Stablecoins are cryptocurrencies designed to minimize the volatility of traditional digital currencies like Bitcoin, Ethereum, Litecoin, etc. These stablecoins mimic the value of fiat currencies like the Euro, Dollar, Yen, etc. Stablecoins allow users to quickly and cheaply transfer value across the world while maintaining price stability.
It is interesting to note that cryptocurrencies’ value is not tethered to any asset from a free-market standpoint. However, when it comes to cryptocurrency usability, it can be complicated. The fluctuations in the value of cryptocurrencies have made them high-risk investments and not ideal for making payments.
Stablecoins do not have the problem of price volatility. Therefore, they see a negligible price movement and closely monitor the value of the underlying asset or fiat currency that they emulate. They serve as reliable safe-haven assets in volatile crypto markets.
Types Of Stablecoins And How They Work
There are different categories of stablecoins, and they work in different ways. Here are some of the most common types of stablecoins:
The most popular stablecoins are the ones that are directly backed by fiat currency with a 1:1 ratio. This type of stablecoin is fiat-collateralized. A bank serves as a central issuer, holds an amount of fiat currency in reserve, and gives out proportionate tokens. An excellent example of fiat-backed stablecoins includes the JPM Coin and Tether.
Crypto-backed stablecoins look like their fiat-backed counterparts. However, the main difference is that they use cryptocurrency is used as collateral. These crypto-backed stabelcoins are trust-minimized, but voters determine the monetary policy as part of their governance systems. It means you are not trusting a single issuer; instead, you trust the entire network participants to act in the issuer’s best interest.
These stablecoins are neither backed by fiat or cryptocurrency. Their peg is controlled by algorithms and smart contracts that manage the supply of tokens issued. The monetary policy is akin to the one employed by central banks to manage national currencies.
Pros and Cons
The major advantage of stablecoins is its ability to provide higher predictability and stability in the crypto market. On the downside, fiat-collateralized stablecoins are less decentralized than traditional cryptos. The crypto-collateralized and algorithmic stablecoins demand that users trust the wider community to ensure the systems’ longevity.
Stablecoins are an indispensable component of the crypto market. Although they have their disadvantages, they serve as safe-haven for traders and investors. While they were initially designed to manage risk, we can now see that the application of stablecoins goes beyond trading.
Okereke has a passion for researching blockchain and cryptocurrency. He enjoys creating long form educational content to inform others on the opportunities in this space.