Understanding Stablecoins: What are they, and what role do they play in cryptocurrency?

This was originally posted on Planner Bee.

Cryptocurrency can be an area that is filled with unfamiliar terms, complex concepts and wild price swings, especially for the uninitiated and newcomers. Stability, therefore, is a highly sought-after commodity.

Enter stablecoins: a distinct type of digital assets designed to provide a safe harbour amidst the volatility crypto market. For those new to the world of cryptocurrency, understanding stablecoins and their role in the ecosystem is essential.

Let’s take a deep dive into what they are, how they work, the problems they solve and dispel the myths surrounding this class of digital asset.

So, what are stablecoins?

Think of stablecoins as cryptocurrencies with a life vest – anchoring their worth to external assets or algorithms such as the US Dollar, Euro or even gold. Unlike their volatile peers Bitcoin and Ethereum, the pegging mechanism ensures that the value of stablecoins remains relatively constant over time, making them more appropriate for financial applications and daily transactions.

The role of stablecoins in the crypto ecosystem

Imagine entering into a busy exchange where all the traders deal with erratic, ever-changing tokens. Setting a fixed price for any goods and services would be next to impossible. Stablecoins act as the standard currency, facilitating easy and reliable transactions within the crypto ecosystem.

Here are a few other common roles that stablecoins play

Reliability

Stablecoins serve as a vital link between the volatile world of digital assets and the stability of traditional financial systems. Their stability, which comes from being pegged to an external commodity, makes them an appealing option for investors, traders and daily users looking to minimise the risks associated with cryptocurrency investments. This facilitates easier entry and exit.

Cross-border payments

Stablecoins help facilitate seamless transactions within the crypto space. They enable users to send and receive payments efficiently without the risk of volatile price swings and avoid any delays that might occur with third-party services. This stability is especially useful in cross-border payments and remittances.

A tale of two pegs

So how exactly do stablecoins keep their relative price stability? They maintain reserve assets through supply-controlling algorithmic formulas, or as collateral. In short, stablecoins peg their market value to some external reference, whether a currency or to the price of a commodity.

Pegged to fiat currencies

The most common type of stablecoin is fiat-backed, which involves pegging their value directly to fiat currencies like the US dollar or Euro. These fiat-backed stablecoins maintain a one-to-one ratio with their respective fiat currency, effectively mirroring its value. Collateralisation and regulatory compliance are usually used in conjunction to achieve this pegging, which guarantees that every stablecoin in use is supported by an equal quantity of fiat reserves kept in custodial accounts.

Asset-backed stablecoins

While fiat-backed stablecoins dominate the stablecoin landscape, some stablecoins are tied to a basket of real-world assets such as precious metals, commodities, or even other cryptocurrencies. For instance, gold-backed stablecoins, such as PAX Gold and Tether Gold, are backed by physical gold bullion that is kept in reserve. Stablecoins supported by commodities, such as oil, real estate, or agricultural products, offer users diversification and stability but might introduce potential complexities, depending on the underlying assets.

The problems stablecoins solve

Stablecoins address several pain points within the crypto ecosystem, making them an indispensable tool for users and businesses alike.

1. Reduced volatility

By offering a reliable store of value, stablecoins protect users from the unpredictable price swings commonly associated with other cryptocurrencies. This stability is particularly valuable for newcomers, risk-averse investors and businesses seeking to hedge against market volatility.

2. Facilitating financial inclusion

Stablecoins simplify the transaction process in the crypto space, enabling cost-efficient payments worldwide. This financial inclusion has far-reaching implications, allowing greater entry for users digitally in places with poor traditional financial infrastructure.

3. Enhancing decentralised finance (DeFi)

With the stability that this asset brings, stablecoins help propel the growth of DeFi platforms with seamless execution of smart contract-based financial transactions, unlocking unprecedented levels of liquidity and efficiency within the DeFi ecosystem without depending on traditional financial institutions.

However, there are also some potential downsides:

1. Centralisation

Fiat-backed stablecoins rely entirely on centralised reserves, which, if not managed properly, could pose potential risks and unwanted exposure.

2. Regulation

With the ever-evolving regulatory landscape surrounding stablecoins, there could be impact on their usage and functionality on a global scale.

3. Transparency

There will definitely be more stablecoins appearing with time. Not all stablecoins are created equal and doing your own research before investing is crucial.

Stablecoins in a nutshell

Stablecoins are an important development in the world of cryptocurrencies, providing accessibility, stability, and dependability in a largely volatile environment.

Stablecoins, whether backed by physical assets or fiat currencies, are essential for promoting adoption, streamlining transactions, and encouraging creativity within the larger crypto ecosystem. As such they look set to be a mainstay of this transformative financial revolution as the cryptocurrency industry continues its evolution.