY in the neighborhood of 8% - 14%. With rates this high, why isn’t everyone putting the money in stablecoins? They are still a form of cryptocurrency and there are no guarantees. It is possible to lose all your investment in a stablecoin, while financial institution savings accounts are FDIC-insured up to $250,000.
Read Part 1: Cryptocurrencies
Stay tuned for Part 3: Central Bank Digital Currency, coming next week!