Are Stablecoins Safe? A Look Into Stablecoin Risks

Unlike other crypto assets, stablecoins have fewer risks because they aren’t typically affected by strong price swings. But with stablecoins growing in popularity in the last few years, their risks are also becoming more prominent. As the adoption of stablecoin grows for several use cases, some of the flaws will begin to show. That means it’s essential for you to understand and know how to assess the risks associated with these assets. Read on to learn more about stablecoin risks and how safe this type of cryptocurrency really is.

What Is a Stablecoin?

A stablecoin is a cryptocurrency that offers price stability, used as a way to hold the value of your money and hedge against price swings.

The goal of stablecoins is to keep a 1:1 peg to an external reference, which is often the US dollar. This allows traders and investors to hedge against the volatility of other cryptocurrencies. Most stablecoins are backed by reserve assets like dollars, euros, gold, or other cryptocurrencies like bitcoin and ether. Some stablecoins are pegged to the price of commodities like gold, silver, and oil. And some other stablecoins aren’t backed by anything, just computer codes.

The stablecoin market has exploded, its market cap expanding to reach more than USD 150 billion. Even though stablecoins represent only a small portion (about 15%) of the whole crypto market, they play a significant role in the trading and liquidity of top crypto assets.

Types of Stablecoins Explained

There are two broad types of stablecoins: collateralized and non-collateralized stablecoins. 

Collateralized Stablecoins

Collateralized stablecoins are stable cryptocurrencies backed by an underlying reserve, either fiat currencies or cryptocurrencies. The reserve provides a way for the stablecoin to hold its peg and allows users to redeem their stablecoins for fiat currency, commodities, or other cryptocurrencies.

• Fiat-Backed Stablecoins

This is one of the most popular stablecoins, as they make up almost 90% of the stablecoin market. These stablecoins are backed 1:1 by a fiat currency. Examples of these include USDT, USDC, BUSD, and others. 

A third-party financial institution holds the fiat currencies that back these stablecoins, and it’s expected that the same proportion of fiat currencies are reserved for supporting the number of stablecoin tokens in supply.

• Crypto-Backed Stablecoins

These are stablecoins backed by other cryptocurrencies. In this case, the reserve of cryptocurrencies is stored on the blockchain through smart contracts instead of third parties. Often, crypto-backed stablecoins are over-collateralized to account for the volatility of cryptocurrencies, and some have a 200% collateralized ratio. 

To create these stablecoins, you must deposit and lock other cryptocurrencies. For example, the most prominent crypto-backed stablecoin DAI is pegged at 1:1 to the USD. You must lock up a specific worth of ether (ETH) as collateral to create a new DAI stablecoin. When you want to withdraw, you can put the stablecoin back into the smart contract and take out your collateral.

• Commodity-Backed Stablecoins

As the name implies, these stablecoins use commodities as collateral. These include assets like gold, other precious metals, and oil. Gold is the most common collateral. Examples include Paxos Gold (PAXG) and Tether Gold (XAUT). 

These stablecoins make it easier to gain exposure to commodities without holding the physical assets. Rather than going through the stress of storing bars of gold, you could just hold stablecoins pegged to the price of gold. 

Non-collateralized stablecoins

• Algorithmic Stablecoins

Algorithmic stablecoins use algorithms and smart contracts to manage the coin supply to achieve price stability. They do not have fiat currencies or cryptocurrencies as collateral. However, their prices are often pegged 1:1 to fiat currencies like the USD. 

To maintain its peg, the algorithm behind the stablecoin automatically reduces the supply of tokens in circulation whenever its price falls below its target peg. And when the price rises above, it increases the supply of new tokens to push down the price. 

Though these stablecoins are innovative, they haven’t proven successful yet on a massive scale.  

Stablecoins Risks Explained

Regulatory Risks – Given the potential importance of stablecoins in the global economy, regulators have started paying attention. Especially in the United States, which is looking to protect the dominance of the USD, issuers of fiat-backed cryptocurrencies have been required to comply with local and foreign policies of the government. 

For example, in August 2022, Circle, the issuer of USDC, had to freeze several wallet addresses listed by US Treasury officials following sanctions on Tornado Cash, an open-source blockchain project.  

Third-party risks are associated with fiat-backed stablecoins issued by central authorities. Since they are a business, there are possibilities of mismanagement of funds, bankruptcy, and embezzlement of funds. Users risk losing their funds without legal recourse and proper transparency on periodic audits.

Manipulation risks – Most stablecoins are issued by centralized entities, which means you have to trust that the executives of these companies will take their fiduciary duties seriously. The company could also print the stablecoins as much as it wants, similar to the central banks, which could lead to hyperinflation and loss of funds.

In the case of algorithm stablecoins, smart contracts are susceptible to hacks and manipulation from the team or an outside party. 

Assets reserve risks – Crypto-backed stablecoins could lose their peg with sudden volatility in the price of the cryptocurrencies used as collateral. As cryptocurrencies haven’t reached full maturity as an asset class, there’s the real risk of the collapse of a crypto project used as collateral, which ultimately jeopardizes the stablecoin and leads to the loss of funds.

Exposure to the traditional financial sector – More than 90% of stablecoins in the crypto market currently have exposure to the traditional financial industry, which means the actions and inactions of central banks and banks can affect the value of stablecoins in real terms.

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