What Are Stablecoins and How Do They Work?

Stablecoins are cryptocurrencies that can maintain a predictable value, or price level, over time. This is accomplished by using a large pool of funds from investors more interested in the investment potential than transacting on the coin.

As a result, stablecoins can better weather the ups and downs of cryptocurrency markets because they often hold their value much closer to other currencies like fiat currency or gold.

Stablecoins are cryptocurrencies whose value is fixed or tied to that of another currency, commodity, or financial instrument. This can be done by linking the cryptocurrency’s value to the underlying asset’s price.

The extreme volatility of the most popular cryptocurrencies, such as Bitcoin (BTC), which has made crypto investments less appropriate for everyday transactions, is the motivation for creating stablecoins, which aim to provide an alternative.

The main difference between crypto and fiat currencies, such as the US dollar or the pound sterling, is that crypto’s virtual nature prohibits them from forming a long-term store of value. Bitcoin’s (BTC) price has seen wild fluctuations in recent months due to the introduction of new technology, but it remains volatile.

Its price has gone down by nearly 50% in a few months. This makes it difficult for many people to invest their fiat currency in BTC. Stablecoins aims to serve as a digital alternative to fiat currencies and precious metals, as they maintain a steady value and are less volatile than cryptocurrencies.

Why Are Stablecoins So Essential?

Why Are Stablecoins So Essential

According to the United Nations Conference on Trade and Development, the value of cryptocurrencies is rapidly increasing. Their prices are increasing faster than inflation. The adoption of blockchain technology can prevent these drastically erratic movements from happening in the future.

More specifically, it can protect investors from sudden price drops and allow them to take advantage of cryptocurrency’s rise in value by purchasing at a cheaper cost. These digital coins are also a good way to store value and save for the future since their prices remain stable.

Stablecoins is a practical approach to make cryptocurrencies closer to fiat currencies. Investors can use them to build more trust in the technology, making it easier for more people and organizations to invest in cryptocurrencies. This can be achieved by providing them with a safe asset that doesn’t fluctuate dramatically on the market.

How Do Stablecoins Work?

How Do Stablecoins Work

As a result, stablecoins can better weather the ups and downs of cryptocurrency markets because they often hold their value much closer to other currencies like fiat currency or gold.

There are two main types of stablecoins: fiat-backed and crypto-collateralized. They provide different advantages as well as disadvantages for investors. Crypto-collateralized coins are backed by a physical cryptocurrency locked in a smart contract, which is not accessible without breaking the smart contract. Fiat-backed stablecoins rely on an IOU issued by a financial institution or other regulated entity, assuring the coin will be redeemable for its face value.

Stablecoins are backed by various assets, including fiat currency (which refers to currencies like the US dollars in your bank account), other cryptocurrencies, precious metals, and computational functions. Stablecoins are also known as “pegged” cryptocurrencies.

However, a cryptocurrency’s supporting source might influence its risk level: For example, a fiat-backed stablecoin may be more stable than other cryptocurrencies since it is connected to a centralized financial system. This system has a figure of authority (like a central bank) that may intervene and exert price control when unstable market values.

Stablecoins not linked to centralized financial systems, such as a stablecoin backed by bitcoin, have the potential to undergo significant and rapid price fluctuations. This is partly due to the absence of a regulatory authority that controls what the stablecoin is tethered to.

Types of Stablecoins

Fiat-backed Stablecoins

Tether is a popular fiat-backed stablecoin. It uses the USD as its underlying currency, which is why it is so popular. The value of USDT can be easily transferred while also doing transactions on the blockchain where it was created and maintained.

USDT provides users a seamless way to make transactions without exposure to major price fluctuations. It can also help find lost funds because they are linked to real dollars held out of circulation in the regular financial system.

However, the true value of USDT is tied to the US dollar’s value, making it vulnerable to major fluctuations in the currency markets. The price of USDT is often pegged 1:1 with a certain amount of fiat currency held in reserve by Tether Ltd. This could cause volatility in USDT if this amount ends up being too low or too high compared to what was originally intended.

Crypto-Collateralized Stablecoins

Comparing fiat-backed stablecoins to crypto-collateralized ones, the latter offers much more stability in its value. Crypto-collateralized stablecoins have their cryptocurrency that is used for backing their value. MakerDAO uses Ethereum (ETH) for this purpose, but other cryptocurrencies could also be used. This type of stablecoin can be very useful for investors because it can preserve and increase their capital without diluting its supply.

However, since cryptocurrencies back crypto-collateralized stablecoins, they can be susceptible to the same volatility as other cryptocurrencies. Crypto-collateralized stablecoins also require users to stake their cryptocurrencies on the network to create DAI tokens. This adds a measure of complexity that may deter investors that want a simpler solution.

