Blockchain has the capability to disrupt every industry. This innovative technology aims to create a new payment system for the world ensuring complete transparency, faster transactions, decentralized, and using cryptocurrencies. However, the value of cryptocurrencies is highly volatile and fluctuates on a daily basis. Bitcoin and Ethereum are two dominant cryptocurrencies with lots of speculation, which further fuels the volatility. In the long run, this can hinder the adoption of cryptocurrencies, especially since businesses shy away from unnecessary currency risk. It is difficult to pay salaries for your team in Bitcoin if its purchasing power is constantly fluctuating. This makes it tough to transact with in many cases. The volatility also hinders blockchain-based loans, prediction markets and other financial aspects that require a certain level of price stability.
Above all, there are users who want to simply store and use their crypto coins to buy things, on a censorship-resistant ledger, without the worries of a local bank or a collapsing economy.
The demand for a price-stable crypto coin has been in the air for a long time. Building a stablecoin is thus considered the holy grail of the cryptocurrency ecosystem.
Reasons for Price Stability
The two main reasons for the price stability of fiat currencies are the backing from reserves and timely market actions from authorities such as the Federal Reserve. The fiat currencies are pegged to assets like gold or forex which serve as collateral, they are free from wild valuation swings in the market.
Even in extreme cases where the valuation may experience a drastic move, there are always controlling authorities who manage the demand and supply of the currency to maintain stability. Major cryptocurrencies lack these two features — they aren’t backed by a reserve and don’t have an authority which can control the prices as and when required.
Stablecoins attempts to bridge this gap between fiat currencies and cryptocurrencies.
What is Stablecoin?
It is a price-stable cryptocurrency whose market price is pegged to another stable asset like the US Dollar, gold or the Euro. Stablecoins were invented to be used just like cryptocurrencies — simple, stable, scalable, and secure means for transactions. Because most businesses wouldn’t want to accept money in a cryptocurrency that might lose its value considerably the next day.
Stablecoins are a form of digital money that mimic traditional currencies, and they are collateralized to the value of an underlying asset. They were introduced in 2018 and have gained popularity all over the globe.
Currently, there’s a stablecoin invasion happening with more than 57 coins already released and many more in the pipeline.
Types of Stablecoins
In a broad category, stablecoins can be identified into three distinct types:
1. Centralized Stablecoins — Backed by Fiat
This is the most popular kind of stablecoin, which is directly backed by a fiat currency in a 1:1 ratio. Also known as fiat collateralized coins, they are launched by a central organization, like a company, bank, or even a government. Some examples include Tether (USDT), USD Coin (USDC), and Gemini USD (GUSD).
2. Decentralized Stablecoins — Backed by Crypto
This is a new type of stablecoins that aren’t backed by a central operator but they are governed by a consensus of people who are a part of the network. Cryptocurrency is used as collateral in crypto-backed stablecoins. This means that you’re not trusting one person, but the entire network participants that act in the best interest of users. DAI is a decentralized stablecoin by Maker DAO and its value is pegged to the US Dollar 1:1.
3. Decentralized Algorithm Stablecoins
These stablecoins rely on algorithms and smart contracts to make sure that their price remains stable. They don’t have any collateral backing their system. The monetary policy of these coins is similar to the functionality used by central banks to manage national currencies. Some examples of algorithm stablecoins include Ampleforth, and Carbon.
Pros and Cons of Stablecoins
The biggest benefit of stablecoins is that they offer a medium of exchange that complements cryptocurrencies. Currently, crypto adoption is facing trouble in everyday use because of their volatility. Stablecoins offer higher stability and predictability, solving this ongoing challenge.
Plus, as a safeguard against volatility, stablecoins can integrate cryptocurrencies with traditional financial markets. Although these two markets exist in separate ecosystems with hardly any interaction, there might be a disruption with the introduction of stablecoins. It’s also likely that stablecoins will see a higher usage in credit markets and loans — the industry that is dominated by fiat currencies up until now.
Stablecoins can also be used by investors to hedge their portfolios to reduce overall risk. Furthermore, it can be an effective strategy to use a maintained store of value while you’re buying other cryptocurrencies whose prices have dropped.
Although stablecoins have the potential to support the adoption of cryptocurrencies on a wider level, they still have a few limitations. For instance, the fiat-collateralized variants aren’t as decentralized as the regular cryptocurrencies because there’s a need for a central entity to hold the assets. In case of the crypto-collateralized or uncollateralized stablecoins, the user needs to place trust in the community and source code for the longevity of the ecosystem. Since these are new technologies, they might take some time to mature.
Looking Ahead Towards Stability
There’s no doubt that stablecoins will have a place in the crypto space. They offer a promising bridge between cryptocurrencies and the real world of fiat. They are also a great storage space for investors or traders to find a temporary escape from the high volatility of cryptocurrency markets.
The value and stability that stablecoins bring to an individual and a business all around the globe can be disruptive in this digital currency ecosystem and also help to address real economic challenges.