Explained-In-3: Stablecoins [Tether]

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  1. 2. What are the risks associated with stablecoins?
  2. 3. What could happen if a stablecoin unpegs for a prolonged time?

Tether, one of the major crypto stablecoins, which is pegged to the US dollar, briefly broke its peg this past week. While it is supposed to be valued one-to-one with the US dollar, Tether traded as low as $0.95 before recovering. Here’s a quick overview of stablecoins and what could happen if they trade below peg value for any extended period of time.

Photo by David McBee from Pexels

1. What is a stablecoin?

A stablecoin is a cryptocurrency that has its value pegged to another asset. The asset is usually one that is more stable than traditional crypto, such as US dollars or gold. Stablecoins are generally used to reduce the volatility often associated with cryptocurrencies.

2. What are the risks associated with stablecoins?

The two primary risks associated with stablecoins are:

a) Whether the stablecoin’s supporting entities actually have the underlying asset collateral they claim to have.

b) Whether the underlying assets are secure and accessible when needed (e.g. at a reputable bank or other credible storage facility).

3. What could happen if a stablecoin unpegs for a prolonged time?

Stablecoins are always fluctuating in their value, albeit relatively minor ($0.001). However, if a major stablecoin such as Tether were to substantially lose its USD peg for a prolonged period of time, and in this context “substantially” would be 5–10 cents, it could have a destabilising impact on both crypto and wider traditional markets due to asset sell-offs.

Essentially what could happen would best be described as a bank run . As the stablecoin experiences prolonged pressure, a series of events would unfold:

— > Stablecoin holders sell their holdings in a rush to claim fiat (USD) before the price sank lower;

— > As a result of the rush exit, the stablecoin’s backers would be forced to sell the traditional assets they hold in order to meet demands.

— > This selling chain reaction could have an impact on traditional markets depending on the volume and pace of traditional assets being offloaded.

As cryptocurrencies and stablecoins grow in popularity, the potential spill over of any major crash into traditional markets becomes more concerning, and central banks will surely be conscious of this. With the recent increased market volatility, governments should expedite regulation for the stablecoins space in order to mitigate risks associated with potential spill-over into traditional markets.