Explanation: what are stablecoins, the asset that rocks the cryptocurrency market?

Representations of cryptocurrencies including Bitcoin, Dash, Ethereum, Ripple and Litecoin are seen in this illustration photo taken 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 sub-category of coins is designed to hold constant value: stablecoins.

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

But an unexpected collapse of the fourth-largest stablecoin TerraUSD, which broke its 1:1 dollar peg, drew attention to the asset class. Read more

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Here’s what you need to know:

WHAT ARE STABLECOINS?

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

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

HOW IMPORTANT ARE THEY?

Stablecoins have a market capitalization 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 data from CoinMarketCap.

But they have grown in popularity in recent years. The largest stablecoin, Tether, has a market capitalization of around $80 billion, having jumped 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.

Although it is difficult to obtain data on the specific uses of stablecoins, they play a crucial role for cryptocurrency traders, allowing them to hedge against bitcoin price spikes or store cryptocurrency. unused money without transferring it back to fiat currency. Read more

In its semi-annual Financial Stability Report released on Tuesday, stablecoins warned by the US Federal Reserve are increasingly being used to facilitate leveraged trading in other cryptocurrencies.

As of 2018, stablecoins have been increasingly used in international trade and as a way to avoid capital controls, says Joseph Edwards, chief financial strategist at crypto firm Solrise. The Tether stablecoin in particular is used for commerce in China and South America, he said.

HOW DO THEY WORK?

There are two main types of stablecoins: those that are backed by reserves made up of assets, such as fiat currency, bonds, treasury notes, or even other cryptographic tokens, and those that are algorithmic, or “ decentralized”.

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

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

Asset-backed stablecoins have come under pressure in recent years to be transparent about what’s in their reserves and whether they have enough dollars to back up all the digital coins in circulation. Read more

Meanwhile, TerraUSD is an algorithmic stablecoin. This means he has no reservations. Instead, its value was supposed to be maintained by a complex mechanism involving the exchange of TerraUSD coins with a floating cryptocurrency called Luna to control supply.

WHAT CAN DO?

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

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

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

Tether has sought to reassure investors, saying on its website that holders can still redeem their tokens at the rate of 1:1.

WHAT ARE REGULATORS SAYING?

As regulators around the world attempt to establish rules for the cryptocurrency market, some have pointed to stablecoins as a particular risk to financial stability – for example, if too many people try to cash in their stablecoins in same time.

In its Stability Report, the Fed warned that stablecoins are vulnerable to investor runs because they are backed by assets that can lose value or become illiquid during times of market stress. A run on the stablecoin could therefore ripple through the traditional financial system by creating strain on these underlying assets, he said.

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Reporting by Elizabeth Howcroft; Editing by Michelle Price and Lisa Shumaker

Our standards: The Thomson Reuters Trust Principles.

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