What Is a Stablecoin? A short overview just for you

Key Takeaways:

· A stablecoin is a cryptocurrency whose market value is guaranteed by some external reference.
· In Stablecoins, a currency or a commodity's price, such as gold, is linked to a stablecoin.
· Through collateralization (backing) or algorithmic mechanisms of buying and selling the reference asset or its derivatives, Stablecoins achieve their price stability.

1. What are Stablecoins?

Unlike other cryptocurrencies, Stablecoins offer price stability backed by a reserve asset. In recent years, Stablecoins have gained traction because they attempt to offer the best of both worlds: instant processing of cryptocurrency payments and a stable valuation of a fiat currency without fluctuating.

They were developed in response to the volatility of traditional cryptocurrencies such as Bitcoin. Their utility as a payment method is limited by their huge changes in market value in a short time.

Despite its popularity, Bitcoin's value is notoriously volatile. When the Coronavirus pandemic was at its peak in March 2020, it went from about $5,000 to almost $65,000 by April 2021, then it plummeted by more than 50% to about $30,000 by June 2021. A price of $65,000 has been in effect since November 2021. Within a few hours, the cryptocurrency can move by more than 10% in either direction.

The short-term volatility of Bitcoin and other popular cryptocurrencies makes them unsuitable for everyday use by the public. The primary function of a currency is to serve as a medium of exchange and as a store of value, and its value must remain relatively stable over the long run. Users may not adopt it if there are uncertainties about its purchasing power tomorrow.

It is ideal for a crypto coin to maintain its monetary value while having the lowest inflation possible, which will encourage users to spend them instead of saving them. Stablecoins provide a solution for achieving this behavior.

Therefore, Stablecoins have become a key component of DeFi products in which transactions can be carried out without a middleman such as a bank or a broker. Inflation is the dismiss of purchasing power of one currency over time. It is calculated by the increase in the average price level of certain goods and services that provide a quantitative estimation of how fast purchasing power declines.

In short, Stablecoins are a type of cryptocurrency token that is built to offer more stability than other cryptos and are linked to another asset as a backup. They are built to resist volatility in a way that other cryptocurrencies can’t, but still offer mobility and accessibility.

2. Types of Stablecoins

Fiat currencies, such as the US dollar or the Euro are backed by the full faith and credit of the government that issued it and its bank system. This offers price stability for fiat currencies which, however, are still controlled and steered by their central banks. Whenever a major event happens which could impact the nation, currency, or the bank sector, the central bank issues policies which would affect the fiat currency as well as inflation.

Stablecoins try to bridge the gap between fiat currencies and cryptocurrencies while giving the stablecoin holder certain protection against inflation and bank regulations.
Stablecoins fall into three categories according to their working mechanisms:

· Fiat-Collateralized Stablecoins

With fiat collateralized Stablecoins, a fiat currency reserve (for example the U.S. dollar), is used as security for this crypto coin. Other forms of insurance can be gold or silver but is usually a strong fiat currency like the US dollar or euro. An example of this category is the USDT. In November 2021, USDT is the fourth-largest cryptocurrency by market capitalization, worth more than $73 billion.

· Crypto-Collateralized Stablecoins

Crypto-collateralized Stablecoins are backed by other cryptocurrencies. Since the reserve cryptocurrency may also be affected by high volatility, such Stablecoins are over-collateralized. This means that a larger number of cryptocurrency tokens is used as a reserve for issuing a lower number of Stablecoins.

Let’s use an example to understand this.

A $2,000 worth of coin A may be held as reserves for issuing $1,000 worth of crypto-backed stablecoin B, which can take 50% of swings in the reserve currency.

· Non-Collateralized Stablecoins

Non-collateralized Stablecoins don't use any reserve but include a working mechanism, like a fiat central bank, to maintain a stable price. For instance, a common mechanism is to increase or decrease the supply of tokens on a need basis.

It follows the same mechanism as a central bank which prints banknotes to maintain valuations of the fiat currency.

Smart contracts can be implemented on a decentralized platform that can run autonomously. Rather than having the terms of the contract between buyer and seller directly written into lines of code, a smart contract executes itself. Blockchains are distributed, decentralized networks where code and agreements are exchanged. The code controls the execution, and transactions are trackable and irreversible.

3. Stablecoins vs. other cryptocurrencies

All cryptocurrencies are based on blockchain technology, which enables secure ownership of digital assets for each user and token. Cryptography algorithms protect the users and tokens against counterfeiting and fraud and allow these tokens to circulate and be used within decentralized networks.

The value of most cryptocurrencies is determined by the demand of the token while holders of this token hope that their token will increase in value.

But this doesn’t apply to Stablecoins. They are designed not to change much in value and are tied to a backup asset such as gold or the US dollar.

A stablecoin that's linked to the value of a dollar is very unlikely to experience any dramatic price change within a week. Therefore, you are not going to miss out on a big gain (or huge loss) since it's very stable.

4. Stablecoin Regulation

Stablecoins continue to come under more and more attention by regulators due to their worth of more than $130 billion and potential impact on the traditional financial system.
Additionally, politicians have increased calls for greater stablecoin regulation. For instance, in September 2021, Senator Cynthia Lummis called for regular audits of stablecoin issuers.
The regulations on Stablecoins will impact all the other cryptocurrencies so let’s see how things turn out to be in the year 2022. Will this be the golden year for all crypto tokens? Let’s hope.

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Author: article_bot
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