What Are Stablecoins

As beneficial and financially liberating as cryptocurrencies are, their high volatility significantly hinders mainstream adoption. Their values are unsteady and unpredictable, posing a challenge for widespread acceptance. For instance, the value and price of Bitcoin went from $50,000 to $15,000 in 2022. 

To encourage individuals worldwide to adopt them as a means of exchange in their day-to-day lives, the issue of unpredictability — price volatility — must be addressed. Consequently, stablecoins were explicitly designed to address this issue.

As the name implies, stablecoins are cryptocurrencies whose values are steady and stable, resulting from being pegged to stable assets such as the US dollar. Examples of stablecoins include Tether (USDT), USD Coin (USDC), Euro Coin (EURC), and Binance Dollar (BUSD).

In this article, you will learn about stablecoins, understand their importance, discover the different types, find out how to use them, purchase them, and explore their prospects.

Importance of Stablecoins

To Facilitate Mainstream Crypto Adoption: Their volatile nature is a significant factor hindering the widespread adoption of cryptocurrencies. The market's unpredictability poses risks, particularly for investors and individuals with a low tolerance for risk. Stablecoins safeguard against volatility, providing holders security and protection from erratic market conditions. Unlike other cryptocurrencies, stablecoins maintain a stable value and do not experience significant price fluctuations.

Global Accessibility: Stablecoins offer universal access, providing an open and global financial tool to anyone with an internet connection, irrespective of gender, social status, or similar factors. There are no restrictions on using them for payments and digital services.

Cross-Border Remittance: Due to the inherent stability of stablecoins, along with the easy accessibility of blockchain technology, low transaction fees, and speedy transfers, they serve as an excellent payment option for both individuals and businesses. For instance, you could send millions in stablecoins to a business owner and incur transaction fees of less than $10.

Anti-Inflation: Stablecoins play an essential role in developing economies, helping individuals safeguard their wealth against inflation and currency devaluation, which are common issues in these regions.

How Are Stablecoins Different From Other Cryptocurrencies?

Flexibility: Stablecoins allow users to experience the advantages of digital currencies, including decentralization, autonomy, and low transaction costs, while offering the stability characteristic of fiat currencies. This stands in contrast to other cryptocurrencies, such as Bitcoin, which do not provide the same level of stability. For instance, you can conduct transactions anonymously, directly, and swiftly using stablecoins such as USDC. Furthermore, your holdings remain unaffected by price volatility, even in a declining market. In contrast, with cryptocurrencies like Bitcoin, you benefit from decentralization and speed but not stability.

Pegged: Stablecoins are backed by assets, which protects them from volatility and helps maintain a stable price. In contrast, most other cryptocurrencies lack this backing, leaving them more susceptible to price fluctuations.

Resilience: Stablecoins are resilient against volatility, even in challenging cryptocurrency market conditions. For instance, in 2022, Bitcoin experienced a noteworthy drop in value, plunging from $50,000 to $15,000. Meanwhile, the market cap of Binance USD (BUSD) increased from $1 billion in January 2021 to $19 billion in December 2022, showcasing its adoption.

Types of Stablecoins

Stablecoins Are Designed With a Single Purpose: to safeguard against the volatility associated with unpegged cryptocurrencies such as Bitcoin, Dogecoin, and Ether. However, stablecoins vary based on their backing mechanisms, the assets used for backing, and the teams or organizations responsible for their issuance. Stablecoins can be categorized into fiat/commodity-backed, crypto-backed, or algorithm-backed stablecoins.

Fiat/commodity-backed Stablecoins: These are the most common type of stablecoin. They're backed by either fiat assets such as the US dollar or commodities like gold. USDC, for instance, is a well-known example of a fiat-backed stablecoin, with each USDC equal in value to one US dollar due to the backing of the US dollar.

Crypto-Backed Stablecoins: These stablecoins are secured by other cryptocurrencies through a process known as crypto-collateralization. To safeguard against volatility for users and holders, the value stored in reserves for these stablecoins typically exceeds the value of those issued. A case in point is the Dai stablecoin from MakerDAO, where each Dai in circulation is backed by 1.5 times its value in Ethereum.

Algorithm-Backed Stablecoins: These stablecoins maintain their value through smart contracts or algorithms. The smart contracts adjust the circulating supply in response to market conditions, ensuring price and value stability. For instance, when the value of algorithm-backed stablecoin drops, the smart contracts reduce the stablecoin's circulating supply, creating scarcity to boost its value. Also, when the price declines, the smart contracts increase the supply to maintain a steady price.

The Pros of Stablecoins

Minimized Risks: Stablecoins present significantly lower risks than unpegged cryptocurrencies such as Bitcoin, offering protection against market volatility and unfriendly conditions.

Alternative Source of Income: You can generate passive income through staking or lending. By locking up stablecoins within a specific network,  you can earn interest rates higher than what is obtainable with traditional banks. Additionally, you can trade stablecoins and even build a profitable career from it.

Hedge Against Inflation And Currency Devaluation: Currency Devaluation can be problematic, especially for low-income people. Since their value is steady and backed by a stable asset, saving in stablecoins can help protect business owners and individuals from the consequences of inflation and currency devaluation.

Seamless And Cost-Effective International Remittances: Engaging in cross-border business transactions often leads to substantial transaction fees. The World Bank's remittance report from June 2023 indicates that the average cost of sending remittances is 6.20% of the transferred amount. In contrast, stablecoin transactions and remittances are swift, straightforward, secure, and cheap.

The cons of Stablecoins

As good as stablecoins are, they are not without its risks and problems.

Liquidity Risk: This involves the probable challenge of not being able to quickly sell assets without losing some value. This risk becomes noticeable when there's a dip in demand. This means more people want to sell than they are looking to buy. For stablecoins that aren't as popular, their value can take a hit when there's an imbalance — too many sellers and insufficient buyers. This situation is particularly concerning as it increases the risk of investment loss.

Regulatory Risk: Stablecoins are relatively new in the financial landscape, and governments and regulatory bodies are currently understanding how they work and determining the best ways to approach them. There is a possibility that regulators might implement policies that are not favorable, which could negatively affect your investments and the stability of the stablecoin in question.

Counterparty Risk: Since stablecoins are typically pegged to other assets, such as fiat currency or cryptocurrencies, their stability depends on the reliability of the entity backing them. If the company or organization fails to uphold its responsibilities, it poses a risk to your investment.

Technical Risks: Stablecoins operate on blockchain technology, which, while secure, is still in the development stage. This means it isn't completely free from the risk of breaches or technical issues. If a security breach does occur, it could expose the stablecoin to unexpected volatility.

Market Risks: While stablecoins aren't affected by the usual ups and downs of the crypto market, their worth is tied directly to the assets backing them. So, if those assets lose value, the stablecoin's value could also take a hit. In addition, a sudden spike in demand for a stablecoin can push its value and price above the pegged level. Also, a drop in demand could see its value fall below the pegged price.

Just like any other investment, stablecoins have their unique set of challenges. It's essential to do your research thoroughly before deciding to invest.

Conclusion

Stablecoins have become popular alternatives to Bitcoin and other altcoins due to their stability, security, and certainty, but they are open to problems. Stablecoins are still affected by issues like lack of regulation and security breaches. You must do your due diligence by conducting thorough research and understanding the potential risks and benefits before investing in stablecoin.