What exactly are stablecoins?
Introduction:
In the rapidly growing field of digital currencies over the last 20 years, stablecoins have emerged as major participants. Stablecoins are cryptocurrencies pegged to a reference asset, such as the U.S. dollar. Unlike cryptocurrencies: Bitcoin and Ethereum, which often experience significant price volatility, stablecoins have the potential to play a crucial role in the future of global finance. They could become the backbone for payments and financial services. Their primary purpose is to address the high volatility of most cryptocurrencies, which has limited their use as a store of wealth and a medium of commerce. However, a question remains: are stablecoins truly stable? In this post, we will explore the reality behind stablecoins and their stability.
What are the pros and cons of stablecoins?
Stablecoins have become an essential component of the constantly changing cryptocurrency landscape. These digital asset classes are essential for several reasons because they offer stability in an unpredictable world. Stablecoins are superior to other cryptocurrencies in several ways. We are going to look at some of their advantages:
Price stability: Stablecoins strive to uphold a consistent value, enhancing their suitability for both transactions and as a means of preserving value.
Decentralization: Similar to other cryptocurrencies, stablecoins are decentralized, which means they are not controlled by any central authority.
Accessibility: Stablecoins are accessible to anyone with an internet connection, irrespective of their geographical location or financial situation.
Stablecoins do, however, have certain drawbacks, such as:
Absence of regulation: Because stablecoins are not subject to the same laws as conventional currencies, they are more vulnerable to manipulation of the market and fraud.
Counterparty risk: A stablecoin may lose value if the lone entity backing it fails. This is the case with certain stablecoins, for example, UST in May 2022 experienced a sudden and rapid collapse from $1 to nearly 0 in a matter of days.
Algorithmic risk: Algorithmic stablecoins rely on complex algorithms to determine their value, making them prone to errors and other technical issues.
Types of Stablecoins
Stablecoins have emerged as a popular digital asset within the cryptocurrency market, aiming to provide price stability amidst the notorious volatility of cryptocurrencies. There are different types of stablecoins, each with its own mechanism for maintaining stability. There are several types of stablecoins, including:
Fiat-Backed Stablecoin
These stablecoins are backed by fiat currencies such as the Euro or US dollar, and are known as fiat-backed stablecoins. They represent the most widely used type of stablecoin, aiming to maintain a steady value by holding reserves of the underlying fiat money. Because fiat-backed stablecoins are supported by a physical asset, they tend to be more stable than other types. Examples of popular fiat-backed stablecoins include Tether (USDT), Binance USD (BUSD), TrueUSD (TUSD), and USD Coin (USDC).
Crypto-Backed Stablecoin
These stablecoins, referred to as crypto-backed stablecoins, derive support from cryptocurrencies like Ethereum (ETH) and Bitcoin (BTC), as opposed to traditional fiat currencies such as the US dollar and the euro. Because they operate on decentralized blockchain networks, these stablecoins provide the stability found in conventional fiat-backed stablecoins. An example of a stablecoin with crypto backing is Wrapped Bitcoin (WBTC), which is issued as an ERC-20 token on the Ethereum blockchain and is backed by real Bitcoins.
Commodity-Backed Stablecoin
Another category of stablecoin is known as a commodity-backed stablecoin. These stablecoins are specifically supported by tangible assets such as gold, precious metals, oil, real estate, or other physical commodities. The value of these stablecoins is directly linked to the underlying commodity, providing stability and preserving value.
A well-known example of a stablecoin backed by a commodity is the gold-backed stablecoin. Typically, the value of these stablecoins is tied to the price of gold, with each token representing a specific quantity of gold. Due to being backed by a less liquid asset compared to fiat-backed stablecoins, commodity-backed stablecoins are less commonly utilized.
Algorithmic Stablecoin
This variety of stablecoin is termed an algorithmic stablecoin due to its absence of support from tangible assets. Instead, it sustains its value through the utilization of sophisticated algorithms. As these stablecoins rely on consumer demand to maintain their value, they are the most volatile among stablecoin types. DAI stands out as a popular algorithmic stablecoin backed by Ethereum, and additional examples encompass Ampleforth, Frax, Terra, and ESD.
The Stability of Stablecoin
Stablecoins occasionally fall short of their objective to provide stability in the volatile world of cryptocurrencies. Similar to how fiat-backed stablecoins utilize reserves in traditional financial institutions as collateral to maintain their peg to fiat currency, crypto-backed stablecoins also rely on other cryptocurrencies for the same purpose to uphold stability.
The price volatility observed in the top five stablecoins and the Terra UST crash in May 2022 underscored the challenges in maintaining stability in stablecoins. These incidents have prompted significant questions about the effectiveness of stablecoins in achieving stability.
The assets backing stablecoins must be transparent, allowing users to view the collateral supporting these digital currencies. This transparency is vital for building trust. Additionally, regulatory uncertainty and a lack of frameworks pose additional threats to achieving true stability.
Despite the stated goal of stablecoins to bring stability to the crypto market, they remain susceptible to the intrinsic volatility of the market. To foster trust within the cryptocurrency sector among users, transparency in asset backing and the establishment of regulatory frameworks are essential for ensuring stability.
The Future of Stablecoin
Although stablecoins can completely change the cryptocurrency market, there is still uncertainty about their future, and there are risks involved. Financial stability faces several issues as a result of these concerns. There is still no consensus among regulators regarding the best legal structure for stablecoins. They are still working on it. Additional worries include a lack of transparency, the possibility of centralization, which might be manipulated and undermine stability, and the counterparty risk, which depends on the reliability of the issuers or institutions handling the collateral.
Moreover, we must acknowledge that economic volatility can have a detrimental effect on the underlying collateral, making long-term stability extremely difficult, particularly in times of financial crisis or regulatory uncertainty.
Addressing the risks and putting legal frameworks in place are necessary for stablecoins to succeed. Stablecoin acceptance may increase if they have sufficient decentralization, transparency, and robust collateral procedures that enable them to revolutionize standard financial transactions.
Conclusion
Stablecoins are a type of cryptocurrency intended to maintain a steady value by tying their value to an outside source. Price stability, decentralization, and accessibility are just a few of the benefits they have over other digital currencies. But there are major disadvantages as well, such as algorithmic risk, counterparty risk, and a lack of regulatory framework.
Stablecoins, according to certain economists, could have several advantages. Compared to what customers and businesses are currently experiencing, these benefits include more affordable, safe, instantaneous, and competitive payment choices. They could quickly lower the costs associated with accepting payments from companies and streamline government operations involving conditional cash transfer programs, such as the payments made during the COVID-19 era, including the distribution of stimulus funds. They might also assist in establishing a connection between the financial system and those who lack or have inadequate banking.
However, in the absence of robust legal and economic foundations, there is a legitimate apprehension that stablecoins may not meet the anticipated standards and may encounter problems such as collapsing akin to an unstable currency board, going through a "break the buck" event akin to money market funds in 2008 that was subsequently financed by the reserve, or even becoming worthless and thereby causing financial turmoil akin to the "wildcat" banks of the 19th century.