Stablecoins Generated by Algorithms

Stablecoins based on algorithms might or might not have underlying reserve assets. The fundamental difference between them is the approach taken to maintain the value of the stablecoin by managing the supply of the stablecoin using an algorithm, which is effective computer software that executes a predetermined formula.

This is comparable in some respects to the practices of central banks, who likewise do not rely on maintaining a reserve asset to maintain the value of the currency they issue. The distinction is that a central bank like the Federal Reserve in the United States makes public monetary policy based on parameters that are easily understood, and the fact that it is also the issuer of legal currency does wonder for the credibility of the policy that it sets.

The issuers of algorithmic stablecoins do not have such advantages to rely on in the event of a crisis. On May 11, 2022, the price of the algorithmic stablecoin known as TerraUSD (UST) plummeted by more than 60 percent, causing its peg to the United States dollar to evaporate. This occurred at the same time that the price of the related Luna token, which was used to peg Terra, plummeted by more than 80 percent overnight.

Purpose of Stablecoin

The purpose of stablecoins is to deliver a cryptocurrency that can be used for the settlement of transactions, store value, and be used as a currency. The biggest advantage of using the stablecoin is it helps to reduce price volatility and prevent market manipulation that has been driving the crypto-market prices. Stablecoins provide the link between fiat money and cryptocurrencies.

To understand how stablecoins work, we need to understand how a fiat currency works. Fiat money is a currency in which a country has the authority to control its monetary policy. The country’s fiat policy backs a fiat currency. Technically, a fiat currency is “backed” by the issuing government’s promise to pay the bearer on demand the sum of money stated while at the same time trying to back up their money with scarce goods and goods that have little or no value.

In simple terms, fiat currencies mean government-backed currencies. The fiat currency backed by the government is the ‘legal tender,’ In the absence of government intervention, it will not have any value.

Now comes stablecoins which are backed by real-world assets. The reason stablecoins are beneficial is that they can be used as a medium of exchange; they could also act as a store of value in the absence of their value being backed by a sovereign nation. Lastly, they could be used as a benchmark to compare crypto-currencies against.

If you’re a digital merchant, it is challenging to accept cryptocurrencies when the digital currency market can drastically alter the value of your business. It’s very hard for you to accept a payment for a product at one moment and then welcome another customer who wants to buy the same product only to see their money drop by 30 or 35 percent. This is especially true for businesses that rely on consumer spendings, such as retailers and restaurants.

What are stablecoins used for?

What are stablecoins used for

Stablecoin holders can take advantage of various opportunities since stablecoins are based on blockchain technology. Investors were provided a haven of stability away from the volatile nature of other crypto assets when the first stablecoins were launched as replacements for fiat currencies on cryptocurrency exchanges.

In decentralized finance (DeFi), stablecoins can now be used to make loans at interest rates that are superior to those offered by conventional savings accounts or to take out loans backed by cryptocurrencies. It is essential to remember that stablecoin offerings do not provide any form of government-backed insurance, although stablecoins have the potential to provide higher returns than conventional savings products.

Stablecoins have been generated on various blockchain networks to facilitate the execution of smart contracts, and they are being utilized extensively within the decentralized finance industry and on exchanges.

Applications such as decentralized exchanges (DEXs), which rely on blockchain technology, can be created on top of blockchain networks that support smart contracts. Marketplaces known as decentralized exchanges allow transactions to occur directly between different traders.

Stablecoins can be used to pay salaries in cryptocurrency since they make it cheaper to transport money across borders. Additionally, stablecoins can be used to buy goods and services online. Paying a transaction fee to shift funds around on the blockchain is only necessary.

In addition, the settlement of international transactions can take place on the blockchain in a shorter time, ranging from a few seconds to an hour, depending on various conditions. The type of network being utilized, the possibility of network congestion, the total amount paid in fees, and the intricacy of the transaction are all examples of these considerations. However, the traditional financial system could take several days to resolve transactions that involve multiple countries.

Stablecoins’ low volatility lets investors keep their cash on the blockchain while decreasing risk, in contrast to typical cryptocurrencies, which do not have a fixed price and whose value might be volatile and unpredictable.

Conclusion:

There are several key traits of a stablecoin; however, it is important to note the multipurpose nature of stablecoins. The ability to settle between different types of tokens on the blockchain makes them more attractive to the industry than other cryptocurrencies.

The main purpose of using stablecoins is to make trading easier for traders. For a decentralized exchange (DEX) to work efficiently, it needs to be secure, efficient, and have low transaction fees. The first three traits are important in financial technology (fintech). The fourth trait is not necessary, but it is a blessing.

Stablecoins can be used to make payments over the blockchain easier and cheaper. The digital currency market has grown tremendously, with many new digital currencies coming out daily. However, the lack of relationships between all these digital currencies makes it harder for exchanges to work efficiently. No one knows what the future holds. But there are many options with stablecoins.