Cryptocurrencies, such as bitcoin and ether, can be subject to substantial price volatility. At times, the annual price volatility of many cryptocurrencies exceeds 100% or four times the level of a stock market index. Similar to the role that money market funds play in the stock market, stablecoins provide investors a crypto asset that is designed to be stable, or have minimal volatility. Stablecoins are designed to be pegged to a specific asset, such as remaining very close to the value of one dollar, one euro, or one ounce of gold. Stablecoins can be borrowed and lent, with lenders earning a yield on their stablecoin investments.
Investors are encouraged to understand how each stablecoin is regulated, designed, and backed. Some stablecoins, such as Gemini dollar, Binance dollar, or USDC, are regulated by US banking regulators, regularly audited, and are backed dollar-for-dollar with lower-risk, cash-equivalent assets held off-chain in the traditional banking system. Off-chain assets may be subject to counterparty risk and should be transparent and auditable.
While Tether (USDT) also holds over 70% of its value in off-chain cash-equivalent assets, there is a question as to the safety and volatility of other assets held in Tether’s reserves, which may include loans, cryptocurrencies, and gold.
Other stablecoins may use on-chain collateral to back their value. While this on-chain collateral can be highly transparent, it is more often invested in cryptocurrencies than low-risk cash-equivalent assets, which can introduce volatility. Maker DAO allows investors to mint the DAI stablecoin at a fixed price of one dollar by depositing collateral into the DAI system. Dai is built on top of the ETH blockchain using on-chain collateral backing the value of the stablecoin at 1 USD through a minimum overcollateralization rate of 150%. That is, depositing $15,000 in ether would allow an investor to mint $10,000 in DAI. As the price of ether declines, the investor may be required to return the DAI or invest more ether, as the stablecoin requires a degree of overcollateralization.
Stablecoins using on-chain collateral may be subject to substantial risk as seen in the losses experienced by Terra USD when the value of its collateral token LUNA experienced a catastrophic loss of value.