Explainer: What are stablecoins, the asset that moves the cryptocurrency market?

Depictions of cryptocurrencies including Bitcoin, Dash, Ethereum, Ripple, and Litecoin are seen in this illustrative image, taken on June 2, 2021. REUTERS/Florence Lo/Illustration

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LONDON, May 12 (Reuters) – Most cryptocurrencies have a major problem with price volatility, but one subcategory of coins is designed to maintain a constant value: stablecoins.

As cryptocurrency prices plummeted this week, with bitcoin losing around a third of its value in just eight days, stablecoins were supposed to be insulated from the chaos.

But an unexpected collapse in fourth-largest stablecoin TerraUSD, which broke its 1:1 peg to the dollar, has drawn attention to the asset class. read more

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This is what you need to know:

WHAT ARE STABLECOINS?

Stablecoins are cryptocurrencies designed to protect against wild volatility that makes it difficult to use digital assets for payments or as a store of value.

They try to maintain a constant exchange rate with fiat currencies, for example through a 1:1 parity with the US dollar.

HOW IMPORTANT ARE THEY?

Stablecoins have a market cap of around $170 billion, making them a relatively small part of the overall cryptocurrency market, which is currently worth around $1.2 trillion, according to CoinMarketCap data. .

But they have gained popularity in recent years. The largest stablecoin, Tether, has a market cap of around $80 billion, having risen from just $4.1 billion at the start of 2020.

The No. 2 stablecoin, USD Coin, has a market capitalization of $49 billion, according to data from CoinMarketCap.

While data on the specific uses of stablecoins is hard to come by, they play a crucial role for crypto traders, allowing them to hedge against spikes in the bitcoin price or store idle cash without transferring it back to fiat currency. read more

In its semi-annual financial stability report on Tuesday, the US Federal Reserve warned that stablecoins are increasingly being used to facilitate leveraged trading in other cryptocurrencies.

From 2018 onwards, stablecoins have been increasingly used in international trade and as a way to get around capital controls, says Joseph Edwards, head of financial strategy at crypto firm Solrise. The Tether stablecoin, in particular, is used for trade in and around China and South America, he said.

HOW DO THEY WORK?

There are two main types of stablecoins: those that are backed by reserves that comprise assets, such as fiat currency, bonds, commercial paper, or even other cryptocurrencies, and those that are algorithmic or “decentralized.”

Major stablecoins like Tether, USD Coin, and Binance USD are backed by reserves: they say they have enough dollar-denominated assets to maintain a 1:1 exchange rate.

The companies say that one of their stable coins can always be exchanged for a dollar.

Asset-backed stablecoins have come under pressure in recent years to be transparent about what is in their reserves and whether they have enough dollars to back all of the digital currencies in circulation. read more

Meanwhile, TerraUSD is an algorithmic stablecoin. This means you have no reservations. Instead, its value was supposed to be maintained by a complex mechanism involving exchanging TerraUSD coins with a free-floating cryptocurrency called Luna to control the supply.

WHAT CAN GO WRONG?

TerraUSD’s stability mechanism stopped working this week as investors lost faith in Luna, amid a broader downturn in crypto markets. TerraUSD price plummeted to as low as 30 cents.

In theory, asset-backed stablecoins should hold up despite this.

But Tether also broke away from its dollar peg for the first time since 2020 on Thursday, falling to as low as 95 cents.

Tether sought to reassure investors, saying on its website that holders could still redeem their tokens at a 1:1 rate.

WHAT DO THE REGULATORS SAY?

While regulators globally are trying to set rules for the cryptocurrency market, some have highlighted stablecoins as a particular risk to financial stability, for example if too many people tried to withdraw their stablecoins at once.

In its stability report, the Fed warned that stablecoins are vulnerable to investor runs because they are backed by assets that may lose value or lose liquidity in times of market stress. Therefore, a run on the stablecoin could spill over into the traditional financial system by creating stress on these underlying assets, he said.

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Information from Elizabeth Howcroft; Edited by Michelle Price and Lisa Shumaker

Our standards: the Thomson Reuters Trust Principles.

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