What are stablecoins, and how do they differ from other cryptocurrencies?

The price of bitcoin, ether and other popular cryptocurrencies plunged this week as investors trimmed their losses and sought refuge in less volatile assets. One catalyst for this week's rout are growing concerns about so-called stablecoins, another kind of cryptocurrency that is supposed to protect buyers from the sharp swings typical of virtual money. 

Read on to learn about stablecoins.

What are stablecoins?

Stablecoins are cryptos that are tied to a reserve asset such as a currency (like the dollar or euro) or a commodity (like gold, oil or real estate). Backing by other assets makes the value of stablecoins less prone to roller-coaster changes in price, hence the name. 

For example, stablecoin PAXG, or Pax Gold, is tied to gold prices, whereas terraUSD is pegged to the U.S. dollar. There are roughly 200 varieties of stablecoins worldwide, according to the Blockchain Council. As of Friday, the three largest stablecoins by market value were tether at $78.6 billion, USD coin ($49.9 billion) and Binance USD ($17.2 billion). 

As of Friday, the total market value of stablecoins was $163 billion, according to CoinMarketCap.

What are stablecoins used for?

Investors use stablecoins to protect their money from sudden price swings associated with other cryptocurrencies. In effect, stablecoins are meant to serve as the tokenized version of fiat currency or other assets with a fixed value. 

Decentralized finance platforms like BlockFi and Celsius use stablecoins to lend crypto to their customers. The reason they use stablecoins is that the value of the collateral- or currency-backed tokens is unlikely to change dramatically between the time a customer gets approved for a loan and the cryptocurrency lands in the individual's digital wallet.

More advanced crypto investors may use stablecoins to avoid paying transaction fees on crypto exchanges like Binance and Coinbase, many of which don't charge fees for currency exchanges for stablecoins.  

Are stablecoins actually stable? 

Crypto creators have marketed stablecoins as safe and predictable, but as investors discovered this month that is not always the case.

Although it's pegged to the U.S. dollar, for example, the stablecoin terraUSD fell to $0.77 this week. Luna, another dollar-backed stablecoin, fell below $1 on Wednesday night; tether fell Thursday to $0.95. 

Some investors were so outraged by the devaluation of their stablecoins that they filed a lawsuit Thursday against Coinbase. The lawsuit is centered on the stablecoin GYEN, which is pegged to the Japanese yen.

"Investors placed orders believing the coin's value was, as advertised, equal to the yen, but the tokens they were purchasing were worth up to seven times more than the yen," the lawsuit states. "Just as suddenly, the GYEN's value plunged back to the peg — falling 80 percent in one day."

Why are some stablecoins falling? 

Stablecoins have fallen victim to a larger cryptocurrency sell-off that kicked into high gear soon after the Federal Reserve raised interest rates by half a percentage point. Higher interest rates, combined with rising inflation and supply-chain woes, have left investors fearing the U.S. economy will buckle under pressure in the near future. 

Because of this mounting economic uncertainty, many investors have shifted their portfolios away from riskier assets, including  stablecoins and other cryptos. The price of most cryptocurrencies fell anywhere from 5% to 85% in the past week, according to CoinMarketCap data. 

What are government regulators concerned about?

U.S. lawmakers are mulling ways to regulate the burgeoning cryptocurrency market, and stablecoins have been at the center of those discussions. 

Stablecoins in particular need policing because of their rapidly growing popularity and because "they are backed by assets that may lose value or become illiquid during stress" which makes them "vulnerable to runs," according to a Federal Reserve report released Monday. A "run" in the banking world is when all or most of the account holders withdraw their money at the same time because they think the institution won't be around much longer. 

The Fed report also noted that the stablecoin sector is "highly concentrated with the three largest stablecoin issuers — Tether, USD Coin, and Binance USD — constituting more than 80% of the total market value."

U.S. Treasury Secretary Janet Yellen echoed the call for stablecoin regulation this week, noting how quickly a price drop could impact investors. 

"A stablecoin known as TerraUSD experienced a run and had declined in value," she told a Senate banking committee on Tuesday. "I think that simply illustrates that this is a rapidly growing product and that there are risks to financial stability and we need a framework that's appropriate."