Are Stablecoins Safe?

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Contributor, Benzinga
November 25, 2024

Stablecoins are seen as safer investments since they are pegged to stable assets. 

Stablecoins are a hot topic in the world of crypto, as they allow users to participate on blockchains with less volatility. Are stablecoins safe? Stablecoins are a type of cryptocurrency that is pegged to the value of another asset like a currency, commodity, or other cryptocurrency. Most are pegged to stable currencies such as the U.S. dollar. These fiat-backed stablecoins are intended to provide a more steady store of value than other cryptocurrencies, which can be unpredictable. However, the safety of stablecoins depends on a variety of other factors, including the methods it uses to sustain its peg, the stability of the underlying asset and the security of the platform issuing the stablecoin.

Make sure to do your due diligence and research, as stablecoins attempt to hold stable values but don’t always deliver stability at all times. As seen by the recent de-peg of USDC, stablecoins are subject to non-negligible amounts of risk. Regulatory oversight of stablecoins can vary and are not as strong as with traditional financial institutions. For instance, Terra USD (UST) was considered a stablecoin, but when it collapsed, an estimated $60 billion was eliminated from the market.

Are Stablecoins Safe?

Many investors consider stablecoins to be safer than other cryptocurrencies because they are designed to be pegged to stable assets. The risk each incurs depends on a variety of factors, starting with their general design, with four main types — collateralized, algorithmic, centralized and decentralized.

Collateralized Stablecoins

Collateralized stablecoins are backed by collateral to ensure their value remains stable. For example, Tether (USDT) and TrueUSD (TUSD) are stablecoins that are collateralized by large reserves of assets. They are often backed 1-1 with assets like cash, CDs, loans, corporate bonds and commercial paper (unsecured loans). Unfortunately, not all of these stablecoin companies can be trusted to report the contents of their reserves accurately.

The lack of regulatory oversight in the industry means that stablecoin reserves are not always being monitored. For example, Tether allegedly got away with lying about its reserves for years — claiming it held 1-1 backing all in cash at all times — before the New York Attorney General discovered the issue and fined the company. Another type of stablecoin — the crypto-collateralized stablecoin — is backed by other cryptocurrencies.

Algorithmic Stablecoins 

Algorithmic stablecoins are a type of stablecoin that uses algorithms to maintain value instead of holding traditional reserve assets like fiat currency or commodities. The algorithm adjusts the supply of the stablecoin in response to market demand and other factors to keep the price stable. Algorithmic stablecoins do not always hold reserve assets to back their value, which can make them riskier compared to reputable collateralized stablecoins. The recent crash of TerraUSD (UST) in May 2022 highlights the risks associated with algorithmic stablecoins, as value plummeted from issues with algorithmic backing.

Centralized Stablecoins 

Centralized stablecoins are maintained by the issue’s reserve of the attached currency or other assets. Centralized stablecoins make it easy to transact everyday purchases. Traders that need to access cryptocurrencies right away can do so because they do not need intermediaries to facilitate the transfer. USDC is an example of a centralized stablecoin, meaning that each USDC is backed by 1 USD or an asset that is equivalent to USD.

Decentralized Stablecoins 

Decentralized stablecoins are stablecoins run by decentralized platforms or organizations. Their code is on-chain and thus is open to the public and transparent, although anyone with enough blockchain experience can audit a decentralized stablecoin. Because they are on-chain, the government or third parties can not block users from accessing the stablecoin. Their transparency makes them essentially trustless. You don’t need to trust a centralized entity to issue one stablecoin for each $1 of reserves. MakerDAO’s DAI, a decentralized algorithmic stablecoin, maintains a peg by having cryptocurrency as collateral locked into a smart contract. The stablecoin is mostly backed with Ethereum and other USD stablecoins. DAI now has a significant amount of its treasury in USDC, and since USDC is a centralized stablecoin, so is DAI (to a degree).

Crypto enthusiasts generally agree that decentralized, collateralized stablecoins are the most-safe stablecoins, and algorithmic stablecoins are the riskiest.

Are Algorithmic Stablecoins Safe?

Unlike other cryptocurrencies that are known for their volatile prices, algorithmic stablecoins can be pegged to a specific asset, such as the US dollar or gold. By relying on a combination of monetary policy and market dynamics, these stablecoins can automatically increase or decrease their supply to keep their price stable. Some examples of algorithmic stablecoins include DAI and Frax which used to be an algorithmic stablecoin but is moving away from this due to safety concerns and UST which was an algorithmic stablecoin but has since failed.

The safety of algorithmic stablecoins depends on various factors such as the underlying algorithm, the level of decentralization and the collateralization mechanism.

