Stablecoins: Definition, Types, & How They Work

Many new crypto investors, myself included, inevitably ask, “Are stablecoins a good investment?”

This low-volatility digital asset plays an important part in many crypto portfolios to manage risk and generate income, along with a few risks to know about.

What are Stablecoins?

A stablecoin is a type of cryptocurrency pegging its value to a real-world asset, such as U.S. dollars or gold.

A coin may have a static $1 value. It doesn’t have the eye-popping price action like Bitcoin, so it won’t make you rich through trading or long-term holding. 

Instead, stablecoins help preserve your crypto wallet balance similar to a cash savings account.

For example, you may buy this digital asset while waiting for an ideal entry point for a crypto trade. Another possibility is to pay for goods and services with a predictable value.

How do stablecoins work?

The primary role of stablecoins is completing crypto-based transactions with a stable market value.

They usually trade at a 1:1 ratio to an underlying asset and usually have an unchanging value, similar to uninvested cash, although you can earn interest rewards.

These near-instant transactions occur on the blockchain instead of using fiat currency or volatile cryptocurrencies.

This predictability means you know precisely how many units you need versus Bitcoin and altcoins which can easily fluctuate up to 5% to 10% in value daily.

Some of the benefits, according to a Federal Reserve study, include:

• Price stability: You usually buy or sell stablecoins at $1 as the provider mints or burns units to maintain the 1:1 peg or collateral value. Further, you avoid the price volatility of Bitcoin and altcoins, leading to unpredictable spending power. 
• Real-world collateral: Most coins use tangible assets, such as government currency or precious metals, to preserve their trading value and market cap.
• Multiple use cases: Use them to buy, sell, or transfer assets between businesses and friends. They can also protect your portfolio value during crypto winters when investable tokens have decreasing trading prices. 
• Near-instant transaction speeds: Each transaction settles on the blockchain within seconds or minutes, not hours or days. 
• Competitive fees: Crypto-backed transactions can incur lower costs for the sender and recipient versus traditional money transfer apps and wiring services. 

I like having a small stablecoin balance in my trading portfolio to buy more crypto at a desirable entry point.

Simultaneously, I seek ways to earn staking rewards from this uninvested balance.

Universal Adoption

Multiple cryptocurrency exchanges support nearly every stablecoin, so you can use them to fund purchases and transfers when the recipient uses a different exchange. 

For example, I may have Coinbase, and you may use Gemini, but we can still easily transfer funds.

The beauty of decentralized finance (DeFi) is that you don’t need to perform currency conversions or bank with a particular financial institution.

Moreover, most exchanges have a proprietary stablecoin, such as the Gemini Dollar (GUSD) or Coinbase’s USD Coin (USDC), giving investors instant liquidity within the platform. 

Your fiat money deposits convert into your exchange’s in-house stablecoin before buying crypto assets.

Collateral-Backed

The largest stablecoins are fully backed by real-world assets or other liquid cryptocurrencies.

This collateral preserves the peg value and allows you to convert your crypto back into paper money.

The liquidity pool is usually the native fiat currency for that particular project. So, US-launched coins will hold U.S. Treasuries or dollars, while a European Union coin has Euro reserves.

Tax Treatment

There are two instances when you might pay taxes on stablecoin transactions:

• Capital gains taxes from selling your stablecoins or converting them into another virtual currency. Assets held for less than 12 months are subject to ordinary income tax. Holding for at least a year before selling helps you qualify for lower long-term brackets.
• Crypto staking rewards are subject to ordinary income taxes as they are short-term earnings.

Since stablecoins staking are not built for price appreciation like most investment assets, you most likely won’t sell them for a profit.

Instead, you must make money by earning interest from your deposits similar to a bank savings account.

The IRS guidelines for digital assets apply to stablecoins similar to Bitcoin and altcoins. Your exchange provides a year-end tax document itemizing your potential gains and losses for your crypto and stablecoin transactions.

A crypto Roth IRA lets you enjoy tax-free investment returns on your retirement assets.

