Stablecoins are a type of cryptocurrency that is designed to maintain a stable value relative to an underlying asset, such as a fiat currency or a commodity. These coins are typically backed by a reserve of the underlying asset, which helps to ensure that the price of the coin remains stable. Stablecoins are becoming increasingly popular as they offer the potential to provide a more stable store of value than traditional cryptocurrencies, which tend to be subject to large price swings.

There are several types of stablecoins, each with its own approach to maintaining a stable value. The most common types are:

Fiat-collateralized stablecoins, which are backed by a reserve of fiat currency,

Crypto-collateralized stablecoins, which are backed by a reserve of another cryptocurrency, and

Synthetic stablecoins, these are stablecoins, where a smart contract manages a cryptocurrency that is designed to have a stable value.

Risks involved with using stablecoins

Stablecoins, like any other financial instrument, pose certain risks to the financial system. Some of the main risks include:

Credit risk: Stablecoins that are pegged to a fiat currency, such as the US dollar, are subject to the credit risk of the issuer. If the issuer is not able to meet its obligations, the stablecoin’s value may be impacted.

Liquidity risk: If a large number of holders of a stablecoin decide to redeem their coins for the underlying asset at the same time, the issuer may not have enough liquidity to meet the demand, which could lead to a drop in the stablecoin’s value.

Regulatory risk: Stablecoins are subject to the same regulations and laws as other financial instruments. As regulations evolve, stablecoins may be subject to new rules and restrictions, which could impact their value.

Reputation risk: If a stablecoin issuer is involved in any scandal or illegal activities, it could damage the stablecoin’s reputation and negatively impact its value.

The risks involved with synthetic stablecoins

The biggest risk associated with synthetic stablecoins that are backed by an algorithmic central bank is the risk of the algorithm itself. This includes the risk that the algorithm may not function as intended, leading to an imbalance in supply and demand, and resulting in a deviation of the stablecoin’s value from its target peg. The algorithm may also be vulnerable to hacking or malicious attacks, which could lead to a loss of funds or the collapse of the entire system. Additionally, the algorithm may be subject to bugs or errors, which could cause unexpected behaviour and lead to losses for its holders.