While algorithmic stablecoins can offer stability to their holders, they also carry risk. For example, the algorithm may fail to maintain the stablecoin's peg, causing its value to fluctuate unexpectedly and potentially collapse entirely. This is what happened to Terra Luna’s UST stablecoin. Additionally, some algorithmic stablecoins may not have sufficient collateralization or decentralization, which could make them vulnerable to manipulation or hacking attempts.

With the most popular algorithmic stablecoin Terra USD (UST) crashing in May 2022, it’s no surprise that many crypto enthusiasts started to think that algorithmic stablecoins are the riskiest kind of stablecoin. However, MakerDAO’s algorithmic stablecoin DAI is considered safe because it is significantly overcollateralized. Four of the top five market stablecoins are collateralized stablecoins.

Risks of Investing In Stablecoins

While stablecoins have gained popularity for their perceived stability and ease of use, like any investment, they carry risks. Several potential risks exist, including the risk of phishing scams, volatility, smart contract risk and illiquidity.

  1. Risk of phishing scams related to your crypto wallet: Phishing scams can be a risk for any type of cryptocurrency investment. Hackers may attempt to steal your cryptocurrency by tricking you into revealing your private keys or seed phrases through fraudulent websites or emails. It's important to use a reputable and secure wallet and be cautious of unsolicited messages or requests for your private information. Never click random links in your email, even if they look legitimate.
  2. Risk of volatility in the event the stablecoin depegs: Stablecoins are designed to maintain a stable value, but in the event that the underlying mechanism fails, a bank run occurs or the market experiences extreme volatility, the stablecoin may lose its peg to the asset it is intended to track, resulting in a loss of value for investors.
  3. Smart contract risk: Smart contracts are self-executing programs that run on a blockchain. If the smart contract is poorly written or vulnerable to attack, it could result in the loss of funds. It's important to thoroughly research any smart contract or platform before investing in it.
  4. Illiquidity risk: Some stablecoins may have lower trading volumes or less liquidity than others, which could impact the ease with which you can buy or sell them. This may be more of a concern for smaller market-cap stablecoins, which may be less widely traded.

As with any investment, it's important to understand the risks involved and conduct your own research before investing in stablecoins.

Safest Stablecoins 

Considering the potential risks associated with investing in stablecoins, it's important for investors to evaluate their options and choose stablecoins that prioritize safety and security. Some stablecoins are designed with robust transparent mechanisms to maintain their stability and ensure transparency, while others are backed by reputable institutions or comply with regulatory standards. Some of the safest stablecoins available in the market today include USDC, USDT, DAI and LUSD.

USD Coin

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USDC

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USD Coin (USDC) has emerged as a reliable stablecoin option in the cryptocurrency market, thanks in large part to its fully collateralized mechanism. It was launched in 2018 by Circle, a cryptocurrency start-up. This collateralization mechanism provides transparency and security for USDC users, as the reserve holdings are regularly audited by third-party accounting firms to ensure full backing. As a result, USDC has gained popularity as a stable and secure alternative for individuals and businesses looking to engage with the cryptocurrency market.

However, it ran into concerns recently regarding the centralized nature of USDC's collateralization mechanism. A large portion of Circle’s reserve holdings (about $3.3 billion) was held by a single institution, Silicon Valley Bank. After Silicon Valley bank collapsed in March, USDC lost its peg for a few days (dropping a few cents) because investors worried it couldn’t handle a bank run. Luckily for Circle, the Treasury Department made all SVB depositors whole and USDC quickly regained its peg. Hopefully, the company has learned its lesson and plans on spreading out its reserves more in the future.

Furthermore, the Centre Consortium, a partnership between Circle and Coinbase, manages the token issuance for USDC, which has raised questions about the level of decentralization of the stablecoin. Additionally, while USDC's treasury is managed by behemoths like BlackRock and Fidelity, some critics argue that this centralized management structure goes against the decentralized nature of cryptocurrency.

Despite these concerns, USDC remains a popular and reliable stablecoin option in the cryptocurrency market. The fact that USDC is fully collateralized and subject to regular audits provides transparency and security for users, and its widespread availability and use cases make it one of the safest stablecoins on the market.

Tether (USDT) 

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Tether

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Tether (USDT) is a widely used stablecoin in the cryptocurrency market, and some consider it the second safest stablecoin behind USDC. But it has been subject to some controversy over the years. While Tether claims that it is fully collateralized and maintains a stable value pegged to the US dollar at a 1:1 ratio, it offers little transparency and has never produced a full, unbiased audit of reserves. Many critics argue that it lacks the same level of transparency and regulatory compliance as other stablecoins like USDC.

Tether Limited, the company behind the stablecoin, has faced accusations of fraud in the past for allegedly lying about its reserves. However, it should be noted that Tether has not been found guilty of any wrongdoing and has maintained its position as a popular stablecoin option despite the controversy.

While Tether is widely used and considered a safe stablecoin by many in the cryptocurrency market, its lack of transparency and past controversies should be taken into consideration by investors and users.

