A common argument against the validity of cryptocurrencies is that they are extremely volatile. The market is unpredictable, and the value of any cryptocurrency, the most common one being Bitcoin, can drop at any moment.
Stablecoins offer a way out of Bitcoin’s volatility and unpredictability. Typically, stablecoins are supported by a reserve asset, such as the U.S dollar. The asset that backs stablecoins is usually one that is reliable and doesn’t change much over time.
The guarantee of stability and privacy that stablecoins offer makes them popular in the world of the crypto trade. These coins can be backed by physical assets, such as the price of gold.
Learning more about stablecoins could come in handy as you set out on your journey in the crypto trade.
Basics Of Stablecoins
Even though stablecoins are growing more and more popular by the day, Bitcoin remains the most sought-after cryptocurrency. However, it suffers from high volatility.
The inaccessibility and unreliable nature of Bitcoin gave way to the growth of stablecoins. These coins are far more reliable as they derive their value from an external reference that is inherently stable.
By pegging their market value to stable assets, such as the U.S dollar, or gold price, stablecoins overcome Bitcoin volatility. Moreover, they retain the privacy and security offered by all cryptocurrencies.
Stablecoins seek to provide the best of both worlds – security and stability. The sudden ups and downs that most cryptocurrencies are prone to is a non-issue for stablecoins as they fluctuate very little.
Why Are Stablecoins Important?
The first stablecoin was created and introduced in 2014 and was known as Tether. This remains the model that most recent stablecoins seek to emulate. Every time users deposit a dollar, they would be given a token. Theoretically, tokens can be converted to the original currency whenever the user requires them.
Tether remains the most popular stablecoin, and as of July 2021, there was approximately $62 billion in Tether outstanding. Tether and other stablecoins started as a means to purchase other cryptocurrencies.
Since crypto exchanges had no traditional banking services or centralized authority, stablecoins arose as a means to buy Bitcoin.
Stablecoins can also work in conjunction with smart contracts that require no seal of legal authority, unlike traditional contracts. This makes them easily programmable and much faster than conventional contracts.
Smart contracts through stablecoins ensure a seamless trading experience with no legal hassles. Due to their independence and stability, they can also be useful in insurance, market prediction, payments, and lending activities.
What Makes Stablecoins Reliable?
There are two reasons for the reliability of stablecoins – the reserves of fiat currencies that back them up and timely action taken by financial authorities such as central banks.
Underlying assets that the stablecoins are pegged to serve as collateral. Gold or Forex is free from the wild fluctuations in price. Hence, the stablecoins are also prevented from becoming volatile.
Even under circumstances where the reserve starts to experience sudden and undesirable changes, financial authorities step in and keep it in check. This crucial feature that most economies rely on – a central authority – is generally absent in other cryptocurrencies.
Types Of Stablecoins
There are three types of stablecoins, which are categorized according to their functions and mechanism.
These types of stablecoins use a currency reserve, as the U.S. dollar, to serve as collateral. While there are other forms of collateral, such as gold or oil, fiat-collateralized stablecoins use fiat currencies as collateral.
Tether is a popular example of this type of stablecoins. Most other stablecoins are also fiat-collateralized, such as TrueUSD. Both these stablecoins have the support of the U.S dollar and can also be converted to the same when the user requires it.
These stablecoins are backed by other cryptocurrencies. This may seem like it kills the purpose of having a stable reserve. However, most crypto-collateralized stablecoins are supported by a wide range of other cryptocurrencies.
Having a large number of currencies supporting one stablecoin means that these stablecoins are “over-collateralized.” While these stablecoins are also reliable, most investors and crypto experts argue that fiat-collateralized stablecoins are a better and safer option.
Algorithmic (Non-Collateralized) Stablecoins
As the name suggests, these stablecoins don’t have any pegged reserve to support them. However, they do have a mechanism in place to guarantee stability, like a central bank. For example, the basecoin follows a consensus mechanism to ensure the safety of the currency and market.
The mechanism adopted is meant to keep wild fluctuations in check per the contract details.
Risks Of Stablecoins
Stablecoins seem like the deal alternative to Bitcoin and other volatile cryptocurrencies. However, despite the privacy and reliability, financial experts still warn against their use and advise investors to be cautious before using stablecoins.
Even though stablecoins are fast, easy, and cheap, there is no authority to regulate their movement or creation. Their stability is derived from a reserve, which is supported by an authority.
Economists argue that the lack of a direct authority to manage stablecoins, or any cryptocurrency, makes them unreliable and dangerous for the economy.
Many investors often avoid the world of crypto trade because it is far too risky. However, stablecoins are an alternative that offers a way out and ensures that the benefits of the crypto trade are intact. They also have the added support of a reserve.
But cryptocurrencies are still being explored, and economies worldwide still have a long way to go. Being cautious with stablecoins can go a long way in securing your profits.