Cryptocurrency has been trying hard to catch up with fiat since its inception. The builders of the blockchain system believe that crypto can be an alternative to paper money. A lot of are going on in this regard. The biggest downside of crypto coin is its volatility. The market is just unpredictable. Bitcoin was worth pennies at one point. But today, its price has reached over $12,000. The same trajectory has been seen for other cryptocurrencies. Stablecoin is an attempt in this regard to address the volatility factor.
Stablecoin is a digital asset. It copies the stable value of fiat currency. They are a way of cheap transfer of value at a faster pace around the world. In short, stablecoins have good qualities of both crypto and fiat (like Euros and Dollars).
Bitcoin, ethereum, and other cryptocurrencies are extremely eruptive in value against fiat currencies. It makes the asset more unique in existence within the free market. Nevertheless, the day to day usability of crypto diminishes immensely.
Why is Stablecoin, stable?
Fiat currencies’ value depends on assets like Gold and other forex reserves. In the case of inflation, the value of fiat does not fluctuate much. Additionally, central banks take control of market moves to hold the value of currency within a certain range. Cryptocurrencies, on the other hand, aren’t pegged to any asset. They lack central authority as ‘decentralization’ is the key feature of crypto. Hence, the prices swing wildly overtime.
Stablecoins are pegged to fiat. Fiat acts as collateral. Therefore, the value of stablecoin remains stable.
Types of Stablecoins:
Stablecoins are divided into three categories based on their working mechanism. Here are the short explanations of these types:
It is the most common type of Stablecoin. Fiat directly backs it with a 1:1 ratio. In the tech community, it is also known as the fiat-collateralized coin. The science here is that a bank (or any other central authority) keeps fiat currency in reserve. It can then issue Stablecoins in accordance with that reserve.
For example, a reserve of one million US dollars can back the issuance of one million tokens. The users can employ them for exchange of value purposes. They work like other cryptocurrencies. Besides, you can exchange them for equivalent dollars at any time.
The trust issues are high regarding the issuer of Stablecoin. As a buyer, you cannot be sure whether the bank really has reserves to back the token. You have no way of investigating the matter either. So, go for an issuer with a good reputation and get reviews from other Stablecoin users as well.
This particular type of Stablecoin is backed by cryptocurrency. Crypto acts as a collateral reserve. However, as cryptocurrency is a volatile reserve, therefore, the number of reserves is higher for the issuance of a small number of Stablecoins. For instance, $1000 worth of crypto reserve backs issuance of $500 worth of tokens. This way a 50% jump in currency’s value has little impact on Stablecoins value. Additionally, monitoring of price moves can help in maintaining stability.
Smart Contracts are responsible for the issuance of crypto-backed Stablecoins. That is to say in order to get tokens a user has to lock its crypto into a contract. Subsequently, if he/she wants crypto back then they can exchange it for Stablecoins.
An example of crypto-collateralized Stablecoin is MakerDAO’s DAI. It is pegged against the US. dollar and allows the use of crypto as a reserve asset.
Algorithms and smart contracts manage the issuance of algorithmic Stablecoins. They are neither backed by crypto nor by fiat currency. The monetary policy for this type of token closely resembles that of central banks. The supply of tokens diminishes if the price falls below the pegged fiat’s price. Accordingly, if it surges in price in relation to fiat then new tokens enter into circulation.
The first step towards starting an algorithmic Stablecoins supply is creating a smart contract. The smart contract is then implemented on a decentralized platform. Subsequently, it runs on its own to issue currency just like banks printing currency notes.
Basecoin is an example of algorithmic Stablecoin. It is pegged to the US. dollar.
Stablecoins have the following advantages in the financial world.
- They are a source of value exchange in the financial arena. Cryptocurrencies are less usable in everyday transactions. Stablecoins resolve the issue with stability and predictability in price.
- Stablecoins bridge the gap between the traditional financial market and the cryptocurrency market. They provide the best of two worlds. With more stability in digital format, Stablecoins have the potential of surpassing government-issued currency.
- Trading in cryptocurrency is considered risky by many investors. The market is new and extremely volatile. However, with Stablecoins traders can hedge their portfolios. The risk diminishes when as a trader you keep value in a stable format. Besides, you can easily exchange Stablecoins for an equivalent amount of fiat at any time. So, the token is just a store of value. You can cash out whenever you want.
Stablecoins are an innovation in the crypto world. They have some downsides as well owing to the fact that technology is still new. The first limitation is that fiat-backed Stablecoin is largely dependent on a central authority for the issuance of tokens. Consequently, they are not as decentralized as other cryptocurrencies.
The second limitation is the ‘trust’ factor. For collateralized as well as algorithmic Stablecoins the issuing authority plays a wide role. However, buyers have no way of knowing whether the provider has assets in reserve to back tokens or not. Nonetheless, the issue will resolve as the Stablecoin technology matures in the real world.
Cryptocurrencies have gained ground as legitimate currency over the years. The ideal use of crypto is for the exchange of value. However, volatility and price jump has turned it into an asset for holding and trading. Stablecoins counter the volatility factor. They enhance the usability of digital currency. Hence crypto users can utilize this currency for the exchange of value in traditional.
Note: You can learn about decentralized finance (DEFI) and other blockchain technologies on our blog.