What Are Stablecoins?

3 min read

What Are Stablecoins?

A stablecoin is a digital token that is intended to maintain a constant peg with some other asset, usually a fiat currency. Stablecoins are often issued on their own blockchain or an existing blockchain and are almost always backed by a centralized party.

Why Are Stablecoins Valuable?

Like all goods in the market, stablecoins are only worth as much as people are willing to pay for them. Stablecoins derive their value from the fact that the centralized parties who back them guarantee to always be willing to buy stablecoins for the exact same price, the peg.

For example, Tether (USDT), a U.S. dollar stablecoin issued on the Bitcoin blockchain, is pegged at a value of $1. Tether Limited, the company backing Tether, sells Tether tokens for $1 and promises to always buy them back for $1.

In the past, Tether claimed to be full reserve, meaning that every Tether token they issued was backed by one U.S. dollar. They changed this policy after its fallaciousness was discovered in 2019.

Nevertheless, Tether has maintained the peg of $1, and Tether is one of the most widely used stablecoins.

What Are Stablecoins Used For?

Stablecoins are mostly used to make transferring fiat currencies easier and faster. Typically, bank and wire transfers take multiple days to clear. On the other hand, stablecoins use blockchains such as Bitcoin’s, and can thus achieve rapid final settlement.

Trade Settlement and Arbitrage

Traders use stablecoins to quickly move money between different exchanges, and to trade in and out of various cryptocurrencies without being encumbered by the speed of the traditional financial system.

The rapid settlement of stablecoins opens the opportunity for arbitrage. When the price of Bitcoin or another asset is different between two exchanges, a trader can rapidly sell the asset for stablecoins on the exchange where it is higher, transfer the stablecoins to their account at another exchange, and buy the same asset at a lower price.

International Money Movement

Although stablecoins are issued by a centralized third party, they still enable money to be moved fairly seamlessly across borders. This allows traders to purchase stablecoins in one country, move them to another country, and either buy Bitcoin or sell for the local fiat currency.

Do Stablecoins Affect Bitcoin?

Stablecoins are a powerful on-ramp for Bitcoin. They allow users to buy Bitcoin more rapidly and in situations where capital controls or local regulations might not have permitted them to buy Bitcoin otherwise. Stablecoins benefit Bitcoin by making Bitcoin more accessible and by making Bitcoin markets more efficient.

Some critics claim that stablecoins, Tether in particular, artificially inflate the price of Bitcoin by rehypothecating or over-issuing stablecoins, allowing users to buy more bitcoin than they otherwise could have. This criticism overlooks the fact that all banks, including central banks, regularly rehypothecate and over-issue fiat currency. In addition, central banks openly, arbitrarily create new money out of thin air. The rapid expansion of fiat money supply since 2008, when Bitcoin was invented, is indeed a driving force behind Bitcoin’s rapid price appreciation.

Notice: River does not provide investment, financial, tax, or legal advice. The information provided is general and illustrative in nature and therefore is not intended to provide, and should not be relied on for, tax advice. We encourage you to consult the appropriate tax professional to understand your personal tax circumstances.

Key Takeaways

  • A stablecoin is a digital token that is intended to maintain a constant peg with some other asset, usually a fiat currency.
  • Stablecoins are issued by centralized third parties, but have so far remained less regulated than fiat currency.
  • Stablecoins are used by traders and exchanges to rapidly and borderlessly move fiat currency.
  • Stablecoins help traders seize arbitrage opportunities and help other individuals move fiat across borders.