Despite the fact that cryptocurrencies and the surrounding ecosystem provide enticing and maybe lucrative possibilities, many cryptocurrencies are extremely volatile. If you believe that the value of Bitcoin could increase ten times a year, you may hesitate to spend it. Similarly, borrowing a cryptocurrency that could decrease in value after you receive it might not be ideal. Transferring money between traditional financial systems and cryptocurrency networks can also be challenging and expensive.

All the challenges highlighted above are why stablecoins were created. The concept of stablecoins may seem contradictory to some because cryptocurrencies are commonly associated with volatility due to hype and speculation. However, stablecoins, as their name suggests, are designed to provide a haven from the turbulent nature of investing in cryptocurrencies.

Key Takeaways

• Stablecoins are a digital currency created to keep their value steady and consistent.
• Stablecoins are mainly utilized on DeFi platforms as a means for individuals to hold funds within the cryptocurrency ecosystem.
• Tangible assets support certain stablecoins, while others rely on algorithms or volatile cryptocurrencies.
• Occasionally, stablecoins may no longer match the value of the underlying asset they are pegged to.
• Traders can utilize stablecoins to keep their funds within the cryptocurrency ecosystem, offering stability during trading intervals or when the market experiences high volatility.

What is a Stablecoin?

A stablecoin refers to a particular kind of digital currency tied to an external asset, typically one with a stable value like a fiat currency or gold. Unlike many other cryptocurrencies that experience extreme price fluctuations, stablecoins provide a more reliable option for storing funds on the blockchain and enabling smooth transactions among individuals and organizations. To ensure stable value, stablecoins often establish a reserve of either a single asset or a collection of assets that support the stablecoin.

How Do Stablecoins Work?

Popular cryptocurrencies like Bitcoin (BTC) and Ether (ETH) are known for their high levels of price instability. Volatility indicates the level of uncertainty surrounding an asset’s value. When there is high volatility, the asset’s price can fluctuate dramatically in either direction. In contrast, low volatility suggests a relatively steady price. Volatility is often measured by analyzing the asset’s daily returns in percentage points (pips).

Even the most widely recognized cryptocurrencies can experience price swings of more than 10% during turbulent market conditions, which impacts their usefulness as a medium of exchange.

In contrast, stablecoins are designed to maintain a stable value, making them reliable stores of wealth and encouraging their use in everyday transactions. Stablecoins also enhance the mobility of cryptocurrencies within the ecosystem. Holders of stablecoins and traditional fiat currencies can trust that the purchasing power of their holdings will remain consistent over short periods, allowing them to make purchases of goods and services. 

As said before, stablecoins set themselves apart by using blockchain technology. Stablecoins often have reserves maintained in the same fiat currency or an equivalent highly liquid investment as their backing. However, stablecoins are supported by gold as well. Stablecoins are anchored to their underlying assets in a variety of ways. Four of them are discussed below:

• Traditional collateralized: These stablecoins are supported by a one-to-one ratio of the underlying asset. For instance, Tether, the largest stablecoin in circulation, claims to hold one US dollar for every USDT issued.
• Crypto-collateralized: These stablecoins are backed by other cryptocurrencies and are typically overcollateralized to account for volatility. For example, a buyer may need to deposit 1,000 ether to purchase 500 DAI.
• Commodity-collateralized: These stablecoins are backed by assets like gold, which have gained popularity, especially after Russia invaded Ukraine.
• Algorithms are used to control the circulating supply of algorithmic stablecoins like UST. The algorithm changes the quantity in circulation up or down to maintain balance anytime the market price is different from the value of the actual asset.

Stablecoins Vs. Traditional Cryptocurrencies

Why are Stablecoins Important to Cryptocurrency?

Given that they meet the requirement for security in dealings with money using cryptocurrencies, stablecoins have grown to be a crucial component of the crypto ecosystem. They allow customers to use cryptocurrencies to buy financial goods like mortgages and specific insurance policies that require excellent reliability. This creates new possibilities and increases the range of available financial products for cryptocurrencies beyond conventional fiat currencies.

Compared to traditional assets like securities, shares, and currencies, cryptocurrencies are recognized for their high volatility. Because of this volatility, predicting and relying on the price of a digital currency over the short or long haul is difficult. As a result, financial transactions requiring a steady value over time, such as real estate sales, are less appropriate for cryptocurrencies.

Stablecoins were created to meet this need and contribute significantly to the cryptocurrency economy. They maintain the advantages of cryptocurrencies while providing the stability, long-term purchasing power, and predictability of fiat currencies. These benefits can include quick and simple foreign currency transactions devoid of the astronomical costs imposed by banks.

How are Most Stablecoins Used?

Stablecoins are undergoing advancements and changes. However, two prominent use cases have gained widespread adoption:

• Facilitating cryptocurrency trades: Traders commonly employ stablecoins to streamline transactions between cryptocurrencies. Rather than selling one cryptocurrency for cash and then using that cash to purchase another cryptocurrency, traders can utilize stablecoins as a convenient intermediary.
• Enabling purchases of goods and services within blockchain networks: When buying digital goods in virtual marketplaces, the fluctuating value of cryptocurrencies poses challenges. Stablecoins offer a solution by providing a stable value for seamless transactions.

Although stablecoins share similarities with cash, they are not the same thing. While it is possible to convert cash into stablecoins and vice versa, stablecoins cannot fully replace the functionality of physical cash.

