May 23, 2022

What is a stablecoin?

What is a stablecoin?

Stablecoins are nothing more than cryptocurrencies created in order to maintain a price with little variation in the market, generally representing a fiat currency within a blockchain. Stablecoins aim to keep the qualities and benefits of cryptocurrencies while reflecting fiat assets with a demonstrated level of valuation stability. To achieve stability in their valuation, stablecoins generally use collateralization with another financial asset. In this way, they seek to keep their value stable in the face of various market situations.

Why Were Stablecoins Created?

The stablecoin was born out of the need to regulate cryptocurrency’s high volatility. Despite being a full economic revolution, cryptocurrency valuations are quite volatile. This volatility is linked to market speculation in a variety of ways. A circumstance that is reflected in the cryptocurrency markets’ ongoing bullish and negative movements.

The goal is for users who are concerned about such volatility to be able to use stablecoin. So, resolving this issue would hasten user and business adoption of cryptocurrencies.

What are the ways of supporting stablecoins?

Stablecoins require a physical, monetary, or link to another cryptocurrency to preserve its value. These backup strategies are what help achieve that purpose. In this way they have managed to offer members of the community consistency in the prices of crypto assets. The forms of backup for stablecoins are as follows:

Fiat currency support

For stablecoins, this is the most frequent backup technique. In general, the cryptoactive is backed by guaranteeing the same proportion of each network token (1: 1). The US dollar, euro, and Japanese yen are among the currencies utilized. This means that one unit of fiat currency will guarantee the value of each token.

Support in commodities

In stablecoins, this is another popular type of backup. This system operates by leveraging commodities to support the stablecoin’s value. Gold, silver, diamonds, and oil are examples of them. The backup ratio might be as basic as a one-to-one ratio or rely on low-cost algorithms. Ex. Digix Gold is a stablecoin that states that one gram of gold is equal to one token DGX. In this approach, it is able to maintain a price equilibrium for the crypto asset. The gold is also maintained as bullion as a reserve in this situation. This enables them to be validated and audited by a reputable third party, ensuring their approval.

Support for other crypto assets

This is another common stabilization method that is typically somewhat complicated. This is due to the utilization of a complicated economic system to keep prices stable. This aims to protect the stablecoin’s price from fluctuations in the value of the backup crypto asset. However, this system aims to get rid of the centralism of supporting stablecoin using fiat currency.

The method this time is to back up a token with the reserves of another cryptocurrency. But this can result in a drawback caused by the instability of the cryptocurrency itself.

Stablecoin public vs. Private

Stablecoins can also be classified as public and private. Private are those issued by commercial companies, and central banks issue the public. Stablecoins offer the possibility of developing an international currency linked to a basket of fiat currencies or commodities. This would further reduce volatility. They can protect themselves against fluctuations in the value of national currencies. It also has the potential to dramatically increase the efficiency of cross-border settlement.

To date, private companies have been the pioneers in the development of stablecoins. This is due to the barriers faced by central banks seeking to offer fiat digital currencies.

An example of the development of stablecoins in the private sphere is the launch of a US dollar stablecoin for Circle. This is a payment company backed by Goldman Sachs, with the support of Coinbase. Circle USDC is a cryptocurrency that runs on the Ethereum blockchain and is designed to be used by customers for cryptocurrency payments and transactions.

Stablecoins use cases

Global Currency

Stablecoins are designed to tackle the problem of volatility, acting as a bridge between cryptocurrencies and fiat currencies. A stable and decentralized digital currency could become a medium of global exchange. This is an especially important application in emerging markets experiencing debilitating levels of inflation and economic chaos, such as Argentina and Venezuela.

Decentralized Financial Services

Currently, institutional arrangements limit access to capital markets. Financial market transactions cause friction, and transaction costs are scale-dependent, with information costs being the most significant component.

The existence of a banking system is justified by the fact that banks can act as financial intermediaries. This is because banks have a competitive advantage in gathering information and evaluating credit risk. However, the relationship between finance and the economy is not neutral. Misallocations of funds can occur, and financing and capital gaps can arise.

Given this, small companies are at a disadvantage. This is because capital markets tend to prioritize large, established companies. As a result, small and new businesses find it difficult to obtain seed capital and early expansion.

Stablecoins seek to solve this problem by allowing access to financing. Example of it; they are the fair loan and derivatives markets. They also seek to reduce costs in the supply chain and international trade by eliminating intermediaries who charge fees for guaranteeing secure transactions, granting stable capital and intermediating cross-border initiatives.

Advantages and disadvantages of stablecoin

Advantages

  1. Stablecoins are backed by real-world assets. This is especially true for stablecoins based on currency and commodities. As a result, coin holders have a tangible asset that is backed by real value. Allowing them to convert these assets into genuine assets by redeeming them at the conversion rate.
  2. It offers great stability in its market value. Although stability does not mean invariance, stablecoin prices are not as susceptible to large variations in cryptocurrency prices. These characteristics are something that investors of this type of cryptocurrency greatly appreciate.
  3. Because of tokenization, they have a lot of liquidity. This is especially true when stablecoins are based on commodities, as it adds liquidity to the market, allowing for better price formation.

Disadvantages

  1. Stablecoin is a highly centralized system. This centralization is evidenced by the necessity for third parties such as suppliers, custodians, and the project itself.
  2. Audit processes are expensive and time-consuming. This is due to how intricate the operating system can be.

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