Cryptocurrencies have yet to reach mainstream adoption, but one part of the market that has seen substantial growth are stablecoins.
Stablecoins refer to a range of cryptocurrencies that derive their market value from some external reference. It essentially means that unlike fiat money, they are backed by a reserve asset like gold or fiat currencies. Stablecoins don’t have the wild volatility associated with other crypto assets such as Bitcoin.
Because they are designed to maintain a steady price, stablecoins have become a major source of liquidity in cryptocurrency markets. They are used by traders and investors to buy other cryptocurrencies on exchanges that don’t accept fiat currencies, and as a place to park funds when other cryptocurrency assets are experiencing big price swings.
They can be categorized on the basis of their working mechanisms: crypto-collaterized, fiat-collaterized and commodity-collaterized stablecoins.
Why Is There a Need for Stablecoins?
Cryptocurrencies are not conventional assets and some countries still consider these as illegal investments. Hence, cryptocurrencies are highly volatile assets. Short-term volatility renders cryptocurrencies unsuitable for everyday use by retail investors or non-experts.
Cryptocurrencies are not just any asset class but currencies. They must be a store of value, which implies that their value must be stable over a long period. An investor needs to be sure that the purchasing power of a currency will appreciate or remain stable in the future.
The value of fiat currency is guaranteed by the government and can only be issued by the central bank of the country. Their value is often pegged to other assets, such as forex reserves, or commodities, such as gold, which can act as collateral for lenders. It is why, in general, sovereign currency dominated government debt is considered to be the safest asset.
But cryptocurrencies are not issued by the state hence they cannot be controlled by authorities or institutions like banks.
To control the inflationary tendency of cryptocurrencies, users must be convinced to spend the tokens instead of saving them. Stablecoins enable us to bridge this gap between the stability of fiat currency versus cryptocurrency. Stablecoins are supposed to remedy the volatility issues, by providing the much-needed stability. As digital currency, stablecoins can be used to make payments across the world and have the potential to serve this huge unbanked and underbanked population.
Stablecoins can be categorized on the bases of their working mechanisms:
These are the most common type of stablecoins. Fiat-collateralized stablecoins are backed by sovereign currency such as the British pound or the US dollar and usually pegged at a 1:1 ratio. It means that to issue a certain number of tokens of a given cryptocurrency, the issuer must offer dollar reserves worth the same amount as collateral.
The most popular fiat-collaterize stablecoin is Tether. It is collateralized 1:1 with the U.S. Dollar, so 1 Tether is equal to $1.
The drawback of fiat-collateralized stablecoins is that they are not transparent or auditable by everyone. Therefore, users require trust in the operator to trade in these currencies, since there is no way to inspect whether the exchanges are following protocol or not. They limit the true potential of cryptocurrencies since they essentially act only as proxies for fiat currencies.
The value of crypto-collateralized stablecoins is pegged to that of other cryptocurrencies. Since everything occurs on the blockchain, these currencies are much more transparent, have open source codes, and can be operated in a decentralized manner, unlike their fiat-backed counterparts. However, they are also more complex to understand, and therefore lack popularity.
The most popular crypto-backed stablecoin is Dai, created by MakerDAO, whose face value is pegged to the U.S. dollar, but is collateralized by Ethereum.
These are stablecoins that are backed by stable assets, like precious metals, gold, real estate, and oil. This theoretically indicates to investors that these stablecoins have the potential to appreciate in value concurrent with the increase in value of their underlying assets, thereby providing an increased incentive to hold and use these coins.
An example of commodity-collaterized stablecoin is Digix Gold (DGX). It is backed by physical gold where 1 DGX represents 1 gram of gold.
How Are Stablecoins Used?
Stablecoins are most popularly used to quickly switch between a volatile cryptocurrency and a stablecoin, while trading, to protect the value of holdings.
The main purpose is for stablecoins to be widely used as currency for daily transactions in the future. Stablecoins allow for the use of smart financial contracts that are enforceable over time.
In the event of a local fiat currency crashing, people can easily exchange their savings with USD-backed or Euro-backed or even gold-backed stablecoins, thereby preventing the further depreciation of their savings.
Stablecoins are expected to pave the way for cryptocurrencies to become mainstream. Moreover, with a huge unbanked and underbanked population globally, and people and businesses looking for faster, easier, and cheaper ways of sending payments across borders, stablecoins have huge potential for growth. Yet, it is still early to tell, this type of digital asset is worth exploring.