Crypto has greatly impacted the financial sector, revolutionizing and innovating in a rapidly-evolving space. Crypto trading has also shot to the top of investor radars thanks to the astronomical returns possible. However, they still remain unused in payments due to their volatility and price risk. Stablecoins are one potential solution to this problem.
What is Stablecoin?
Stablecoins are a type of crypto token that aims to provide stable prices. The goal of stablecoins is to reduce the volatility seen in other cryptos, making them more suitable for use as a medium of exchange and store of value.
Suppose you want to conduct a transaction in Bitcoin, where 1 BTC = $100. If you send a BTC to the receiver today, it is possible that its value can significantly reduce tomorrow, going to just $95 or $90. This is a risk most businesses do not want to take. Stablecoins alleviate this concern by ensuring each token will always be worth the same amount.
Types of Stablecoins
- These stablecoins maintain reserves of a fiat currency like the US Dollar or assets like gold and silver. They are used as collateral to guarantee that each token holds a 1:1 price with the underlying asset.
- Some examples of this type include Binance USD (BUSD) and USD Coin (USDC).
- These tokens are collateralized using other large crypto tokens. Typically, these tokens are overcollateralized to ensure that volatile crypto prices do not affect the token’s price.
- Examples include DAI, which is collateralized by Ethereum and other tokens up to 150% of the value of the tokens. This insures the stablecoin against a 50% decline in the collateral.
- Algorithmic stablecoins may not hold any assets in reserve. Instead, the value of the token is maintained by controlling the supply according to a set formula. If tokens are minted and burned according to the demand, then their price can be kept at a steady level.
- TerraUSD is an infamous example of this type of stablecoin, due to its sudden plunge in price on May 11, 2022. This removed its peg from the US Dollar and made the token unreliable.
How Do Stablecoins Work?
Maintaining Price Stability
The most essential task for stablecoins is to keep their price pegged at the required level. Any major deviation from this level makes the token seem unreliable for transactions or other financial use cases.
How they do this changes from project to project. Fiat-backed stablecoins maintain reserves of the asset they are backed by. If you want to acquire USDT tokens, you have to send US dollars to Tether’s accounts. In return, Tether sends you back USDT tokens.
Read more: USDT VS USDC
Crypto-backed stablecoins are different, in that you must deposit crypto tokens as collateral into the platform’s smart contracts. The smart contract then grants you stablecoins in return. Finally, algorithmic stablecoins do not have any reserves, so they manage supply and demand to maintain steady prices.
Issuers of stablecoins must prove to users that the reserves are sufficient to exchange tokens for USD or collateral. Reserves are thus held in publicly viewable smart contracts or with trusted third parties like financial institutions. The reserves are also audited by independent sources.
Advantages of Using Stablecoins
The primary benefit of stablecoins is that they eliminate or greatly reduce the volatility of crypto tokens. While this removes them from consideration as investments, it is a huge boon to their use in payments or financial applications.
Another advantage is that since stablecoins are not held as investments, they flow more freely in the market. Additionally, minting new tokens is a quick and easy process that sends them straight to your crypto wallet. Many can also be converted back into fiat currency or crypto collateral easily.
Use Cases for Stablecoins
What are stablecoins used for?
Payments and Transactions
Stablecoins finally make it easier for crypto tokens to be used in payments. Since the price does not fluctuate, businesses do not need to worry about their reserves falling in value. Higher usability and acceptance make stablecoins a compelling alternative to traditional modes of payment.
Trading and Hedging
Trying to use fiat currencies when trading crypto is an expensive and slow process. There is a huge fee associated with turning fiat into crypto and back again. Stablecoins greatly reduce the fees required, making the process much more streamlined.
Decentralized Finance (Defi)
Stablecoins are essential to the DeFi ecosystem. One of the most popular DeFi services is lending and borrowing, which are usually conducted using stablecoins. They can also be used as a means of payment on the platform, to ensure its earnings remain stable.
Risks and Challenges
Stablecoins are currently not regulated by any central authorities. Thus, you cannot fall back on government support if a stablecoin project fails, like TerraUSD or Luna. Additionally, one platform’s reports may be very different from another, as there is no standardized reporting mandated by an authority.
This is the risk that the stablecoin platform does not have sufficient reserves to return your collateral or convert tokens into USD. This can lead to an immediate collapse in prices and eliminate the main advantage of stablecoins. This risk is usually managed through the audits a platform undergoes to ensure that reserves match the coins in circulation.
Liquidity risk can arise when platforms cannot issue stablecoins fast enough to match the demand. This can be a hurdle in many transactions where you may need new coins and can cause delays in several processes. However, this risk is usually short-lived, as when the project catches up to demand all stablecoins are minted.
Potential Impact of Stablecoins
Stablecoins are a critical innovation in crypto, as they allow many use cases that were otherwise not viable. They form the backbone of the DeFi space, creating many more opportunities for trading and investment in the sector. Additionally, stablecoins make it easier to integrate crypto into our daily lives as there is no risk of volatility.
Future Developments and Advancements in Stablecoin Technology
The crypto industry continues to grow every day. Inevitably, innovations in stablecoin technology, along with new price stability measures will improve their usability and reduce risks. Additionally, better uptime on supporting systems can allow seamless minting of new tokens 24/7.
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FAQs on What Are Stablecoins
What is Meant by a Stable Coin?
A stablecoin is a type of crypto token that eliminates price volatility. This makes it easier to use in financial applications and payments. It is pegged to a fiat currency or commodity. Few stablecoins are also algorithmically driven.
Which Stablecoin is Best?
While it is difficult to declare one best stablecoin, some of the most used coins include Tether (USDT), USD Coin (USDC) and DAI.