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.
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.
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:
Can be extremely low
Similar to traditional currencies or assets like precious metals
Determined by the blockchain protocol
Medium of exchange unit of account and store of value
Some coins are seen as a store of value (e.g., Bitcoin), while others are seen as a medium of exchange.
Backed by algorithms or assets in reserves
Not backed by any commodity.
Degree of Authority
Most are controlled centrally.
Most aim to be decentralized.
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.
Stablecoins are undergoing advancements and changes. However, two prominent use cases have gained widespread adoption:
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.
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:
Stablecoins differ from traditional currencies because they are not issued or regulated by central banks or governments. Instead, they are privately issued cryptocurrencies.
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.
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.
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.
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.
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.