It’s an exciting time to get started investing in cryptocurrency. Cryptocurrency adoption is surging globally, and China has now recognized cryptocurrency as an investment alternative, a major tonal shift from one of the largest markets in the world.

Yet many new investors remain concerned about cryptocurrency’s volatility and ability to maintain valuation, given that cryptocurrency isn’t tied to any fiat currency.

Stablecoins offer a slightly different approach while keeping many of the advantages of cryptocurrency. Here’s a look at stablecoins and whether stablecoins alternative investing might be the right choice for your portfolio.

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What are Stablecoins?

A stablecoin is a specialized class of cryptocurrency that attempts to offer price stability lacking in other cryptocurrencies.

Like other cryptocurrencies, stablecoins are decentralized digital currency which relies on blockchain to record transactions and are not issued by any central government. However, you’ll recall that a key feature of most cryptocurrencies is that they’re not tied to any fiat currency. This is part of why they’re volatile—the value of a single coin may fluctuate wildly in a way that has little comparison to fiat exchange rates.

Stablecoins work a little differently.

How They Work

Unlike other cryptocurrencies, stablecoins attempt to peg their value to an external asset.

This makes them quite different from other cryptocurrencies like Bitcoin, which aren’t pegged to an external asset. Those cryptocurrencies derive value from a combination of software-driven cryptography, peer-to-peer technology, and what consumers are willing to pay for them. Unfortunately, this is also what makes cryptocurrency values so unstable.

Stablecoins track the value of an underlying asset, which keeps the value of the coin stable over time (relative to the asset it tracks, anyway). Because stablecoins track the value of an asset, they’re often backed by that asset. For example, a stablecoin issuing organization will typically set up a reserve at a financial institution which holds the underlying asset.

For example, let’s say a stablecoin tracked and was backed by the U.S. dollar. The issuing organization might hold $100 million in reserve and issue $100 million coins at $1 per coin. If the holder wanted to cash out, they could easily transfer the stablecoin into cash.

Types of Stablecoins

Most stablecoins are backed by hard assets, though not all. There are four types of stablecoins based on the type of asset backing:

• Fiat-backed
• Crypto-backed
• Precious metal-backed
• Algorithmic stablecoins

Fiat-backed stablecoins are backed by fiat currencies, often the U.S. dollar or the euro. It’s an IOU situation described in the previous example—anytime you want to cash out your coins, you can convert them into hard cash in the pegged fiat currency. And because they’re pegged to fiat currency, price fluctuations are limited (which doesn’t automatically make them safer).

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Cryptocurrency-backed coins are backed by other crypto assets. And because the underlying asset is known to be volatile, these coins are overcollateralized to ensure they retain value. Basically, this type of stablecoin builds in a cushion to account for inevitable cryptocurrency value fluctuations so that the stablecoin remains more or less stable. That said, you have to keep a close eye on the value of the underlying crypto asset.

Precious metal-backed stablecoins are backed by a precious metal, often gold. Gold has often been seen as a hedge against market volatility, which is part of what makes this type of stablecoin attractive. However, these types of stablecoins are centralized, which is a drawback for crypto investors drawn to decentralization.

Then there are algorithmic stablecoins, which are pegged to an underlying asset but aren’t backed by it (and can sound counterintuitive to the whole point of stablecoins). Rather than relying on an asset, such stablecoins rely on computer algorithms to prevent major value fluctuations. Think of it like the Fed’s techniques for stabilizing inflation. If a stablecoin is pegged to $1 USD but the coin goes up, the algorithm will release more tokens into the supply to keep the price down.

Why People Use Stablecoins

If you’re one of those investors who scratches their head and asks, “But where does cryptocurrency get its value?” stablecoins might be attractive to you. Ditto if you’re the type of investor who’s leery of cryptocurrency’s known volatility.

Unlike fiat currency, stablecoins offer much of the accessibility and mobility benefits of other cryptocurrencies, but unlike other cryptocurrencies, they’re not subject to the same madcap value swings.

On the flipside, a stablecoin is not the same investment you would get with another type of cryptocurrency. The whole point of the system is to maintain stable value—which means you won’t see the soaring prices you would see in another cryptocurrency (and thus the soaring returns by selling at the right moment).

Stablecoins Alternative Investing: Is It Worth It?

Stablecoins alternative investing is possible. If you’re smart about it, it could even be a good idea. But you have to know what you’re signing up for.

First, you have to know the risks. Stablecoins come with two of the major risks attached to other cryptocurrencies (security and counterparty risk) and one risk that’s uniquely their own (reserve risk).

The big one to be aware of is reserve risk. Remember, stablecoins aren’t fully backed by their pegged asset or reserve currency. The issuer has to maintain reserves independent of a central bank, which means the issuer has to have sufficient reserves to 100% support the stablecoin. If the issuer doesn’t, you may not be able to cash out.

Second, pay attention to safety signifiers. Any legitimate issuer will provide rock solid reserve reports (hint: if they don’t have reserves reports, run the other way). Also, read the fine print on the issuer’s statements, and pay careful attention to the value of the backing asset.

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