Stablecoins, Their Purpose and Application in the World of Cryptocurrencies
The invention of the alternative decentralised monetary system called Bitcoin has caused a massive revolution in money perception and available money systems. Over the years, bitcoin and other cryptocurrencies have proven the perfect tool for preserving value when inflation in countries around the world has hit its all-time highs in the past few decades.
Besides protection against inflation, cryptocurrencies have introduced many innovations to the financial sector. For example, fast and cheap international transactions and the ability to interact with a world of decentralised finance in which funds are entirely under your control, and there is no need to share sensitive information with third parties.
Cryptocurrencies have proven to be a revolutionary invention that is gradually gaining more and more attention from investors. However, due to significantly higher volatility than traditional fiat currencies, prevails an opinion that keeping your wealth in cryptocurrencies is high risk and inefficient short term. Intraday price movements in the tens of percent up or down have caused volatility to become one of the biggest enemies of cryptocurrencies, indirectly preventing new investors from entering the market.
Stablecoins are the answer to addressing high volatility in the cryptocurrency ecosystem. It is an innovative asset class that has brought an essential combination of traditional and modern financial systems to the growing environment of cryptocurrencies. Stablecoins strive to offer the best of both worlds – fast, secure and cheap transactions and the price stability of conventional currencies.
What Are Stablecoins?
Stablecoins, like other cryptocurrencies, are based on blockchain technology, which uses cryptography and encryption to enable secure and decentralised ownership of digital assets. However, this specific type of asset differs from other cryptocurrencies. Their prices are tied to the values of traditional money and commodities, such as the US dollar, euro or gold. This makes it possible to use stablecoins for everyday transactions without having to worry about high volatility, which makes it difficult to use cryptocurrencies for everyday purposes.
Prior to the existence of stablecoins, there were no ways for investors to avoid high volatility in the cryptocurrency market. The creation of stablecoins pegged to traditional money has thus brought about a solution that, among other things, allows investors to preserve their wealth if they expect a decline in the value of assets.
The five largest stablecoins today include Tether (USDT), USD Coin (USDC), TerraUSD (UST), Binance USD (BUSD) and DAI. The cumulative market capitalisation of these stablecoins is more than $176.8 billion.
The basic functions of stablecoins in practice include:
- Fast and secure payments – Stablecoins allow you to send money quickly and cheaply without worrying about losses due to price changes.
- Volatility Elimination – Cryptocurrencies such as Bitcoin or Ethereum are prone to fundamental factors and innovations that can quickly drive the price of these assets up or down. In contrast, stablecoins provide investors with the certainty that the price of their assets will not significantly fluctuate under the influence of various factors.
- Interest collection – Through decentralised finance, there are many ways to collect interest for holding stablecoins. This interest rate is usually several times higher than interest rates in banks or other centralised institutions.
- International transactions – Through stablecoins, it is possible to make international payments in a few seconds without the need to interact with banks.
- Hedging – Stablecoins allow investors to avoid investment losses if they expect a significant decline in the cryptocurrency market.
Types of Stablecoins
The creation of a class of assets similar to traditional fiat currencies required introducing a certain tying mechanism, which ensures that the asset’s price will be as close as possible to the value of the underlying asset in the long run. Although there are several ways to achieve this goal, in practice, we usually encounter stablecoins pegged to other assets serving as collateral – tools to back the asset. Recently, algorithmic stablecoins have come to the fore, and their operation does not rely on coverage by other assets but a computer code. However, let’s step back and gradually introduce all types of stablecoins.
Stablecoins Backed by Fiat Currencies
Backing stablecoins with fiat money is based on maintaining coverage reserves depending on the nature of the stablecoin. If stablecoin is pegged to the US dollar, it is usually backed by US dollar reserves. For these stablecoins, each one-dollar token in circulation is backed by the dollar equivalent in reserves – either in cash or in money equivalents. The best-known assets in this category include the two largest stablecoins: Tether (USDT) and USD Coin (USDC).
Stablecoin reserves are maintained by central entities that regularly review their funds and work with regulators to ensure that stablecoin issuers continue to maintain and back them.
Anyone can send and receive stablecoins already in circulation, although the central entity that issues them may have the power to freeze stablecoins at suspicious addresses under specific conditions. Such a case occurred when Tether and Circle froze millions of dollars at addresses connected to illegal activities.
Stablecoins Backed by Crypto
This type of stablecoin uses other cryptocurrencies as collateral for its coverage. However, due to the volatile nature of cryptocurrencies, these stablecoins tend to be excessively collateralised to ensure that stablecoin retains a fixed value even at times of high volatility in the cryptocurrency market. Cryptocurrency-backed stablecoins are usually managed through a set of smart contracts that dynamically ensure the issuance and burning of new coins while providing a higher level of transparency.
