Stablecoin refers to a type of cryptocurrencies that tries to tackle price fluctuations to maintain a more stable price.
The way of doing this is to link the stablecoin’s market value to some external reference, most commonly a fiat currency like the USD, although some stablecoins are linked to commodities, such as a precious metal like gold.
The price stability can be achieved by collateralizing it with some underlying asset – real, fiat or virtual.
Being asset-backed enables stablecoins to maintain their prices and avoid excess volatility, which essentially defines the cryptocurrency market.
There is another type of stablecoin that is not collateralized but rather uses algorithms to balance supply and demand to maintain a stable price.
Stablecoin refers to a range of cryptocurrencies that derive their market value from some external reference.
Stablecoins can be categorized on the bases of their working mechanisms – crypto-collateralized, algorithmic, and fiat-collateralized stablecoins.
The Need for Stablecoins
Cryptocurrencies use decentralized networks via blockchain technology, making duplication or counterfeiting almost impossible. However, cryptocurrency is not a regulated asset and even illegal in some countries. As a result, it is a highly volatile asset class.
The price movement of cryptocurrencies can be very volatile. For example, the value of Bitcoin peaked in November of 2021 at around $68,000 from the roughly $5,000 per Bitcoin price a year before and down to only $18,000 a Bitcoin a year later in 2022.
The uncertainty surrounding price movements also means that the direction of trades can vary even within short periods of time. Such short-term volatility renders cryptocurrencies unsuitable for everyday use by retail investors or non-experts, since a currency must be a store of value, which implies that their value must be stable over a long period. An investor needs to be sure that the purchasing power of a currency will appreciate or remain stable in the future.
The value of fiat currency is guaranteed by the government and can only be issued by the central bank of the country. Their value is often pegged to other assets, such as forex reserves, or commodities, such as gold, which can act as collateral for lenders. It is why, in general, sovereign currency dominated government debt is considered to be the safest asset.
But cryptocurrencies are not issued by the state, which means that they must seek other avenues for price stabilization.
Cryptocurrencies cannot be controlled by authorities or institutions such as central banks. A demand and supply mismatch cannot be neutralized by financial intermediaries.
To control the inflationary tendency of cryptocurrencies, users must be convinced to spend the tokens instead of saving them. Stable coins enable us to bridge this gap between the stability of fiat currency versus cryptocurrency.
Categories of Stablecoins
Stablecoins can be categorized on the bases of their working mechanisms:
1. Fiat-Collateralized Stablecoins
Fiat-collateralized stablecoins are, as the name suggests, backed by sovereign currency such as the pound or the US dollar. It means that to issue a certain number of tokens of a given cryptocurrency, the issuer must offer dollar reserves worth the same amount as collateral.
Commodities such as gold can also be used here. The reserves are often maintained by custodians that function independently and are audited for compliance on a regular basis. Cryptocurrencies that are backed by dollar deposits include TrueUSD and Tether (USDT).
2. Crypto-Collateralized Stablecoins
The value of crypto-collateralized stablecoins is pegged to that of other cryptocurrencies. Since the underlying asset, in this case, is also a cryptocurrency, it is not conventionally safe and may also be highly volatile.
The term used to refer to such kinds of stablecoins is “over-collateralization.” It means that a relatively large amount of reserve cryptocurrencies may be needed to issue even a small number of tokens.
3. Non-Collateralized (Algorithmic) Stablecoins
Non-collateralized stablecoins are those that do not involve the use of any reserve asset. Instead, their stability is derived from a working mechanism, such as that of a central bank.
For example, the cryptocurrency base coin uses a consensus mechanism to determine whether it should increase or decrease the supply of tokens on a need basis.
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