Stablecoins explained: their role and value in crypto trading

Stablecoins are a type of digital currency built to hold a steady price, typically tied to a conventional currency like the US dollar. In contrast to Bitcoin or Ethereum, known for big fluctuations, stablecoins aim to remain near a set value.

The most popular stablecoins, Tether (USDT) and USD Coin (USDC), each target a value of roughly $1. Put simply, stablecoins are essentially digital dollars functioning on a blockchain.

High volatility marks cryptocurrencies like Bitcoin and Ethereum. That volatility makes them suitable for investment and trading but less handy as a consistent medium of exchange. Consider a trader who sells $50,000 in Bitcoin and wishes to lower exposure without shifting funds to a conventional bank.

The trader can exchange Bitcoin for USDT or USDC. That move takes them from a volatile crypto to a dollar-pegged asset, all while staying within the crypto world. That's a key reason stablecoins were created: they offer a stable store of value inside crypto markets.

What mechanisms keep stablecoins' value steady?

Most large stablecoins are supported by reserves intended to uphold their value. For a stablecoin pegged to the dollar, the issuer holds assets to keep tokens near $1.

For instance, if an issuer has $10 billion in stablecoins outstanding, it would maintain reserves to back that $10 billion. The makeup of these reserves differs by issuer but may include cash and liquid assets like short-term US Treasuries. The core aim is keeping the stablecoin's value consistent.

Despite their design for stability, stablecoins can break their peg. Tiny moves from $1 are common, notably in heavily traded stablecoins. USDT or USDC might trade at $0.999, $1.001, or sometimes a few cents off, based on liquidity, demand, exchange factors and fees. The crucial difference is between a brief minor shift and a sustained or major devaluation from the peg.

So how is the peg maintained in practice?

Consider a dollar-backed stablecoin like USDT or USDC. Each token is backed by reserves the issuer holds, meant to keep value near $1. Reserves may include cash, short-term US government securities, and other liquid assets, depending on the stablecoin.

The peg is further strengthened by the option to issue or redeem the stablecoin at approximately its target price. That presents arbitrage chances when the market price strays too far from $1.

Suppose a stablecoin drops to $0.98. A trader who buys it at $0.98 and redeems with the issuer for $1 could earn $0.02 per token, ignoring costs. That incentive boosts demand and pushes the price back toward $1.

The opposite also holds. At $1.02, participants are motivated to sell or mint new tokens at the target and sell them. More supply presses the price down.

That forms a straightforward stabilizing loop. Below target, arbitrage generates buying demand; above target, selling pressure. But confidence is key. Investors must trust backing and redemption ability near $1. Without that trust, arbitrage weakens, leading to a possible depeg.

A depeg happens when a stablecoin deviates significantly from its target. Minor shifts like $0.999 or $1.001 often just reflect temporary liquidity. However, a larger deviation with heavy selling and reserve doubts signals deeper confidence loss.

If investors fear reserves are inadequate or illiquid, they might sell tokens or redeem. More selling drives price below $1, sparking a feedback loop. Nervous holders sell more, accelerating the decline, akin to a bank run.

That's why reserve makeup and liquidity matter. Liquid assets enable fast cash conversion for redemptions. Less liquid or dubious reserves make peg maintenance tough under strain.

Not all stablecoins follow the same approach. Fiat-backed ones depend on reserves and redemption. Crypto-backed types use over-collateralization and liquidation. Algorithmic stablecoins rely on supply-demand adjustments and have proven more fragile to confidence crises.

TerraUSD's 2022 failure showed what occurs when a stablecoin's support mechanism breaks and trust in the peg vanishes.

Why not just use regular dollars?

Bank dollars stay within traditional banking. Stablecoins live on a blockchain, allowing transfers between crypto wallets and direct use on exchanges and dApps. They operate 24/7, beyond banking hours, making them ideal for crypto.

Think of stablecoins as crypto ecosystem cash. If a trader holds Bitcoin and expects a downturn, she can sell Bitcoin for dollars and move to a bank, or sell for USDT.

The trader avoids Bitcoin price risk while capital stays in crypto. To buy Bitcoin later, she can use USDT instantly. That flexibility helps shift between risk-on and risk-off positions.

Stablecoins are a key liquidity source in crypto markets. Numerous pairs like BTC/USDT and ETH/USDT are quoted against them, letting traders trade directly versus a stable dollar asset. Rather than each crypto trading against fiat like USD or EUR, stablecoins act as a universal digital unit, simplifying cross-ecosystem trading.