Potential Risks

Despite having several advantages, stablecoins are not a risk-free store of wealth. It’s possible to lose money on your investment.

Potential risks to be wary of include:

• De-pegging: A particular coin is only as sound as its underlying asset. Minute fluctuations are common, although the value can separate during a liquidity crisis due to insufficient collateral or benchmark asset price volatility (i.e., fiat currency collapse).  
• Protocol glitches: Stablecoins typically operate on smart contracts to automatically conduct transactions. Unfortunately, coding errors and malicious hacks can wreak havoc.
• Minimal price appreciation: This asset lacks price appreciation because it is meant to be a reliable store of value. In comparison, you trade Bitcoin to earn capital gains and increase your net worth. 
• Centralization: Most crypto investors use centralized exchanges to buy crypto and are subject to government regulations. Future policy changes may prohibit account access unless you move them to a hardware wallet first.
• Not government-insured: Unlike traditional assets, cryptocurrency is ineligible for FDIC or SIPC insurance. Exchanges and custodians may offer reimbursement due to cyber fraud, but the asset class lacks safeguards.
• Shifting adoption trends: The crypto universe remains young and rapidly growing. As a result, today’s most popular stablecoins may have less liquidity in the future. This can make it challenging to sell your balance or maintain a store of value.  

As this is a non-productive asset, you won’t want a sizable stablecoin position in your crypto IRA if your investment strategy has a high risk tolerance.

Types of Stablecoins

Stablecoin projects can connect their market value to several different physical or digital asset types.

Fiat-collateralized

Most stablecoins pin their value at a 1:1 ratio on a government currency, such as the U.S. Dollar.

So, $1 converts into a $1 token and vice versa when it’s time to re-enter the banking system. 

Coin issuers use the fiat currency as collateral and their reserves reflect the outstanding market cap, verified through recurring audits.

Prominent USD-backed coins include:

• USD Coin (USDC)
• Tether (USDT)
• Pax Dollar (USDP)

These coins are the closest equivalent to cash reserves in your bank checking account.

Crypto-collateralized

Other cryptocurrencies can serve as collateral instead of government-minted currency.

Because crypto assets are inherently more volatile, the crypto reserves exceed the outstanding market cap to prevent liquidity gaps.

Dai (DAI) is the most notable example that holds various cryptocurrencies and stablecoins as its collateral reserves.

Its white paper specifies that the project soft pegs to the US dollar and currently uses any Ethereum-based coin and real-world assets.

Algorithmic

Algorithmic stablecoins rely on permissionless smart contracts to maintain their peg to the US dollar.

These decentralized tokens are governed by blockchain rules instead of a single entity. However, they can be riskier as they may only have partial collateral for more efficiency.

Two coins fitting this criteria are:

• Ampleforth (AMPL) adjusts the quantity of tokens in user wallets proportional to inflation-adjusted dollars. This protocol launched in 2019 and is one of the oldest algorithm-based cryptocurrency projects.
• Frax Finance (FRAX) automatically burns or mints coins to maintain a 1:1 peg. Previously, it was only partially collateralized, although its v3 protocols approved in 2023 allow for full collateral ratios.

Commodity-pegged

These stablecoins have the backing of physical commodities, including precious metals, oil, and real estate.

You may prefer these cryptocurrencies to store tangible assets or trading commodity-linked funds but with potentially fewer transaction, transfer, and custodian fees.

Pax Gold (PAXG) and Tether Gold (XAUT) are two gold-backed stablecoins. They have high trading volumes while blending the advantages of crypto and hard alternative assets.

U.S. Treasury-backed

Tokens holding short-term U.S. Treasury bills are perceived as low-risk and can payrecurring yields to coin holders.

However, due to current regulations, certain yield-bearing crypto assets are only available outside the United States.

The Ondo US Dollar Yield Token (USDY) is available outside the United States and other restricted jurisdictions. It holds short-term US Treasuries under control agree, and its variable yield that adjusts monthly.

US investors may consider US Yield Coin (USYC), founded by Hashnote and acquired by Circle in 2025. It will integrate with the USDC stablecoin to serve as yield-bearing collateral.

