Meta Description: Stablecoins are important for the cryptocurrency ecosystem because they introduce stability and value that are unique in the field of other cryptocurrencies
One of the key elements which characterize the cryptocurrency market is volatility. Sometimes, depending on their investors' perception or the social media frenzy that may be going around them at the time, the prices of the cryptocurrencies swing dramatically.
The demand for cryptocurrencies has been driven by the fears of missing out and the greed of investors looking for the next big thing that will do to them what Bitcoin and XRP did—XRP went up 38,000% in one year—and by price dislocations caused by off-market "whale" trades or social media hype and manipulative activity.
What is a stablecoin?
It's hard to invest when you're expected to choose a winner from a possible field of more than 23,000 different cryptocurrencies. It makes traders and investors either wait for a very long time for their coins to attain or regain value or sell them against fiat money the moment they start to lose value and sell faster than others—including probably some who have shorted the cryptocurrency in question while driving up the price.
Because, of course, if people wanted something that was safe and that didn't need to be converted back into fiat money and to pay fees every time they did, something different was needed from all the original volatile cryptocurrencies. It brought about the development of a new form of cryptocurrency called a stablecoin, which would not fluctuate much of its value in the least.
The word stablecoin suggests the major characteristic of the coin's not fluctuating in value very much. For some people, indeed, these cryptocurrencies should have been labeled as "pegged coins" because they are priced in US or other dollars, pounds, euros, or alternatively gold or silver.
The rise of stablecoins
As indicated above, stablecoins are a kind of digital currency that serves as a link between the crypto and the physical fiat money; as such, their value is pegged to a particular asset, say the US dollar or gold. In that respect, it would simply be much more stable than usual cryptocurrencies like Bitcoin, Ethereum, XRP, and Solana. Stablecoins have been designed for everyday transactions, more so with cross-border payments, which could be done efficiently at low costs.
Stablecoins, like earlier cryptocurrencies, still use distributed ledgers, aka blockchains, to record and verify payments, thereby avoiding centralized institutions like banks and exchanges. Stablecoins are designed to be far less price-volatile than the "unpegged" earlier cryptocurrency types, which are about ten times more volatile than major national currencies. The largest remaining stablecoin is Tether, which was launched in 2014 and which sees $20-$40 billion in daily volume.
Remaining stable
Like fiat money, central banks and other authorities help keep the price stable. Stablecoins rely on reserves like fiat money—most prefer the US dollar due to the stability of the US Federal Reserve and the good credit rating—and commodities or other physical assets, such as gold.
There are a variety of different types of stablecoins
Algorithm-backed stablecoin
These are the most advanced among the stablecoins, having smart contracts and algorithms that will aid in price stability. Algorithmic stablecoin can be paired with any fiat currency, including the Euro and US Dollar, but also a real asset like gold.
In the case when the price of an asset/fiat money goes up, linked to which this is, then the algorithm removes tokens from the market—that is, it burns coins—so there are fewer tokens for the same value, hence its price increases. And the other way around, mint extra coins so that their prices would not go above the desired value of the asset to which the algorithmic coins are pegged.
There have been some cases where algorithmically-pegged stablecoins got fully unpegged, then lost nearly all their value and never recovered.
Currency or commodity-backed stablecoin
These stablecoins are designed to be issued and backed one-to-one with the underlying currency or commodity. Theoretically, if the protocol contains USD100, then it will issue 100 coins. To convert the reserves of a stablecoin into cash, some of the underlying funds are invested in fixed-income securities that ensure the funds can be redeemed and sustained. Such assets include short-term corporate debt and government-backed debt.
Stablecoins achieve this through a variety of different strategies and technologies that are pegged to fiat currency, cryptocurrencies, commodities, or algorithmic trading. When they cash out, issuers destroy their coins—essentially burning them—to return fiat money to investors.
Since these stablecoins often represent the USD—one coin equates to $1—the issuer should have, at a minimum, enough funds in their account to correspond with said coin supply.
Cryptocurrency-backed stablecoin
Stablecoins pegged to cryptocurrencies, are a basket of cryptocurrencies used as backing, with their value derived from the stablecoin. The creation, also the printing of these stablecoins, is sometimes backed by a basket of cryptocurrencies, which are always overly collateralized to accommodate volatility.
Fiat-backed stablecoin
The most invested-in are the fiat money-backed stablecoins, with the largest being Tether, USDC, and Binance USD. Creators of stablecoins mint their coins and then prove that they have enough money to back each coin with enough assets to maintain the value of that coin against the fiat money it is pegged to—usually US$. Of course, for them to be trusted and their coin to remain reliable, the creators of stablecoins should know how much money they have.
Commodity-backed stablecoin
A lot of these stablecoins will be pegged to commodities like gold, platinum, palladium, or even silver, which act as reserves to give value and stability to these coins. These include commodity stablecoins such as PAX Gold and Silver Token.
Stability and caution
Stablecoins are important for the cryptocurrency ecosystem because they introduce stability and value that are unique in the field of other cryptocurrencies. Stablecoins preserve their value using several different approaches that make them appropriate for routine transactions, money transfers, and value storage: algorithms, collateralization, and decentralized governance.
The developed mechanisms, however, are far from perfect and bring potential risks and sensitivity to changes in the external market with them.
Safety first
Unlike conventional cryptocurrencies, stablecoins are pegged to some real-world asset like money or commodities. While offering much-needed stability to the table for transactions, their dependence on multiple mechanisms—like fiat backing, crypto reserves, algorithmic models—warrants vigilance.
These numerous types of stablecoins provide stability in the highly volatile environment of cryptocurrency, but they are not at all resistant to the market swings either. Stablecoins challenge the high volatility of cryptocurrencies by connecting digital assets with stability. They introduce a new asset and open up the possibility of new forms of digital payment that could fundamentally change banking as we know it.
The future
Although stablecoins promise very compelling benefits in terms of foreign exchange payments, issues about regulatory concerns, and possibly problems of scalability, along with the requirement of interoperability between FinTechs and the broader financial system in different markets, lie in their way.
As blockchain technology further matures and legal frameworks evolve, stablecoins and stablecoin regulation will be expected to grow very fast in playing a more important role in setting the future of digital assets and cross-border payments.
They offer a viable solution to the inefficiencies inherent in traditional cross-border payment systems. Stablecoins democratize access to financial services and drive global economic growth by offering speed, cost-effectiveness, transparency, accessibility, and price stability.
With the increasing usage and innovation that follow popular cryptocurrencies, stablecoins are prone to form part of the cornerstone of the digital economy and change the way we conduct our FX transactions for many years to come.
Frequently asked questions
What is a stablecoin?
Stablecoins are a class of cryptocurrencies designed to decrease the volatility of their price. Most of the time, they are pegged to some stable underlying asset that brings stability and predictability into their value, like fiat money, for instance—the US dollar or the euro—or even commodities like gold.
How does a stablecoin differ from a regular cryptocurrency, say, Bitcoin?
Unlike regular cryptocurrencies—which may swing in price quite significantly—stablecoins aim to maintain a stable value. It is achieved either by pegging the value to some stable asset or by computational processes balancing supply and demand.
How do fiat-collateralized stablecoins maintain their stability?
Fiat-backed stablecoins achieve their stability through the reservation of the appropriate fiat currency. In this regard, for example, stablecoins are issued equivalent to a reserve of fiat money held, so that it can guarantee users the convertibility of the stablecoin into its fiat equivalent.