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Crypto Corner: What are stablecoins?

Yahoo Finance's Zack Guzman breaks down stablecoins.

Video Transcript

- US regulators taking a closer look at systemic financial risk posted by cryptocurrencies. The latest example coming earlier this month. We've talked about this one. The SEC blocked crypto exchange Coinbase from paying customers interest on stablecoins. For a closer look at why stablecoins have become so important, Zach has our first installment of crypto corner explainers. Take a look.

ZACK GUZMAN: Stablecoins are a quickly growing piece of the crypto world and yet, as their name suggests, they set out to accomplish a boringly stable task. Despite that, regulators have increasingly called out potential risks that stablecoins pose to the traditional financial system. So what exactly are stablecoins? Well, stablecoins are digital currencies that are always meant to trade at $1. In times of volatility in crypto, they serve as a safe haven for investors to turn to, rather than having to cash out into real world dollars. Notice how stable the most popular stablecoin Tether has traded relative to Bitcoin's volatile swings.

The issuers of stablecoins maintain their $1 peg by creating or burning a certain number of tokens to correlate with their collateral. The safest stablecoins do so simply by holding an equal amount of dollars in a bank. So $50 million in the bank corresponding to 50 million coins. For example, the Winklevoss Twins Gemini dollar is an example of just that, known as a currency backed stablecoin.

But since stablecoins are generally unregulated, stablecoin issuers can also hold other assets rather than just cash in a bank. For example, Tether, the first ever stablecoin recently unveiled it only holds about 75% of its portfolio in cash and cash equivalents. Only about 5% of its collateral is actually in cold hard cash. The majority is in short term corporate debt known as commercial paper and other things like gold and bonds that can go down in value. That introduces some risk, of course. And Tether has also never been audited.

Perhaps even riskier though, are algorithmically backed stablecoins, which aren't backed by cash or tangible assets at all, but rather by other cryptocurrencies. In theory similar to the way the Fed is able to control the money supply by printing more or less money, code automatically adjusts the amount of stablecoins in circulation up or down based on demand. That can go well, as Terra's USD stablecoin has functioned so far, or it can collapse, as was the case with Iron Finance's Iron stablecoin earlier in 2021. Overall though, the stablecoin market has been exploding recently with the market cap of the larger stablecoins already surging 10x from last year to top more than $100 billion. About $60 billion of that is in Tether alone, with USDC catching up at more than $20 billion.

With that much money at stake, the Fed has increasingly been paying attention to potential risks. As Boston Fed President Eric Rosengren recently pointed out, Tether poses a unique risk to the traditional financial market. As its commercial paper holdings have swelled in size, the company is now among the top 10 holders of commercial paper, getting close to money market funds from some major financial players you may have heard of, like JP Morgan and Charles Schwab.

- I do worry that the stablecoin market that is currently pretty much unregulated, as it grows and becomes a more important sector of our economy, that we need to take seriously what happens if people run from these type of instruments very quickly.

ZACK GUZMAN: So in the short term, those issues could persist but in the longer term, central banks are already experimenting with their own digital currencies. China, for example, is preparing to launch a digital currency of its own and the Fed is experimenting with a digital dollar. This could eventually replace the need to trust private companies and their private stablecoins down the road. So there you have it. Stablecoins, maybe not so boring after all.