Stablecoin Use Cases

As people become more familiar with stablecoin technology, various use cases are emerging, showcasing the versatility of this innovation. These applications are not limited to  trading, lending, escrow services, financial access, and payroll. However, in this piece, we will focus on the primary use cases related to payments:

• Payment transactions with stablecoins: Using stablecoins for payments has become a prominent use case, as businesses that accept stablecoin payments can enjoy lower transaction fees. By accepting stablecoins, companies can bypass the typical 2% to 3% processing fees imposed by financial institutions for fiat transactions.
• Settlements with stablecoins: Stablecoin settlements offer a significant advantage for entities operating around the clock. Since stablecoin transactions occur on the blockchain, which operates 24/7, near-instant global settlements become possible. In contrast, fiat settlements are limited to banking hours or the business hours of centralized financial institutions.
• Remittances with stablecoins: Stablecoins serve as a valuable solution for global payments and remittances, particularly for individuals who greatly benefit from price stability, such as overseas workers. Traditional off-chain remittance services often charge high fees for international money transfers, posing challenges for these workers when sending funds back home to their loved ones.

What Differentiates Stablecoins From Cash?

Stablecoins differ from traditional currencies because they are not issued or regulated by central banks or governments. Instead, they are privately issued cryptocurrencies.

• It’s important to note that stablecoins are not universally recognized as “legal tender” in most countries. Even if a stablecoin’s value is pegged to a specific currency, it may not be accepted as a valid form of payment by government or commercial entities.
• Another crucial aspect to consider is that not all stablecoins are backed by the currency they are pegged to. This can have significant implications. For example, TerraUSD (UST) aimed to maintain a one-to-one peg with the U.S. dollar but did not have actual dollar reserves backing it. Instead, it relied on an algorithmic formula, and another cryptocurrency called Terra (LUNA), which would adjust its supply through algorithmic processes (“mint and burn”) to keep UST pegged at $1 theoretically. This approach worked initially but faced a setback. In May 2022, UST experienced a crash, with its price plummeting to less than one U.S. penny.

Why are Stablecoins Growing in Popularity?

Even before the pandemic, the appeal of digital cash for payments was steadily increasing. Now, after nearly two years of navigating ever-changing regulations in the physical realm, the popularity of online purchases using digital currency has soared. However, this surge has led to many disparate digital money options that lack seamless compatibility. For instance, consider having a balance in Venmo denominated in USD.

It becomes less useful if others are not using Venmo. This is where stablecoins come into play, offering an alternative solution. They provide a unified form of digital currency that can seamlessly traverse different payment systems, regardless of the platform you wish to use for payment. Stablecoins also bring additional advantages, such as faster and more cost-effective cross-border transactions, among other benefits.

How Do Stablecoins Make Money?

Different strategies are used by stablecoin issuers to earn money. The simplest strategy entails levies for issuance and redemption. Nevertheless, depending on the kind of stablecoin, different income generating tactics may be used. In their quest for profits, centralized issuers frequently worry about the transparency of their reserves. This disadvantage is related to the centralized paradigm since holders of these stablecoins run the risk of doing business with a certain counterparty.

By placing their dollar reserves in higher-yielding asset classes, centralized stablecoins make money. Decentralized stablecoins, on the other hand, offer a variety of income schemes that differ according to the protocol. In this case, they may offer voting authority over the stablecoin’s future through the sale of governance tokens, or they might let users earn interest by placing money in blockchain-based smart contracts.

However, the stablecoin issuer faces risks as a result of these investing techniques. They must carefully weigh their options while taking into account the trade-offs associated with them.

Are Stablecoins Regulated?

There is a lack of clear regulation surrounding the stablecoins currently in circulation. The collapse of Terra serves as a reminder of the necessity for regulations that define stablecoins and establish criteria for reference assets while ensuring adequate consumer protections. Many prominent financial regulators are actively contemplating the regulation of stablecoins and the wider crypto asset ecosystem. However, until regulatory authorities provide clear guidelines, consumers should be aware of cryptocurrency’s heightened risks.

How Do Stablecoins Help as a Hedge Against Inflation?

Inflation is a common concern for traditional fiat currencies, especially in developing nations. Conversely, currencies like the US dollar or the euro tend to be more resilient against inflation. Stablecoins, such as Tether and USDC, are designed to maintain a fixed value pegged to the US dollar, making them an effective safeguard against inflation. For instance, individuals can convert their money into stablecoins, which exposes them to the US dollar’s stability and helps preserve the value of their funds.

Consequently, stablecoins provide users with an opportunity to access the realms of global financial prosperity. Anyone with internet access can utilize stablecoins for their daily transactions, enabling them to engage in cross-border payments and participate in the global economy.

Final Thoughts on How Stablecoins Work

Stablecoins hold significant weight within the crypto economy as they address the need for value preservation and price stability in a blockchain setting where digitized cash, which lacks decentralization, might not receive widespread recognition. While all stablecoins strive to maintain a fixed ratio to a specific fiat currency, the stability of their pegs depends on the assets held as collateral.

By utilizing stablecoins, individuals and institutions can remain active in crypto while mitigating the risks typically associated with volatile cryptocurrencies. Stablecoins provide a secure bridge, allowing users to participate in the crypto world without exposing themselves to the common risks in the crypto market.