What is Stablecoin?
Stablecoin refers to a range of cryptocurrencies that derive its market value from some external reference. It essentially means that unlike fiat money, they are backed by a reserve asset like during the Gold Standard Era.
Being asset-backed enables stablecoins to maintain their prices and avoid excess volatility, which essentially defines the cryptocurrency market.
- 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
A cryptocurrency is a type of virtual currency, which functions using decentralized networks via blockchain technology. Users have lauded the processing system, which is instant, private, and smooth.
Since the blockchain is decentralized and on the public domain, it makes duplication or counterfeiting almost impossible. Cryptocurrency is not seen as a conventional asset, and trading is even illegal in some countries. As a result, it is a highly volatile asset class.
The price movement of cryptocurrencies within one trading day, also known as intraday price swings, can be very high. For example, the value of bitcoin peaked in December 2018 to around $19,700, and within two months, its value was only a third of the peak.
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.
Cryptocurrencies are not just any asset class but currencies. They 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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