What is a stablecoin and why is it needed
In the world of cryptocurrencies, there are such coins, the value of which is tied to a specific physical asset, the so-called stablecoins - a special type of digital coins that helps speed up the appearance of money in real life.
In this article, we will go through the definition, the principle of operation, the pros and cons, and so on, so we recommend reading it. We think it will be interesting.
Table of contents
What is a stablecoin: how it works
Stablecoins are digital assets designed to mimic fiat currencies such as the dollar or the euro. They allow traders to transfer stable assets around the world cheaply and quickly.
It is far from a secret that such cryptocurrencies as Bitcoin и Ethereum known for their volatility relative to fiat. This is because blockchain technology is still very new and crypto markets are relatively small. The fact that the value of a cryptocurrency is not tied to any asset is interesting from a free market perspective, but can be a problem when it comes to usability.
As a means of exchange, cryptocurrencies are technologically more convenient, but fluctuations in the exchange rate make them a risky investment, as well as an inconvenient means for making payments. By the time the transaction is completed, the value of the sent coins may differ significantly from the original.
Therefore, a stablecoin was created, which does not have such a problem. Assets of this type are characterized by insignificant price dynamics and changes in the value of the underlying asset or the fiat currency they emulate.
The principle of operation of stablecoins is no different from physical money. The value of the coins is equal to the assets, their ratio is set as 1:1, and they are also used to store capital, settlements or exchange.
Ways to ensure stability
A coin can maintain its stability in many ways:
- fiat-backed stablecoins;
- crypto-backed stablecoins;
- algorithmic stablecoins.
Stablecoins that are pegged to fiat money cost the same as their fiat counterparts. One coin is equal, for example, to 1 dollar, which acts as a pledge that ensures the value of the cryptocurrency. This type of stablecoin has little volatility, but centralization is a negative factor. This method is the most popular.
The value of stablecoins that are pegged to cryptocurrencies is backed by either a certain cryptocurrency or several at once. The main disadvantage of this method is volatility, but the advantage is decentralization and ease of liquidation if necessary.
The last method, which is called algorithmic stablecoins, is characterized by the fact that in this case, stablecoins are not tied to fiat or cryptocurrency. Instead, their binding is provided by the algorithms and smart contracts that govern the issuance of tokens. Functionally, their monetary policy is exactly the same as the policy of central banks in relation to the management of national currencies. This type of coin has decentralization. He is not bound by various pledges, has no obligations. If necessary, the issue of coins is reduced or increased.
Use cases for stablecoins
In fact, the list of stablecoins is quite large, but we will highlight only the most popular and secured ones today:
- Tether (USDT). It is supported by fiat money, for the safety of which the bank in Hong Kong is responsible;
- Binance USD (BUSD). The dollars, which are the collateral of the token, are stored in the bank accounts of Paxos Trust. Each time dollars are received into the bank accounts of this company, allocated to provide Binance USD, a corresponding number of tokens is generated;
- TrueUSD. A stablecoin pegged to the value of the US dollar. Created by American developers, based on Ethereum;
- Paxos Standard (PAS);
- USD Coin (USDC).
Pros and cons of stablecoins
Stablecoins are a universal medium of exchange in the cryptocurrency world, which is their main advantage. Due to high volatility, cryptocurrencies cannot be widely used in day-to-day transactions such as payment processing. The rate of stablecoins is predetermined and predictable, which solves this problem.
By providing protection against volatility, stablecoins are also involved in the integration of cryptocurrencies with traditional financial markets. Currently, these two markets exist as separate ecosystems with rather limited interaction.
In addition to their utility in financial transactions, stablecoins can be used by traders and investors to hedge their portfolios. Allocating a certain percentage of the portfolio to stablecoins is an effective way to reduce overall risk.
Despite the potential of stablecoins as a means of widespread adoption of cryptocurrencies, they still have certain limitations. Fiat-backed stablecoins are less decentralized than regular cryptocurrencies, as they require a central entity to hold the backing assets. For crypto-backed and uncollateralized coins, users must trust the community (and source code) to ensure the longevity of such systems. These are still new technologies, so it takes time for them to reach maturity.
Despite the fact that stablecoins have a number of disadvantages, they are an important component of the cryptocurrency market. Thanks to various mechanisms, this type of digital currency, with its fixed price, can remain more or less stable. This allows them to be used not only as a means of exchange, but also as a way to fix the balance for traders and investors.
Stablecoins are a powerful tool that can strengthen cryptocurrencies and act as a substitute for unstable alternatives where it is not practical.
We believe that with this article, we have closed the issue of stablecoins and we hope that it was useful for you. Successful and profitable investment!