Stablecoins (from “stablecoin” – stable coin) are a special class of cryptocurrencies that are designed to provide price stability. Unlike bitcoin, etherium and other popular cryptocurrencies, stablecoins are linked to real assets such as fiat currencies (US dollar, euro) or commodities (gold, oil). This makes their value less prone to fluctuations, which is especially important in the world of cryptocurrencies, where volatility is often an issue for users and investors. In this article, we’ll look at what stablecoins are, how they work, and what benefits and risks they carry.
1. What are stablecoins?
Stablecoins are cryptocurrencies designed to minimise volatility by linking to the price of a stable asset. Their main objective is to maintain a constant value, which makes them more suitable for everyday use, storage and transactions than regular cryptocurrencies.
Stablecoins can be backed by different types of assets:
(a) Fiat currencies
The most common type of stablecoins are pegged to fiat currencies such as the US dollar (e.g. USDT, USDC, BUSD). These coins are backed by reserves held in banks or other regulated financial institutions, which ensures their stable value.
(b) Commodities
Some stablecoins are pegged to the price of commodities such as gold (e.g. PAX Gold). These cryptocurrencies are backed by physical commodities, making them attractive to investors looking for stability and inflation protection.
(c) Cryptocurrency assets
Other stablecoins are backed by cryptocurrencies (e.g. DAI). These coins can be more volatile than fiat steblecoins because their reserve is digital assets, but sophisticated algorithms and risk management systems help keep their exchange rates stable.
(d) Algorithmic Stablecoins
Algorithmic steblecoins (e.g. Ampleforth) use software algorithms to regulate the supply of coins based on market conditions. When the price of a stablecoin falls below a certain level, supply decreases, and when the price is higher, supply increases. This mechanism stabilises the exchange rate, but such coins can be riskier than fiat or commodity stackablecoins.
2. How do steblecoins work?
Stablecoins work based on asset-binding mechanisms that are used to ensure the stability of their exchange rate. There are several models of how this can happen:
(a) Backup collateral
For steblecoins pegged to fiat currencies or commodities, the issuing company holds an equivalent amount of funds in reserve. For example, each USDT coin issued is backed by one US dollar held in a bank account. In case of need, the user can exchange his/her steblecoins for real dollars through an appropriate platform.
(b) Cryptocurrency collateral
Cryptocurrency stablecoins such as DAI use complex smart contracts to maintain exchange rate stability. Users can deposit the cryptocurrency into a special smart contract that creates the stablecoins. To avoid cryptocurrency volatility, such systems usually require collateral worth more than the issued stablecoins, e.g. 150% of the amount.
(c) Algorithmic model
Algorithmic stablecoins are not backed by real assets. Instead, they rely on algorithms that automatically adjust supply and demand in the market. If the price of a coin deviates from the target level, the algorithm increases or decreases the number of coins in circulation to restore stability.
3. Advantages of Stablecoins
Stablecoins have a number of advantages that make them attractive to both individual users and businesses:
(a) Price stability
One of the main advantages of stablecoins is their minimal volatility compared to traditional cryptocurrencies. This makes them ideal for storing funds, conducting transactions and using them as a means of payment.
(b) Fast and cheap transfers
Stablecoins allow you to transfer money around the world quickly and with minimal fees. They can replace traditional international transfer systems such as SWIFT and make payments more accessible to people in different countries.
c) Access to decentralised finance (DeFi)
Stablecoins are widely used in the DeFi ecosystem for lending, borrowing and income farming. They allow users to earn interest on their funds or borrow against cryptocurrency without the need for banks and financial intermediaries.
(d) Protection against market volatility
During periods of high volatility in the cryptocurrency market, users can transfer their assets into stablecoins to protect their funds from losses. This makes stablecoins a useful tool for preserving capital value during volatile periods.
4. Risks of Stablecoins
Despite all the benefits, steblecoins also carry certain risks that are important for users to be aware of:
(a) Dependence on issuers
Fiat steblecoins, such as USDT or USDC, depend on the credibility of the issuing companies to maintain reserves in full. If the issuer is unable to fulfil its obligations, this could lead to loss of trust and devaluation of the coins.
(b) Regulatory risks
Stablecoins are increasingly coming under regulatory scrutiny, especially in the US and the European Union. There is a possibility of strict regulations being introduced which may affect their availability and use.
(c) Risks of hacking and technical failures
Like all cryptocurrencies, stablecoins are subject to technical risks. If the reserve management system is hacked or the smart contract fails, this could result in the loss of users’ funds.
(d) Algorithmic risks
Algorithmic stablecoins are particularly vulnerable to market fluctuations. In the event of a sudden drop in demand or a market panic, algorithms may not be able to rebalance in time, resulting in significant losses for coin holders.
5. The Future of Stablecoins
Stablecoins already play an important role in the cryptocurrency world and continue to gain popularity. In the future, we can expect to see an increase in the number of regulated stablecoins backed by central banks (CBDCs – central bank digital currencies), which could lead to greater integration of these assets into global financial systems.
In addition, improvements in technological solutions and the introduction of new security protocols will help to make steblecoins even more secure and convenient for everyday use.
Conclusion
Stablecoins are an important element of the cryptocurrency world that provide stability and convenience in the use of digital assets. They offer numerous benefits including volatility protection, fast transfers and access to financial services, but they also have their risks. With advances in technology and regulation, stablecoins could become an integral part of both cryptocurrency and traditional financial systems.