What are stablecoins and how do they work?

The main purpose of stablecoins is to act as a reliable bridge between the worlds of traditional finance and digital assets. They provide a way to hold or transfer value on a blockchain without the dramatic price swings common to other cryptocurrencies, making them a more practical option for everyday digital payments.

Key takeaways:

• Stable value: Stablecoins are designed to minimize price volatility by pegging their value to a stable reserve asset, most commonly a fiat currency like the U.S. dollar.
• Bridging finance: They serve as a crucial link between traditional financial systems and the world of digital currency.
• Practical uses: Their stability makes them useful for digital payments, international money transfers, and as a stable store of value within the crypto ecosystem.
• Not risk-free: While designed for stability, stablecoins carry risks, including the potential for the peg to break, regulatory changes, and lack of government insurance.

Table of contents

• Why stablecoins exist: Bridging traditional money and digital currency
• How stablecoins aim for stability and maintain their value
• Exploring the main types of stablecoins
• Practical ways you can use stablecoins today
• Understanding the benefits and important risks of stablecoins
• The evolving world of stablecoin regulation
• PayPal USD: PayPal’s stablecoin
• Frequently Asked Questions

Why stablecoins exist: Bridging traditional money and digital currency

To understand why stablecoins were created, it helps to look at the world of digital assets they grew out of. They were developed to solve one of the biggest challenges facing early cryptocurrencies: price volatility. Digital currencies like Bitcoin and Ethereum have values that can change dramatically because their prices are largely driven by market supply and demand.

This is where stablecoins come in. They were created to offer a different approach, focusing on stability rather than price speculation. By providing a digital asset with a predictable value, they aim to make cryptocurrency more useful for day-to-day financial activities.

How stablecoins aim for stability and maintain their value

The main way stablecoins can achieve stability is through a process called "pegging," which connects the stablecoin to real-world assets held in reserve, e.g., 1 U.S. Dollar = 1 stablecoin.

How stablecoins are backed

A stablecoin's value is backed by its reserve assets. This is typically done in one of two ways:

• Collateralization: This is the most common method. When a stablecoin is issued, an equivalent asset, like a U.S. dollar, is kept in a reserve. These reserves can be "off-chain" (like cash held in a bank) or "on-chain" (like another cryptocurrency). If a stablecoin owner wants to cash out, the issuer can redeem the stablecoin using those reserves.
• Algorithmic controls (a cautionary note): Some stablecoins have attempted to maintain their peg without collateral, using complex algorithms to control supply by creating or burning coins. These have proven to be extremely high-risk and have often failed. For this reason, well-regulated, fully backed stablecoins are generally considered a more reliable option.

Exploring the main types of stablecoins

Stablecoins are often categorized by the type of collateral that backs them.

• Fiat-backed stablecoins: These are a common type of coin. They are pegged to a government-issued currency, such as the U.S. dollar. PayPal’s own stablecoin, PayPal USD (PYUSD), is a fiat-backed stablecoin.
• Crypto-backed stablecoins: These are backed by a reserve of another cryptocurrency, like Ether. They are often over-collateralized to absorb the price volatility of the reserve asset.
• Commodity-backed stablecoins: These are pegged to the value of physical assets like gold or silver, with the reserves held in vaults.

Understanding the benefits and important risks of stablecoins

Like any financial product, stablecoins come with a mix of potential advantages and significant risks.

Potential advantages

• Stability: Their core benefit is providing a more predictable value compared to more volatile cryptocurrencies.
• Speed & efficiency: Transactions can be faster and more efficient than traditional banking systems.
• Transparency: Transactions are recorded on a public blockchain.

Risks of stablecoins

Stablecoins are not free from risk. They are not FDIC-insured or guaranteed by a government. It is crucial to understand the risks associated with stablecoins, as they can lead to substantial financial loss.

• Loss of peg (de-pegging): The most significant risk is that a stablecoin could lose its intended 1:1 peg to its reserve asset, leading to a direct loss in its expected stable value.
• Regulatory uncertainty: The regulatory landscape for stablecoins is still developing and subject to change across various jurisdictions. Future regulations could significantly impact their usability, value, or even their legality.
• Lack of deposit insurance: Unlike traditional bank accounts, which may be insured by government entities like the FDIC or NCUA, stablecoins are not government insured. This means there is no protection if the issuer fails or if the stablecoin's value collapses.
• Counterparty risk: Investing in stablecoins means you are trusting the issuer to properly manage and hold the reserve assets that back the stablecoin. If the issuer or the financial institution holding the collateral fails, is mismanaged, or engages in fraudulent activity, the stablecoin could become entirely worthless.
• Cybersecurity risks: Stablecoins, like other digital assets, are vulnerable to cybersecurity threats, including hacking, phishing, and theft of private keys. Losses due to such events are typically unrecoverable.
• Smart contract risks: For stablecoins that rely on smart contracts (especially algorithmic stablecoins or those deeply integrated into decentralized finance protocols), there is a risk of bugs, exploits, or failures within the underlying code, which could lead to significant losses.
• Fraud: The cryptocurrency space, including stablecoins, can be targeted by various fraudulent schemes, scams, and illicit activities, which can result in the complete loss of funds.

The evolving world of stablecoin regulation

As stablecoins have grown, so has the attention from governments and financial regulators. In the U.S. and abroad, lawmakers are working to create clear rules to ensure market integrity and protect consumers. The goal of these regulations is to make the ecosystem safer by requiring greater transparency about reserves and stronger protections against issuer failure.

PayPal USD: PayPal’s stablecoin

PayPal has its own stablecoin, PayPal USD (PYUSD),¹ backed by U.S. dollar reserves and cash equivalents. Eligible customers can use the PayPal app or website to buy, sell, hold, and transfer PYUSD directly from their account with PayPal.

PYUSD is designed to maintain a $1 USD value. You can use it use it as a funding source for checkout with crypto (converted to fiat at payment) at eligible online stores, send it to friends and family in the U.S., and convert it to other cryptocurrencies.²