Top 10 Stablecoins by Market Cap

Coin	Symbol	Price	Market Cap
Tether	USDT	$1	$138 billion
USD Coin	USDC	$1	$52 billion
Ethena USDe	USDe	$1	$5.7 billion
Dai	DAI	$1	$5.3 billion
First Digital USD	FUSD	$1	$1.8 billion
Usual USD	USD0	$1	$1.23 billion
USDD	USDD	$1	$753 million
Frax	FRAX	$1	$647 million
PayPal USD	PYUSD	$1	$498 million
TrueUSD	TUSD	$1	$494 million

Stablecoin Regulations

Cryptocurrency regulations differ by country and constantly change as the industry evolves.

Lawmakers develop a consistent framework to protect investors and makers from exchange or token failures and crypto scams.

Typically, you acquire stablecoins from a centralized crypto exchange with Know Your Customer (KYC) and Anti-Money Laundering (AML) compliance.

The platform verifies your state of residence to determine your investment options and monitor for potential fraud.

United States Regulations

United States investors should pay attention to federal branches, including:

• Presidential policy: The Trump Administration is more crypto-friendly and a January 2025 executive order calls for regulatory clarity, encourages the development of dollar-backed stablecoins worldwide, and more.
• Securities and Exchange Commission (SEC): Launching a Crypto Task Force for a clear and comprehensive regulatory framework. The SEC lists the latest legal actions and news.
• Internal Revenue Service (IRS): The federal tax agency currently treats crypto assets as property, subject to short-term capital gains or long-term capital gains.

State governments are also implementing cryptocurrency, digital asset, and blockchain laws. These policies vary from state to state regarding qualifying investments, taxes, and custody.

International Regulations

Below are three examples of how different corners of the world treat stablecoins. As you will see, some nations are more flexible than others.

• European Union: The Markets in Crypto Assets Regulation (MiCA) only applies to centralized tokens. It spells out the collateral minimums and risk management requirements for different coin types.
• United Arab Emirates: One of the most crypto-friendly destinations, has its Payment Token Services Regulation. These regulations clarify the treatment of Dirham-backed stablecoins and those with a foreign currency peg.
• Japan: The Payment Services Act only allows stablecoins to be issued by banks and similar institutions. Bank-issued coins are treated as deposits and eligible for deposit insurance.

How to Invest in Stablecoins

You can buy stablecoins in trading and retirement accounts using your favorite crypto trading platform.

1. Choose an exchange: Decide between a centralized exchange like Coinbase, Kraken, or Gemini, which may offer many investment options. You may prefer a decentralized exchange to trade directly with peers using blockchain technology.
2. Open an account: It only takes a few minutes to join an exchange and fund your portfolio.
3. Research stablecoins: Most likely, there are several tokens to choose from. While the trading prices are similar, perform your due diligence by researching the stablecoin history, collateral pools, and potential rewards and risks.
4. Purchase coins: Fund your transaction with unfunded cash or by converting existing crypto positions into stablecoins.
5. Earn income: Keeping your coins on the exchange may allow you to earn recurring staking rewards as you provide liquidity for various transactions. Most exchanges offer secure storage methods to prevent losing your private keys. 
6. Consider offline storage: Depending on your investment strategy, you may move your tokens to a hardware wallet for optimal security. This move can require sacrificing interest income, but you gain the versatility to deposit on other exchanges.

Should I own any stablecoins?

Stablecoins deserve a spot in most crypto portfolios as a store of wealth, a risk hedge between trades, or a way to weather a market crash.

They also provide price stability for crypto-based transactions and more flexibility than traditional finance.

Earning interest on your holdings is also enticing. However, most long-term crypto investors will still want to focus mainly on Bitcoin and its alternatives for more upside potential. 

Position sizing is critical to optimizing your portfolio for growth by trading tokens with increasing value.

Consider allocating a small percentage of stablecoins to avoid excessive investment losses and earn rewards on your staked holdings.

FAQ’s