One of the significant drawbacks of cryptocurrencies and a limitation to their adoption is how volatile they can be. Its volatility led to the introduction of stablecoins, most of which peg to the USD. Find out how Stablecoins remain Stable, examples, and more.
What is a Stablecoin?
Stablecoins are cryptocurrencies whose market value is pegged to some external reference like that of another currency (like the U.S. dollar), commodity (like Gold), etc. Stablecoins seek to provide an alternative to cryptocurrency volatility, which has made crypto investments more suitable for transactional purposes.
Stablecoins seek price stability by holding reserve assets as collateral or by employing algorithmic formulas that are designed to control supply.
How Stablecoins remain Stable
Stablecoins attempt to tether their market value to an external reference, typically a fiat currency. They are more useful than more-volatile cryptocurrencies as a medium of exchange.
Stablecoins can be pegged to a currency, such as the US dollar, or to the price of a commodity, such as gold, or they can be controlled by an algorithm. They also keep reserve assets on hand as collateral or use algorithmic formulas to control supply.
What are examples of Stablecoins
Stablecoins can be a great place to hold capital between purchases of other cryptocurrencies or a quick way to transfer money between exchanges.
But it’s essential to research which type of stablecoin is a good fit for you. Stablecoins are kept stable via a few basic mechanisms which include:
Fiat-collateralized stablecoins use fiat currency as collateral for the coin’s value, such as the US dollar. Other forms of collateral can include precious metals like gold or silver as well as commodities like crude oil, but most fiat-collateralized stablecoins have reserves of U.S. dollars.
A common method for fiat-backed stablecoins is to set up a reserve equal to the number of coins made available for purchase by the issuer. A third-party custodian usually maintains these reserves. Tether, the largest stablecoin on coinmarketcap, is collateralized and backed by US dollar reserves and has a market cap of $ 66.1 USD.
The term “electronic commerce” refers to the sale of electronic goods. Because the reserve cryptocurrency may also be volatile, such stablecoins are overcollateralized, which means that the value of cryptocurrency held in reserves exceeds the value of stablecoins issued.
Non-Collateralized or Algorithmic Stablecoins
Some stablecoins are not backed by an asset, but rather by algorithms that control the coin’s supply. While this may appear untrustworthy, it is very similar to how most countries manage their own currencies. The Federal Reserve, for example, does not rely on a reserve asset to back the US dollar. Instead, they set monetary policy to influence the value of this fiat currency.
However, fiat currencies have the advantage of being around for a long time. More importantly, people can use them to buy things in everyday life, making them inherently more stable. Non-collateralized stablecoins can’t rely on these factors to help stabilize the currency, which is why they are considered the least stable of all stablecoins.
You can check out this article on What are Algorithmic Stablecoins.
Furthermore, the value of non-collateralized stablecoins can fluctuate dramatically, often overnight. The price of the TerraUSD (UST) algorithmic stablecoin rose more than 60% on May 11, 2022, vaporizing its peg to the U.S. dollar, as the price of the related Luna token used to peg Terra fell more than 80% overnight.
Why Stablecoins are needed
Though Bitcoin remains the most popular cryptocurrency, its price, or exchange rate, is highly volatile. All of this volatility may be beneficial to traders, but it transforms routine transactions such as purchases into risky speculation for the buyer and seller.
Long-term cryptocurrency investors do not want to become famous for paying 10,000 Bitcoins for two pizzas. Meanwhile, most merchants do not want to incur a loss if the price of a cryptocurrency falls after they have been paid for it.
To serve as a medium of exchange, a currency that’s not legal tender must remain relatively stable, assuring those who accept it that it will retain purchasing power in the short term. Among traditional fiat currencies, daily moves of even 1% in forex trading are relatively rare.
As the name implies, stablecoins aim to address this problem by promising to hold the value of the cryptocurrency steady in a variety of ways.
Stablecoins vs Altcoins
In short, Altcoins are simply all cryptocurrencies other than Bitcoin, while Stablecoins are altcoins that are designed to maintain a steady value.
Altcoins are digital coins that were created after Bitcoin to serve as a decentralized method of payment or investment. They all differ from Bitcoin in terms of features and applications, such as faster transaction times, improved privacy protocols, or unique features such as smart contracts and distributed applications (dApps). Most altcoins are highly volatile, which means their prices can fluctuate rapidly over short periods of time.
Stablecoins are altcoins that are designed to maintain a consistent value. They are typically pegged to the US dollar or other fiat currencies. Stablecoins are beneficial for people who want to use cryptocurrency but don’t want to deal with the price volatility of typical altcoins.
Stablecoins are not subject to the same wild swings in value because they are linked to actual currency. Because of their low volatility, stablecoins are primarily used to pay for goods and services.
The below table displays a detailed comparison of Altcoins and Stablecoins
|Volatility||Altcoins that are not pegged to a fiat currency are highly volatile, meaning their prices can go up and down quickly over short periods of time.||Stablecoins, on the other hand, maintain a steady value due to being tied to actual currency, making them much more suitable for payments.|
|Features||Altcoins have different features and uses than Bitcoin, such as faster transaction times.||Stablecoins are mainly used as payment tokens.|
|ROI||The ROI on Altcoins is higher.||The ROI is significantly lower with stablecoins.|
Are Stablecoins safe?
Stablecoins are considered safer than other cryptocurrencies, but determining whether or not a stablecoin is safe depends on an array of factors, like how it’s backed, its issuer, and how future regulations impact the stablecoin.
The safest Stablecoins are coins that are backed by an external asset that is also regarded as safe. An issuer will keep reserves of the pegged asset on hand to increase the stability of a stablecoin. As a result, stablecoins that are completely backed by the asset to which they are linked are regarded as the most secure.
Despite the fact that the lack of regulations surrounding stablecoins has made it easier for issuers to make false claims about their backing, which is a large part of what makes some of them potentially dangerous.
Unless specific legislation is passed requiring stablecoin issuers to follow banking regulations, particularly when making claims about reserve assets. Stablecoins may crash if issuers refuse or are unable to meet new regulatory requirements. Stablecoins that can meet regulatory requirements, on the other hand, are likely to become safer, more widely accepted, and more efficient.
How Stablecoins remain Stable: Bottom line
I hope you have been able to understand How Stablecoins remain Stable, as the cryptocurrency umbrella, has many different types of coins, such as stablecoins, memecoins, etc.
Each coin category has its own risk profile. If you want to invest in a less volatile coin, you should consider stablecoins backed by fiat currency.
Depending on the coin, they can be a good option to temporarily hold value or transfer capital between exchanges. If you’re interested in building a cryptocurrency portfolio, stablecoins can be a good place to start.