What are stablecoins? A major meltdown means all eyes are on the alternative to Bitcoin and Ethereum

Case in point: stablecoins. 

At the center of the most recent crypto crash are stablecoins, cryptocurrencies that are designed to be “stable” by maintaining a peg to a non-crypto asset like the U.S. dollar. This definition was shaken up late last week when stablecoin, TerraUSD (UST) lost its peg to the U.S. dollar and dropped to as low as 30 cents.

UST is an algorithmic stablecoin. That means that unlike regular stablecoins, which say they have reserves to back their worth, UST relied on an algorithm that was supposed to incentivize traders to balance the price of the stablecoin through the use of a sister cryptocurrency. 

The market for stablecoins boomed last year. While in January 2021, the total supply of stablecoins was about $30 billion, as of May 12, 2022, the supply had jumped to about $166 billion, according to CoinMarketCap. 

And although stablecoins have been an increasingly popular avenue for investors and companies looking to get involved with cryptocurrencies, UST’s collapse over the last few days has some investors thinking twice. 

So what are stablecoins, how are they different from your typical cryptocurrencies, and why is there so much interest around them? Here’s what you need to know:

What is a stablecoin, and how is it different from typical cryptocurrencies?

A stablecoin is a type of cryptocurrency whose value is attached to that of a separate asset, such as fiat currencies like the dollar and euro or commodities like gold and oil.

Stablecoins get their stability from being pegged to assets whose values fluctuate relatively little. Because of this, their price is usually steadier than typical cryptocurrencies like Bitcoin, Ether, and Dogecoin, which are not backed by any underlying asset and frequently fluctuate in value.

What are stablecoins used for? Can you transact with stablecoins?

Stablecoins are most commonly used for buying and selling other cryptocurrencies on crypto exchanges, by converting fiat currency into stablecoins and using those stablecoins to buy and sell other crypto tokens. This is how the beleaguered, dollar-backed Tether became the most traded and ubiquitous stablecoin.

Beyond storing value, stablecoins are also being adopted by businesses, particularly by larger and more established companies getting into the crypto space. Payments giant Visa, for instance, is using the dollar-backed USD Coin (USDC) to facilitate crypto transactions, with the goal of letting people convert their crypto assets to buy everyday goods and services. Visa’s network also lets holders of Coinbase debit cards use their USDCs on purchases, without incurring the steep fees charged for other types of crypto transactions.

Stablecoins can also be used across a variety of “decentralized finance,” or DeFi, applications, including “yield farming”—whereby stablecoin holders lend their tokens to others and generate interest in return.

Where can you buy stablecoins? Why would you buy stablecoins?

Stablecoins are available on most major crypto exchanges including Coinbase, Binance, and Kraken. The attraction of stablecoins for investors is that they are usually a much safer and less volatile bet compared to fluctuation-prone tokens—even major ones like Bitcoin and Ether. That supposed stability also makes stablecoins easier to transact with, and more attractive to institutional players looking to get into crypto.

What are the largest and most popular stablecoins?

By far, Tether is the largest stablecoin in circulation, accounting for just less than half of total stablecoin market capitalization on its own. The controversial token, which has faced scrutiny for exaggerating the extent to which it’s actually backed by U.S. currency, is also the third-largest cryptocurrency of any kind by market cap.

USD Coin, which is also tied to the U.S. dollar, is the second-largest stablecoin in circulation and the fourth-largest token of any kind. USDC has recently grown in market share—helped by its adoption by the likes of Visa, which is using it as an on-ramp toward facilitating crypto transactions. But like Tether, USDC has also faced criticism for having claimed that every token is backed by $1 in cash, when it’s actually backed by a combination of cash and noncash assets like Treasury bonds, commercial paper, and corporate bonds.

Other notable stablecoins include the gold-backed Paxos Gold and the oil-backed Petro, which was issued by the government of Venezuela and backed by that country’s oil reserves.

What happened with Terra USD? 

One of the most popular stablecoins was TerraUSD, traded as UST, which saw its price collapse to 30 cents this week, when it should technically always be worth $1. After the stablecoin lost its peg on May 7 it spiraled during the week as investors withdrew funds from the token. 

The stablecoin differs from others in its category like USDC and Tether because it lacked reserves to back it. 

Instead, the coin relied on an algorithm that encouraged traders to profit whenever the price of the stablecoin strayed from its dollar peg. It used a sister cryptocurrency called Luna to balance its price. 

But after Terra lost its peg, a subsequent bank run kept the stablecoin from recovering its dollar value. 

UST is still not worth a dollar and the price of its sister cryptocurrency Luna, dropped 99% and is nearly worthless. 

Are stablecoins regulated?

Like much of crypto, most stablecoins operate in a regulatory gray area—though that will likely change in the near future. 

In a meeting before the Senate Banking Committee this week, Treasury Secretary Janet Yellen called for a renewed look at crypto, and especially stablecoin, regulation. Yellen pointed to the collapse of the UST stablecoin as examples of a crypto product with inherent risks.

“I think that simply illustrates that this is a rapidly growing product and that there are risks to financial stability,” Yellen said at the hearing. “We really need a consistent federal framework.”

 SEC chair Gensler has also pointed to the need for greater investor protections in crypto, and stablecoins are unlikely to be exempt from that.

One related area that has drawn more interest recently is central bank digital currencies (CBDC), government-issued digital tokens that would hold the same value as, and function just like, units of that country’s currency. They have been floated as a way for governments to circumvent stablecoins backed by their fiat currencies, and assert more control over the digital currency ecosystem. Asian countries are already developing CBDCs—with China currently piloting its “digital yuan.” 

In an executive order issued in March, President Biden encouraged the Federal Reserve to continue studying CBDCs and whether one could work for the U.S.

“My Administration places the highest urgency on research and development efforts into the potential design and deployment options of a United States CBDC,” Biden said in his March executive order.

Update, May 12, 2022: This article has been updated with a mention of TerraUSD’s (UST) drop below $1 and other recent stablecoin-related news.