Perhaps the most well-known stablecoin in this category is Dai, pegged to the US dollar and backed by the cryptocurrency Ethereum. If someone wants to issue a DAI worth $1,000, it is necessary to deposit the cryptocurrency Ethereum worth $1,500. If the investor wants his collateral back, he will simply put 1,000 DAI back into the protocol, and his collateral will be returned to him.
Price stabilisation of stablecoin DAI is achieved through price incentives. For example, if the DAI falls to $0.9, it creates incentives to repay the loan, reducing the DAI’s offer and bringing the price back to $1. The same is true for the opposite. Suppose the DAI price rises above $1, for example, to $1.05. Investors are then motivated to issue new DAI tokens and subsequently sell them on the secondary market, which increases their circulation, and the price stabilises back to $1.
This means that in the case of this stablecoin, there is no need to trust any central reserve manager, as the system is managed through arbitration incentives and smart contracts.
Presently, it is possible to borrow stablecoin DAI by inserting collateral not just in the cryptocurrency Ethereum but also in various other cryptocurrencies. The amount of the collateral varies dynamically with different cryptocurrencies, depending on the level of the collateralisation indicator.
Commodity-backed stablecoins are usually backed directly by the physical assets to which their price is pegged – be it gold, oil, or silver. In the ecosystem of cryptocurrencies, we usually encounter stablecoins backed by physical gold, such as Pax Gold (PAXG) or Tether Gold (XAUT). For this specific type of stablecoins, some volatility can be expected, as the prices of these assets usually copy the price of the underlying asset. In this case, their price is determined by the development of the cost of gold.
Commodity-backed stablecoins open the door to investing in commodities such as gold or silver without the need to purchase the physical asset and the need to resolve storage and availability issues. Furthermore, these stablecoins are usually traded 24 hours a day, seven a week, while traditional commodities can only be traded on trading days.
A stablecoin backed by a commodity can also be found in Fumbi. Our innovative Fumbi Bitcoin & Gold Index tracks the value of Bitcoin and PAX Gold so that your finances are split 50:50. The algorithm intelligently buys the cryptocurrency that has fallen and sells the one that has grown. Thanks to this combination, you can easily, and stress-free save for your future.
Algorithmic stablecoins, otherwise referred to as non-collateralised, have brought to the market a new and innovative approach to managing and ensuring the price stabilisation of these assets.
The price of these stablecoins isn’t based on assets but on algorithms that allow traders to issue and burn coins as needed to ensure that their price is fixed. The most popular algorithmic stablecoin is TerraUSD (UST), the third-largest stablecoin by market capitalisation, after USDT and USDC.
UST maintains its dollar value by motivating investors to issue or burn new USTs to maintain its stable price. This process works through interdependent UST pairing with a native Terra token named LUNA.
When the price of a UST falls below $1, traders can burn the UST and remove it from circulation in exchange for one dollar in the LUNA token. This reduces the supply of UST tokens, which pushes the prices up. Conversely, if the UST price exceeds more than one dollar, traders are motivated to burn the LUNA token in exchange for the UST token, increasing their supply in circulation, which pushes the prices down.
Algorithmic stablecoins have been gaining the attention of more and more investors in recent months, mainly due to their significantly higher decentralised nature compared to stablecoins covered by fiat currencies.
Sablecoins and DeFi
Following the boom in decentralised finance, stablecoins have become an integral part of the DeFi sector. Stablecoins allow investors to generate returns on their crypto assets in the DeFi market while mitigating the potential adverse effects of volatility.
Investors looking for higher returns than traditional fixed-rate investments – such as savings accounts, money market funds, or bonds – can digitise their funds and collect significantly higher interest rates on various DeFi and even centralised protocols.
Interest collection through decentralised finance works in a similar way to traditional banks, where investors can collect interest for lending their funds to a bank that subsequently lends them or carries out other investment activities with them. In the case of DeFi, this is very similar, but the borrowed funds are not the responsibility of any third party, but usually a smart open-source contract, the terms of which can be viewed by anyone.
Stablecoins have become an integral part of the ever-growing cryptocurrency market, bringing new earning opportunities and protection to the undesirable effects of price fluctuations. However, despite their enormous and relentless success, the risks involved in their use also need to be considered.
If you decide to use stablecoins, it is necessary to choose those that prove to be stable in the long run and are not associated with any cases concerning, for example, the auditability of their reserves or significant price volatility.
Therefore, before using any stablecoin, first do your own research, based on which you will decide which stablecoin would be the right choice for you
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