What Are Stablecoins? Investing in Cryptocurrency

Stablecoins are a niche part of the ever-growing crypto ecosystem, primarily used by crypto investors as a practical and cost-efficient way to transact in cryptocurrency.

But there’s another key player who has his eye on stablecoins: Uncle Sam. 

U.S. government officials are racing to regulate stablecoins, which are different from other more volatile types of crypto. Where Bitcoin and Ethereum rise and fall by the day and even hour, stablecoins promise to maintain their value because they’re pegged to less volatile assets, like the U.S. dollar or euro. Because of their potential use as actual currency, U.S. government officials fear the potential risks stablecoins pose for consumers and financial markets if they remain unregulated.

“A stablecoin is basically a coin that’s pegged to another asset and it acts almost like a reserve currency. It’s like a common denominator between other cryptocurrencies,” says Humphrey Yang, the personal finance expert behind HumphreyTalks. 

Here’s everything investors should know about stablecoins. 

What Are Stablecoins?

A stablecoin is a type of cryptocurrency that relies on a more stable asset as a basis for its value. Most commonly, people refer to stablecoins as linked to a fiat currency, such as the U.S. dollar, but they can also have value linked to precious metals or other cryptocurrencies. Stablecoins are essentially a less volatile cryptocurrency with greater potential to resemble the types of currencies people already use everyday.

“Its purpose is to provide stability of price as people are transacting across coins or between fiat and digital currencies, because crypto markets can be volatile,” says Doug Boneparth, a financial advisor and president of Bone Fide Wealth in New York.

All stablecoins are backed by some sort of asset or a combination of assets in a reserve; it could be gold, cash, or even short-term corporate debt called commercial paper. The idea is that the money in the reserve serves as collateral for the stablecoin – whenever a stablecoin holder cashes out their tokens, an equal amount of assets is taken from the reserve.

There are many different types of stablecoins, and are not all created equal. Tether (USDT) is known as the first and largest stablecoin, and it was created in 2014. Roughly 85% Tether’s assets are cash, cash equivalents, short-term deposits, and commercial paper, according to its website. “USDT is owned by Tether, so Tether should have on hand $1 for every stablecoin,” says Yang. 

USD Coin is another popular stablecoin that was launched in 2018 by Circle. USD Coin is pegged to the U.S. dollar  and short-duration U.S. Treasuries with a circulating supply of $49 billion, according to Circle. Other stablecoins like Dai, Binance USD, and TerraUSD are also popular, but have smaller market caps and different reserve breakdowns.

How Do You Use Stablecoins?

Stablecoins are useful because they allow people to transact more seamlessly in cryptocurrencies that function as investments, such as Bitcoin or Ethereum. They form a bridge between volatile cryptocurrencies and stable real-world assets, like fiat. By trading with stablecoins instead of U.S. dollars, you’re able to maintain all your transactions within crypto exchanges, which can spare you from the fees you’d likely be assessed on many exchanges. 

Say you have some Solana and Ethereum, and you want to buy more Solana with your Ethereum. You could swap your Ethereum for stablecoins, like USDT, at a U.S. dollar value and from there, you can buy more Solana with your stablecoins. Because Solana and Ethereum are separate blockchains and remain largely cut off from one another, using stablecoins as the middle man can save you on fees and maintain the value of your crypto during volatile trading periods.

“Sometimes a Solana to Ethereum conversion is a little bit tougher because they’re on two different layers, as in they’re two different projects, but the stablecoin acts like the common denominator between the two,” says Yang.

Though crypto traders sometimes use stablecoins for more advanced investments, such as staking and lending, most beginners use them to avoid trading fees. Many crypto exchanges don’t charge fees when exchanging U.S. dollars for stablecoins. Coinbase, for example, doesn’t charge any fees on transfers between USD Coin and the U.S dollar. 

Another use for stablecoins is international remittances, or sending funds across international borders, though that could be risky since there is little to no official regulation. Because stablecoins are a form of private money — that is, money backed by a company and not the government — there’s a real risk that stablecoins aren’t as stable as they’re promoted to be, especially during times of economic trouble. There are also security and fraud concerns. Essentially, if you put your money in stablecoins, there’s no guarantee you’re going to get it back.

Can You Invest in Stablecoins? 

Stablecoins are used as a niche currency in the crypto world — and don’t make for great investments. They are better suited for digital transactions and converting digital assets to and from “real” money. 

Because crypto trading and prices can go up or down very quickly, it can be easier, faster, and cheaper to exchange coins for stablecoins versus trading coins for actual dollars in and out of your bank account. For example, you could quickly convert your Bitcoin to stablecoins pegged to the U.S. dollar, like USDT, and it would continue to live in the exchange you’re operating in and hold its value. You could then exchange those stablecoins for other coins. If you were to convert your Bitcoin directly to U.S. dollars, it could take longer to enter your bank account and would effectively take it out of the crypto exchange. 

“You don’t want to be losing out on money just for going between two different currencies,” says Boneparth.

The Future of Stablecoins 

Regulation will likely be a big theme for stablecoins in 2022, experts say. Like other cryptocurrencies, stablecoins operate outside the U.S. monetary system,  and officials have repeatedly highlighted concerns that they’re slipping through the regulatory cracks. 

Federal authorities such as Securities and Exchange Commission (SEC) Chairman Gary Gensler, Federal Reserve Chairman Jerome Powell, and Treasury Secretary Janet Yellen, among others, are mostly concerned about stablecoins because these types of crypto hold the most potential for future use by everyday consumers to buy things. Because of that, expect continued conversations about stablecoin regulation this year, and possibly even legislation, experts say. 

“I think 2022 will be a bigger year of regulation than any other year before,” says Boneparth. “The more mainstream crypto becomes, the more regulators and policymakers are going to pay attention to it.” 

Stablecoins have been “scrutinized” in particular because regulators don’t know what to make of them and are rushing to figure out how to establish laws and guidelines on how to treat stablecoins, Boneparth says. It’s unclear whether U.S. regulators will choose to treat them as securities, banks, or something else entirely. The White House is planning to release an initial government-wide strategy for crypto and other digital assets, and will ask federal agencies to assess their risks and opportunities, according to a Bloomberg report.

This debate is also intertwined with another hot button topic: whether the Federal Reserve will offer its own central bank digital currency (CBDC). The Fed released a long-awaited report in January exploring the pros and cons of a CBDC, but deferred a final decision on whether to move forward. Instead, the Fed is giving the public and other stakeholders until May 20 to share their input before taking further action. The Fed acknowledged in the report that the move “would represent a highly significant innovation in American money.”

Whatever move the Fed makes next could “fortify cryptocurrencies or detract from their value,” according to Grant Maddox, a certified financial planner and founder of Hampton Park Financial Planning based in South Carolina. “It depends on the direction our government chooses to take,” he recently told NextAdvisor.

Additionally, some experts are saying expected interest rate increases by the Fed this year could stimulate demand for the U.S. dollar, and therefore draw Americans’ attention to stablecoins that are backed by cash. Because the Fed will likely raise interest rates multiple times this year, it “should essentially provide tailwinds for the dollar” and that “stablecoins which are tied to the dollar can also capture this upside,” according to Scott Bauer, a former Goldman Sachs trader who’s now CEO of Prosper Trading Academy, and as reported by Coindesk.

While that remains to be seen, it’s something to keep an eye out for this year, and could potentially affect any regulatory action the U.S. government takes on stablecoins.