Stablecoins are digital currencies with values tied to real-world assets such as the US dollar. They were developed in response to the price volatility of current cryptocurrencies like Bitcoin, whose usability as a payment mechanism is limited by rapid market value variations.
Stablecoins have become a critical component of Defi, or decentralized finance, a rising class of goods in which transactions may be completed without the involvement of a middleman like a bank or a broker. Tether and USD Coin, for example, are two of the cryptocurrency’s most valuable stablecoins.
What are stablecoins?
Stablecoins are a form of cryptocurrency designed to provide greater stability than other cryptocurrencies. Some are backed by a reserve of the asset they represent, while others rely on algorithms or other techniques to keep their values stable.
Other cryptocurrencies vs. stablecoins
All cryptocurrencies are built on the same blockchain technology, which allows for secure digital asset ownership. Cryptocurrencies are distributed over decentralized networks that employ encryption to protect them against forgery and fraud.
Most cryptocurrencies’ worth is primarily dictated by what the market will bear, and many individuals who acquire them do so in the hopes of seeing their value rise. Stablecoins, on the other hand, are intended to have little value fluctuation. You’re less likely to glance at cryptocurrency pricing the next week and realize that you’ve missed out on a significant gain if you spend a stablecoin linked to the value of a dollar.
How do they work?
Fiat cash (conventional currencies like the US dollars in your bank account), other cryptocurrencies, precious metals, and algorithmic functions are all used to underpin stablecoins. However, the source of a cryptocurrency’s support might have an impact on its risk level: For example, a fiat-backed stablecoin may be more stable since it is tied to a centralized financial system with a central authority figure (such as a central bank) that may intervene and control prices when values are turbulent. Because there is no governing agency monitoring what the stablecoin is anchored to, stablecoins that aren’t linked to centralized financial institutions, such as a bitcoin-backed stablecoin, may fluctuate dramatically and fast.
Fiat-backed stablecoins are defined as an IOU: you buy stablecoins with your dollars (or other fiat money) and then redeem them for your original currency later. Unlike other cryptos, which can have wildly fluctuating values, fiat-backed stablecoins strive for extremely low price swings. That’s not to claim stablecoins are completely risk-free; they’re still new, with a limited track record and unknown concerns, and should be approached with prudence. Coinbase, a cryptocurrency exchange, provides a fiat-backed stablecoin called USD coin, which can be traded for one US dollar at a 1:1 ratio.
Stablecoins that are crypto-backed are backed by other crypto assets. Because the underlying asset might be volatile, crypto-backed stablecoins are overcollateralized to protect the stability of the stablecoin. A $1 crypto-backed stablecoin, for example, maybe linked to a $2 underlying crypto asset, so if the underlying crypto loses value, the stablecoin has a built-in buffer and may remain at $1. These assets are less reliable than fiat-backed stablecoins, thus it is important to monitor the performance of the underlying crypto asset behind your stablecoin. Dai is a crypto-backed stablecoin that is linked to the US dollar and runs on the Ethereum network.
Algorithmic stablecoins are not backed by any asset, making them the most difficult to comprehend stablecoin. To protect the coin’s value from changing too much, these stablecoins employ a computer algorithm. If the price of an algorithmic stablecoin is tied to $1 USD, but the price of the stablecoin rises, the algorithm will automatically release additional tokens into the supply to bring the price down. If it goes below $1, the supply will be reduced, causing the price to rise again. The number of tokens you hold will fluctuate, but they will still show your ownership percentage. AMPL is an algorithmic stablecoin that its designer claim is better suited to manage demand shocks.
Are there any risks?
Despite the fact that stablecoins are less volatile than other types of cryptocurrency, they are still based on younger technology that may have unforeseen problems or weaknesses. And there’s always the possibility that you’ll misplace the private keys that grant you access to your bitcoin, whether due to a hack or human mistake.
Stablecoins, on the other hand, has been plagued by regulatory ambiguity. A study published by the Biden administration in November 2021 urged for increased government monitoring of stablecoins. While such adjustments may result in enhanced consumer safeguards, they may also have varying effects on various stablecoins or impose limits on coin holders.
Stablecoins are an important aspect of the crypto economy since they provide merchants and investors with a secure and trustworthy medium of exchange. Furthermore, stablecoins are an important part of bolstering the crypto economy, particularly when the market is down.