A “stablecoin” is a cryptocurrency whose value is tied to another asset class, such as a fiat currency or gold, in order to keep its price stable.
Government-issued national currencies are vital in keeping economies running because, despite inflation, shifting exchange rates, and other circumstances, the value of most of these currencies does not move much in the near term.
Hence, stablecoins are such digital currencies that aspire to be non-fluctuating assets akin to traditional currencies used to buy goods and services across borders.
Many investors are attracted to stablecoins because they provide the efficiency and transparency of cryptocurrencies while alleviating some of the volatility associated with these assets.
However, traders and investors should be aware that not all stablecoins are the same.
Moreover, as money cannot be generated out of thin air, a stablecoin is often backed by the value of an underlying asset or system.
hese stablecoins are kept by a centralized custodian and are collateralized by fiat currencies such as USD, EUR, or GBP.
This form of stablecoin was originally presented in 2014 when a company, Tether Limited, launched USDT, a dollar-backed cryptocurrency meant to trade on the global crypto market 24 hours a day, seven days a week.
Cash-collateralized stablecoins, like USDT, are often administered by a central operator that keeps track of their circulation and allows users to issue and redeem tokens in their custody.
In certain circumstances, these reserves are even inspected on a regular basis to guarantee that the number of tokens exchanged is comparable to the firm’s reserves.
USDT and USDC are two examples of fiat-collateralized stablecoins (pegged to the USD).
These stablecoins are backed by a commodity, such as precious metals like gold, oil, or real estate. These commodities may potentially gain in value in the future, providing an additional incentive for individuals to store and utilize these coins.
Digix Gold (DGX) is an ERC20 token backed by genuine gold reserves, with one DGX equaling one gram of gold.
Some stablecoins even utilize other cryptocurrencies as collateral, like Ether, from the Ethereum network – and bitcoin-backed stablecoins are also pretty common.
These assets often do not have a central administrator and instead rely on open software to allow debtors to lock crypto assets (hence collateralizing them) and produce fresh stablecoins in the shape of loans.
To accommodate for the volatility of the base cryptocurrency, these stablecoins sometimes are over-collateralized, which means that the deposit amount is generally a greater percentage of the stablecoin’s value.
Borrowers who want to reclaim their locked bitcoins must return them to the protocol and incur a charge.
The stablecoin supply cannot be changed by anybody in the network due to its architecture. Contracts are instead configured to react to fluctuations in the market pricing of the locked assets.
A good crypto-backed stablecoin example could be DAI, Havven, and BitUSD.
These are stablecoins that do not rely on collateral to ensure stability but instead rely on various computational techniques (algorithms) to keep the peg with fiat currencies.
So what keeps these stablecoins stable? Well, the stability of these stablecoins is controlled by smart contracts.
Rather than using cryptocurrency deposits or issuing and redeeming debt, the software underlying algorithmic stablecoins mechanically change the cryptocurrency’s supply when demand varies.
If demand exceeds the planned peg, the price of each stablecoin will rise, and the program will increase supply. In contrast, if demand is low, supply will be reduced.
Ampleforth and Yam are two examples of algorithmic stablecoins.
These coins, as the name suggests, combine the aforementioned techniques, for example, they can be largely algorithmic and partially crypto-collateralized OR partially fiat-collateralized and partially crypto-collateralized, and the list can go on and on
The DeFi (Decentralized Finance) ecosystem requires stablecoins due to the severe price volatility that cryptocurrencies experience. As a result, consumers and companies are dubious about crypto as a legitimate form of payment since the value of crypto might abruptly drop.
As a result, a stablecoin has a stronger possibility of becoming a worldwide currency and medium of exchange.
Therefore, stablecoins may be of interest to users since they provide all of the benefits of existing cryptocurrencies, such as efficiency and transparency, while guarding against price volatility.
Furthermore, they are borderless, programmable, and quick to transfer at a minimal cost, making them a useful alternative to traditional financial institutions.
In short, stablecoins were designed for our increasingly global economy, supposedly overcoming a few major difficulties that impede the flow of money. The top main reasons are;
Even experts find it difficult to choose which stablecoins to buy, trade, or even utilize for everyday transactions among the larger ecosystem of 16,000+ cryptocurrencies already accessible.
As with everything crypto, a constant balance must be struck between centralization and decentralization, stability and freedom, regulation and permissionless-ness.
For example, fiat-backed stablecoins are popular because they are as stable as the US dollar (USD) or other widely accepted currencies. However, by tying crypto to a federal currency, fiat-backed cryptos become a target for governmental regulation and become more centralized overall – a trade-off as compared to algorithmic stablecoins, the most decentralized alternative.
There’s also the question of what actually backs each currency. For example, not all USD-backed stablecoins (USDT and BUSD, to mention a few) are backed by an identical 1:1 dollar-to-crypto ratio. The contents of the reserves differ according to the entity behind the currency.
Therefore, consider the following questions while deciding which stablecoin is best and which is the safest stablecoin:
There are a few limitations to stablecoins to consider. Stablecoins have distinct pain points from other cryptocurrencies due to the way they are normally programmed.
If the reserves are kept with a bank or some third party, another risk is counterparty risk. This raises the question of whether the business has the collateral it claims to have.
In the worst-case situation, the reserves supporting a stablecoin may be inadequate to redeem every unit, thus undermining trust in the coin.
Cryptocurrencies were designed to take the position of intermediate corporations, which are normally trusted with a crypto user’s hard-earned money.
(Intermediaries are people having control over that money; for example, they can usually impede a transaction from happening. Some stablecoins re-introduce the option to halt transactions.)
Stablecoins of all kinds exist to make cryptocurrency relatively predictable. While predictable cryptocurrency may appear to be an oxymoron, stablecoins, as the name implies, were designed to counter crypto’s hallmark volatility and serve as a convenient method for crypto traders to sustain their fiat value without having to cash out of the market, as well as to enable users to pay for daily goods and services in crypto without all the budgeting fiasco.
Stablecoins enable a world in which digital payments are seamless and immediate, with no value loss.
Stablecoins, although being a relatively new asset class, have proven to be an important component of the DeFi ecosystem.
Stablecoins, with trading volumes in the hundreds of billions and market capitalizations in the billions, have the potential to become the foundation upon which future financial products and networks are constructed.
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