What are the advantages and disadvantages of stablecoins?

Stablecoins are cryptocurrencies that try to maintain a stable value relative to a specific asset. Typically, this asset is a country's currency, also called "fiat" currency, such as the United States dollar. 

Stablecoins have emerged as a popular alternative to traditional cryptocurrencies due to their price stability. However, like any financial instrument, they come with additional risks that investors should understand. 

Advantages of stablecoins

Stablecoins bridge the gap between the inherent volatility of digital currencies and the stability of traditional fiat currencies. Their primary function is to offer a more predictable and less volatile digital asset by "pegging" their value to a stable reference point.

They are attractive among those seeking to avoid the price unpredictability associated with bitcoin and ether, which can fluctuate significantly in a short period. Stablecoins can facilitate everyday transactions and preserve value without traders exiting the market.

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Stablecoins offer several advantages, making them valuable tools in both the cryptocurrency ecosystem and broader financial markets. Here are some of the key benefits:

  • Price stability: Stablecoins maintain a stable value, reducing the volatility typically associated with cryptocurrencies, making them suitable for everyday transactions.
  • Integration with DeFi: Stable assets providing a stable medium of exchange for various decentralized finance applications such as lending, borrowing and yield farming.
  • Liquidity: Stablecoins provide liquidity to cryptocurrency markets. They let traders to move in and out of positions quickly without needing to convert to fiat currencies, which can be slow and costly.

Disadvantages of stablecoins

One key concern for stablecoins is the integrity of the reserve assets backing them. To maintain their peg, stablecoins must have adequate collateral, which can be fiat currencies, other cryptocurrencies, real world assets or other commodities like gold. Management and transparency of these reserves are critical, as doubts about collateral sufficiency can undermine investor confidence in the stablecoin's value.

Additionally, the reliance on external reserves introduces "counterparty risk," which is the chance that an entity in an investment agreement does not fulfill their obligations properly. With stablecoins, the entities holding the reserves could potentially fail to honor redemption requests. 

While stablecoins offer many advantages, they come with several disadvantages and risks for users to consider:

  • De-pegging risk: Market fluctuations, loss of confidence or liquidity issues can cause a stablecoin to deviate from its intended peg. This was seen most starkly in the collapse of the algorithmic stablecoin TerraUSD.
  • Centralization risks: Many stablecoin assets are issued by centralized entities that control the backing assets and the issuance process. Users must trust that the issuer maintains sufficient reserves and operates sustainably.
  • Reserve management: For fiat-collateralized stablecoins, the management and auditing of reserve assets are critical. Poor management, lack of transparency or fraudulent behavior by the issuer can undermine the the asset's stability.

Disclaimer: This article was produced with the assistance of OpenAI’s ChatGPT 3.5/4 and reviewed and edited by our editorial team.

© 2023 The Block. All Rights Reserved. This article is provided for informational purposes only. It is not offered or intended to be used as legal, tax, investment, financial, or other advice.

About Author

MK Manoylov has been a reporter for The Block since 2020 — joining just before bitcoin surpassed $20,000 for the first time. Since then, MK has written nearly 1,000 articles for the publication, covering any and all crypto news but with a penchant toward NFT, metaverse, web3 gaming, funding, crime, hack and crypto ecosystem stories. MK holds a graduate degree from New York University's Science, Health and Environmental Reporting Program (SHERP) and has also covered health topics for WebMD and Insider. You can follow MK on X @MManoylov and on LinkedIn.