What Investors Should Know About Stablecoins

Cryptocurrencies like bitcoin and Ethereum have a reputation for being exceptionally volatile and unpredictable. Stablecoins, a special class of cryptocurrencies, are meant to provide stability. This moneyland.ch guide provides useful information about stable coins, and looks at whether or not they are a stable store of value for cautious investors.

Was sind Stablecoins?

A stablecoin is a cryptocurrency that aims to maintain a stable value through the use of various mechanisms. Typically, stable coins replicate a specific underlying asset, such as a specific fiat currency or a precious metal like gold.

Stablecoins can be roughly divided into four categories, based on the mechanism used to replicate the price of the underlying asset.

• Stablecoins backed by a fiat currency: These stable coins replicated a fiat currency issued by a central bank, such as the US dollar or the euro. They are collateralised by a reserve of fiat currency corresponding to the total amount of stable coins issued.
• Stablecoins backed by commodities: These stablecoins replicate the price of commodities like gold, and are collateralised by a reserve of the corresponding commodity.
• Stablecoins backed by a cryptocurrency: These stablecoins are partly or fully collateralized by a reserve of the corresponding cryptocurrency. There are also stablecoins that are meant to replicate the performance of a fiat currency, but are collateralized by cryptocurrencies instead of by a fiat currency reserve.
• Algorithmic stablecoins: These stablecoins are not collateralized by actual assets at all. Instead, they aim to maintain price stability using mechanisms that are based on algorithms. The algorithms guide purchases and sales with the aim of keeping the price of the stablecoin steady in comparison to other assets. Stablecoins in this category have earned a somewhat poor reputation because of the risk of loss.

Which stablecoins are available to private investors?

There is a huge selection of stablecoins. Most of them replicate the US dollar, as is the case with all five of the stablecoins with the highest market capitalisation (see Table 1).

Examples of stablecoins that are linked to the Swiss franc include the Crypto Franc issued by Bitcoin Suisse, and the Digital Swiss Franc issued by Sygnum Bank.

What are stablecoins used for?

Stablecoins are not primarily meant to be an investment vehicle. They primarily play a role in transactions, and are used as a bridge between blockchain-based cryptorcurrencies and conventional financial services. They are used as: 

• A medium for making fast, simple, and cheap money transfers worldwide.
• A medium for trading cryptocurrencies on cryptocurrency exchanges.

Stablecoins enable payments to be made within a blockchain ecosystem without having to exchange fiat currencies. That is possible because, at least in theory, a stablecoin that replicates the US dollar should be worth exactly one dollar. 

Are there any risks I should know about?

The risk of losing money with a stablecoin is directly linked to the reliability of both its issuer and the exchanges on which it can be traded. It is important to be aware that there is a counterparty risk. Possible problems that you should pay attention to include:

• Insufficient collateral: The security of a stablecoin largely depends on the way in which it is collateralised, and the amount of collateral used. Algorithmic stablecoins, in particular, are at risk of losing value – as was the case with the stablecoin Terra USD, which experienced a sharp loss in value in 2022.
• Poor liquidity: Stablecoin issuers can experience periods of financial difficulty, especially in times of market turbulence. Liquidity problems can result in a stablecoins becoming difficult or impossible to sell.
• Lack of regulation and transparency: So far, the regulations governing stablecoins have been very patchy. On an international level, the stablecoin sector has lacked transparency with regards to investor protection. That can be problematic because the stability of a stablecoin is directly linked to trust in the currency and its issuer.
• Price fluctuations: While the nominal value of a stablecoin should not normally deviate from that of its underlying asset, the price of the underlying asset can be very volatile. In the case of currencies, you should pay attention to the exchange rate risk. For example, if the US dollar loses value against the Swiss franc, then the Swiss franc value of stablecoins that replicate the US dollar will also fall.

Are stablecoins suitable as an investment?

The primary purpose of Stablecoins is not to be a store of wealth, but rather a medium for transactions. But in spite of that, stablecoins are also used to speculate on their underlying assets, such as currencies and commodities.

While stablecoins are much less volatile than non-collateralised cryptocurrencies liked bitcoin and Ethereum, their ability to yield returns is very limited. Potential returns correlate directly with developments in the price of the underlying asset that the stablecoin replicates. That also has advantages: Because stablecoins are linked to real assets, price developments are much more predictable. 

But bying a stablecoin instead of buying the underlying asset directly has no real benefit for investors. It only brings additional layers of risk, such as the risk of a stablecoin issuer becoming insolvent. If you really want to invest in Stablecoins, it is extremely important to check the credibility of both the stablecoin’s issuer and the exchanges on which the stablecoin can be traded. 

Lending out your stablecoins is a possible option for earning higher returns. Certain stablecoins can be lent out through cryptocurrency lending services in order to earn interest. But it is important to understand that lending comes with risks, as you could lose your stablecoins if the lending service provider becomes insolvent.  

Disclaimer: This article is provided for informational purposes only, and should not be considered as investment advice. The publisher does not accept any liability in connection with this publication.

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