DAI

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Dai

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DAI is a distinctive stablecoin in the cryptocurrency market that is highly regarded for its decentralized nature and security. Unlike other stablecoins, DAI is sustained through a decentralized platform called MakerDAO, which employs smart contracts on the Ethereum blockchain to ensure its peg to the U.S. dollar.

One of the key features is that to keep DAI's value stable, users have to put up more collateral than the value of the DAI they want to generate. This process is called over-collateralization and it protects DAI from crashes in the value of the collateral.

While DAI's decentralized nature and over-collateralization process make it a relatively safe stablecoin option, it should be noted that holding and using cryptocurrency carries inherent risks, including price volatility and potential security issues. DAI's unique features and decentralized nature make it a safe stablecoin option for those looking for a more decentralized alternative to traditional stablecoins.

LUSD 

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Liquity USD

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LUSD is considered a safe stablecoin because of its decentralized design and unique governance system. LUSD is issued on the liquidity protocol by depositing ETH as collateral. The protocol is fully decentralized and governed, which is why many consider it safe. LUSD is over-collateralized with ETH and its value is maintained through an oracle that tracks the price of the U.S. dollar. Its smart-contract-based protocol is designed to maintain its peg to the U.S. dollar, and it has a liquidation system that prevents it from losing its peg during times of high volatility.

LUSD's governance system allows its users to vote on changes to the protocol, ensuring transparency and responsiveness to users' needs. The system incentivizes users to maintain the stability of LUSD's value by rewarding them for performing certain actions within the protocol.

Where to Buy Stablecoins

Looking to buy stablecoins? To buy stablecoins you’ll need to have an account with a crypto exchange. Some popular platforms include Coinbase, Binance, Kraken and Gemini. Stablecoins may be available on decentralized exchanges such as Uniswap and SushiSwap.

Stablecoin Hacks

Stablecoin hacks refer to the theft or loss of stablecoins from security breaches or vulnerabilities in the platforms or wallets that hold them. Just like any other cryptocurrency, stablecoins are not immune to hacking attempts, and stablecoin platforms and wallets have been compromised. It is worth noting that USDC, USDT and DAI have never been hacked (to the public’s knowledge).

Hackers may try to exploit weaknesses in the platform's smart contract or code or steal private keys or passwords used to access the stablecoins. They may also try to trick users into giving them access to their wallets through phishing scams or social engineering tactics. In the event of a stablecoin hack, users may lose some or all of their stablecoin holdings, leading to financial losses. It is important for users to be aware of the security risks associated with stablecoins and take necessary precautions to protect their holdings, such as using hardware wallets and two-factor authentication and keeping their private keys secure.

Best Hardware Wallet for Stablecoins

When it comes to hardware wallets for storing stablecoins, several options are on the market. The best hardware wallet is the Ledger.

Best Hardware Wallet: Ledger 

The Ledger hardware wallet stores stablecoins and other cryptocurrencies. It is a physical device that holds your private keys and allows you to securely access your crypto assets. Ledger wallets come in different models, such as the Ledger Nano S and Ledger Nano X, and support a wide range of cryptocurrencies, including stablecoins like USDC, USDT and DAI.

One of the main advantages of using a Ledger hardware wallet for stablecoins is its strong security features. The device is designed to keep your private keys offline and inaccessible to potential hackers, and it requires a PIN code to access your funds. Ledger provides regular firmware updates to improve the security of its devices and protect against known vulnerabilities.

Another benefit of using a Ledger hardware wallet is its ease of use. The device comes with a user-friendly interface that makes it easy to manage your crypto assets and transfer stablecoins to other wallets or exchanges. It also supports mobile apps that allow you to monitor your portfolio and transactions on the go.

Are Stablecoins a Safe Investment?

While stablecoins are generally regarded as a relatively safe investment, it’s important to do your own research on how the stablecoin you chose to hold is backed. If you plan to use stablecoins in DeFi to earn interest, then the yield may be worth the risk of holding stablecoins. However, if you’re seeking to hold cash and have access to fiat offramps, then holding USD directly may be a safer bet.

Frequently Asked Questions

Q

Are stablecoins regulated?

A

Regulation of stablecoins differs by country, with some governments considering frameworks and others enforcing stricter regulations. Users should remain updated on the regulations in their area.

Q

How are stablecoins backed?

A

Stablecoins can be backed by various assets, including fiat currencies or cryptocurrency reserves. Fiat-backed stablecoins have a 1:1 backing with US Dollars, while crypto-backed stablecoins are supported by a mix of cryptocurrencies to stabilize their value.

Q

Can stablecoins be used for investing?

A

Stablecoins are used for transactions and value storage, and they also play a role in DeFi applications like lending, borrowing, and yield farming, though users should be cautious of the risks involved.

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