The volatility of cryptocurrencies isn’t everything. Stablecoins, on the other hand, are deliberately engineered to keep a set price. In an economy where coins and tokens can crash overnight, there is a huge need for currencies that combine the benefits of blockchain with the ability to track a more stable asset. If you haven’t already begun utilizing stablecoins in your trading or investing, it’s worth learning more about them, as well as the advantages and disadvantages they provide.
What Is a Stablecoin in Cryptocurrency?
Stablecoins are digital assets that are linked to the value of fiat currencies or other assets. You can, for example, buy tokens tied to the dollar, euro, yen, and even gold and oil. A stablecoin allows the holder to lock in profits and losses while transferring value at a consistent price via peer-to-peer blockchain networks.
Bitcoin (BTC), Ether (ETH), and other cryptocurrencies have historically been highly volatile. While this offers numerous opportunities for speculation, it does have some drawbacks. The volatility of cryptocurrencies makes them difficult to employ for day-to-day payments. For example, a business may accept $5 in Bitcoin for a coffee one day but then discover that their Bitcoin is worth 50% less the following. This makes it difficult to develop and run a firm that accepts cryptocurrency payments.
How Do Stablecoins Work?
A pegging method is required to create a coin that tracks the price or value of another asset. There are several approaches, the majority of which rely on another asset acting as collateral. Some methods have proven to be more successful than others, but there is no such thing as a sure thing.
A fiat-backed stablecoin holds a fiat currency in reserve, such as USD or GBP. Each TUSD, for example, is backed by $1 in collateral. Users can then use the pegged rate to convert their fiat to a stablecoin and vice versa.
Crypto-backed stablecoins function in the same way that fiat-backed stablecoins do. However, instead of using dollars or another currency as reserves, cryptocurrencies are used as collateral. Because the cryptocurrency market is so volatile, crypto-backed stablecoins typically over-collateralize their reserves as a hedge against price swings.
Smart contracts are used to control the minting and burning of crypto-backed stablecoins. Users can independently audit the contracts, making the process more credible. However, some crypto-backed stablecoins are managed by Decentralised Autonomous Organisations (DAOs), in which the community can vote on project changes. In this instance, you have the option of being involved or relying on the DAO to make the best judgments.
Consider the following example. To mint 100 DAI tied to USD, you must supply $150 in cryptocurrency as 1.5x collateral. You can utilize your DAI whichever you choose after you obtain it. You might move it, invest it, or leave it alone. If you want your collateral back, you must repay the 100 DAI. Your collateral will be liquidated if it falls below a particular collateral percentage or the loan’s value.
By eliminating the requirement for reserves, algorithmic stablecoins adopt a different approach. Instead, algorithms and smart contracts control the supply of issued tokens. This concept is significantly rarer than crypto or fiat-backed stablecoins, and it is more difficult to implement successfully.
An algorithmic stablecoin system, in essence, will reduce the token supply if the price falls below the fiat currency it tracks. This could be accomplished through locked staking, burning, or buy-backs. If the price exceeds the value of the fiat currency, new tokens are issued to reduce the stablecoin’s value.
What Are the Advantages of Stablecoins?
Investing, trading, and utilizing stablecoins can be a rewarding and powerful experience. Their main strengths include the following:
1. Stablecoins can be used for day-to-day payments. Stability is important to both businesses and individuals. Because of their volatility, cryptocurrencies have not gained widespread adoption for day-to-day payments. Large stablecoins have a track record of holding their value, making them suitable for everyday use.
2. Stablecoins have the benefits of being blockchain-based. Any crypto wallet (which can be built in seconds for free) that supports stablecoins can receive stablecoins. Double-spending and fake transactions are likewise nearly unheard of. Stablecoins are extremely adaptable due to these characteristics.
3. A stablecoin can be used by traders and investors as a hedge. A stablecoin allocation of a particular percentage of a portfolio is a good strategy to limit overall risk. Your overall portfolio will be more resilient to market price changes, and you will have funds on hand in case a good opportunity arises. During a market slump, you can also sell crypto for stablecoins and repurchase them at a reduced price (this is known as shorting). Stablecoins allow you to easily enter and exit positions without having to take money off-chain.
What Are the Disadvantages of Stablecoins?
There are still limitations to stablecoins, despite their potential to support wide cryptocurrency adoption:
1. Stablecoins aren’t guaranteed to maintain their peg. Some large projects have a good track record, but there have also been many failures. When a stablecoin struggles to keep its peg, its value can plummet substantially. Not all stablecoins conduct comprehensive public audits, and many merely provide periodic attestations. Private accountants handle this on behalf of stablecoin issuers.
3. A fiat-collateralized stablecoin is generally more centralized than other cryptocurrencies. The collateral is held by a central institution, which may be subject to external financial control. This effectively gives they have complete control over the coin. You must also believe that the issuer has the reserves that they claim to have.
4. Crypto-collateralized and uncollateralized coins rely heavily on their community to function. Open governance systems are widespread in crypto projects, which means that users have a role in the development and operation of each project. As a result, you must participate or trust the developers and community to operate the project appropriately.
Nowadays, it’s difficult to find an investor or trader who hasn’t held a stablecoin at some point. Stablecoins are frequently held on crypto exchanges in order for traders to immediately capitalize on fresh market opportunities. They’re also great for entering and exiting positions without having to cash out in fiat. Stablecoins can be used for payments and foreign transfers in addition to trading and investing.