In the crypto market, Stablecoins have emerged as a popular type of cryptocurrency that provides stability and bridges traditional financial markets with decentralized digital assets. Stablecoins act as a medium of exchange between crypto and fiat currencies while eliminating the risk of high volatility. In this article, we will do an in-depth overview of what Stablecoins are, how they work, and what advantages they offer to an individual trader.
What are Stablecoins?
Stablecoins refer to a type of cryptocurrency that is built on top of blockchain technology, similar to any other decentralized crypto, however, their value is pegged to another asset. This asset can be anything from fiat currencies like US Dollars, EUR, and GBP, to a physical asset, like gold. Unlike cryptocurrencies like Ethereum, Bitcoin, and XRP, which act as volatile assets and whose prices can dramatically change, Stablecoins are designed to maintain their value, making them suitable as a medium of exchange and for financial transactions.
Types of Stablecoins
However, it is worth noting that fiat-backed stablecoins aren’t normally issued by central banks or government regulatory bodies. Instead, they are managed by independent companies, and their values can go de-pegged in case of instability reserves held by the firm. However, there is no need to worry because these reserves are regularly audited by third-party platforms to ensure the integrity of the firm.
Some benefits offered by fiat-backed stablecoins include:
- Can be exchanged with underlying fiat currencies through P2P exchanges with ease
- Provide stability against market volatility
- Reserves are regularly audited to ensure the transparency and legitimacy of their operations
- Are widely accepted and can be used for financial transactions, such as paying for goods and services
Crypto-backed stablecoins also exist because of interoperability issues faced by blockchain networks. For those who don’t know about interoperability, it refers to blockchain networks’ ability to interact with another third-party blockchain network.
For example, currently, it’s not possible for users on the Ethereum network to directly interact with Binance Smart Chain and conduct transactions simultaneously. To tackle this interoperability issue, developers on different blockchain networks launch stablecoins pegged to cryptocurrencies usually held in smart contracts on a decentralized platform. To maintain the value of stablecoins, an equal amount of reserves are held in blockchain, pretty much similar to ETFs in traditional markets like Stocks and Forex.
Such types of stablecoins aren’t directly backed by another asset. Instead, the value of Algorithmic Stablecoins is maintained and regulated while relying on smart contracts and algorithms based on the supply and demand of cryptocurrency without direct collateralization.
Advantages of Stablecoins
The stability of price against the volatility associated with traditional cryptocurrencies is one of the key advantages that make Stablecoins a reliable digital assets as a store of value.
Fast and Borderless Transactions
Thanks to smart contracts and blockchain technology utilized by Stablecoins, users can make fast and borderless transactions by eliminating the need for intermediaries, reducing transaction costs and validation time, as no manual assistance is required.
Stablecoins have the potential to provide financial inclusion. They act as a medium of exchange, allowing unbanked and underbanked people to access financial services, from digital payments to insurance, lending, and borrowing, without requiring any financial background.
Popular Stablecoins in the Market
Launched in 2014, by Tether Limited Inc., USDT is one of the earliest stablecoins introduced in the crypto industry. The value of Tether is pegged to the US Dollar and is widely used across decentralized and centralized exchanges in the cryptocurrency market.
USD Coin (USDC)
USDC is another stablecoin pegged to USD, created by a centralized company called CENTRE, an organization jointly founded by the popular crypto exchange, Coinbase, and Peer-2-Peer payment network, CIRCLE. The idea of the creation of USDC was first revealed in May 2018, however, it was later launched in September of that same year.
Pegged to the US Dollar at 1:1 ratio, TrueUSD is a Stablecoin fully backed by multiple companies and collateral reserved in escrow. It was initially launched on 5th March 2018 and became one of the largest Stablecoins because of its features like transparency and security.
Initially formed by the Maker Foundation and launched on Maker Protocol in late 2017, DAI is a cryptocurrency-backed stablecoin. After some time, Maker Foundation transferred the control of DAI to MakerDAO, a popular decentralized autonomous organization.
Impact of Stablecoins on the Economy
Remittances and Cross-border Payments
Stablecoins backed by fiat currencies like the US Dollar and EURO can make it easier for users to transfer remittances and make cross-border transactions, thanks to blockchain technology and self-executing smart contracts that eliminate the need for middlemen to verify information. This reduces the cost and period required to validate transactions.
Decentralized Finance (DeFi) Applications
In decentralized finance applications, Stablecoins play crucial roles in facilitating to avail of services like lending, borrowing, and yield farming activities within decentralized ecosystems while avoiding high volatility.
Financial crises after COVID-19 are affecting people’s buying power, especially in second and third-class development countries like Pakistan, Venezuela, Turkey, Zimbabwe, and Sudan because of instability in their native currencies. Stablecoins provide an alternative store of value and a means of preserving wealth against hyperinflation.
Regulatory Challenges & Concerns
Lack of Clear Regulations
Stablecoins, especially fiat-backed ones, are often pegged at 1:1 with underlying assets and are managed by centralized independent companies. However, they operate in a regulatory gray area, with unclear guidelines and oversight frameworks.
Increased adoption of stablecoins also poses systemic risks and attracts hackers and malicious actors to take advantage of it if not managed properly. Although fiat-backed currencies go through independent regulator audits to tackle these issues, we believe it is important for regulators to monitor stablecoins to mitigate system risks and raise awareness among market participants.
Future of Stablecoins
Central Bank Digital Currencies (CBDCs)
Governments and central banks are exploring the possibility of developing CBDCs, also known as Central Bank Digital Currencies, which could coexist with stablecoins and enhance user experience. According to experts, CBDCs won’t affect Stablecoins’ growth because Central Bank Digital Currencies will be directly controlled by government authorities, while Stablecoins are instead operated in a decentralized manner.
Enhanced Privacy and Security Features
Blockchain developers are tirelessly working to enhance privacy and security features to address transaction privacy concerns and mitigate the risk of hacking and malicious attacks.
Interoperability and Cross-chain Integration
Stablecoins aim to become interoperable with cross-chain integration, enabling users across different blockchain networks to seamlessly make transactions and benefit from cross-chain improved liquidity.
In the end, I would say Stablecoin has a great future ahead with the continuous growth it has shown for the past few years and its utility as a financial instrument to tackle market volatility issues. In the future Stablecoins are likely to be integrated into traditional financial markets to address issues associated with transactional privacy and cost, which will play a vital role in increasing its adoption on a mainstream level.
Are stablecoins a form of cryptocurrency?
Yes, they are a type of crypto, but unlike other cryptocurrencies like Ethereum and Bitcoin, known for their volatility, Stablecoins are designed to maintain a stable value of an underlying asset, which can be anything from fiat-backed currencies to gold prices and more.
Can stablecoins be used for long-term investments?
While they do offer multiple advantages as a financial instrument and are often considered one of the best mediums of exchange, and store of value with stability in mind, they may not provide the same long-term investment potential as a traditional cryptocurrency.
Are stablecoins backed by real-world assets?
Yes, many stablecoins are often backed by real-world assets such as fiat currencies and gold.
How are stablecoins different from traditional cryptocurrencies like Bitcoin?
They are different from traditional cryptocurrencies like Bitcoin, Ethereum, and Litecoin in many ways. First, they aren't as volatile as other cryptocurrencies, and second, their values are often pegged to an underlying asset.
Are stablecoins regulated by governments?
Even though Stablecoins are usually offered by centralized firms, they aren't regulated by governments, in most cases, nor are they recognized as a financial asset.