Stablecoins provide a method of bridging the barrier between paper money (fiat) like the U.S. dollar and digital assets. Stablecoins are a creative response to the unpredictability of cryptocurrencies since they are price-stable digital assets that act somewhat like money but retain the portability and utility of cryptocurrencies. Price stability is inherent in the assets themselves. Fiat-backed, crypto-backed, commodity-backed, and algorithmic stablecoins are the four main categories the underlying collateral structure can distinguish.
How Stablecoins work
The market's dynamics can affect cryptocurrencies like any other new asset class. As a result, many cryptocurrency initiatives are actively looking into ways to lower risk and increase involvement in the larger crypto ecosystem. The buy, sell, and stop orders in traditional markets are far from the only available options today. Instead, the assets themselves are being designed with price stability. Stablecoins, a brand-new segment of the cryptocurrency market, are the outcome. These tokens are intended to function steadily, as their name implies. The stablecoin market boomed in 2021–2022 and nearly tripled in market capitalization. Based on market capitalization, the fourth and fifth coins are stable as of mid-year 2022.
Stablecoins are blockchain-based digital currencies identified by one of four underlying collateral structures: algorithmic, crypto, fiat, or commodity-backed. Here are some of these types:
The most widely used stablecoins are fully backed by fiat money. This stablecoin is considered an off-chain asset since another cryptocurrency isn't used as the underlying collateral. The amount of fiat collateral must be proportional to the number of stablecoin tokens in circulation and held in reserve with a central issuer or financial institution. For instance, if an issuer has $10 million in fiat money, it can only release $10 million worth of stablecoins. By market capitalization, Tether (USDT), the Binance Dollar (BUSD), True USD (TUSD), and Paxos Standard (PAX) are some of the largest stablecoins in this category.
These stablecoins have been crypto-collateralized and are backed by a different cryptocurrency. Instead of relying on a single issuer, this procedure uses intelligent contracts and takes place on-chain. To receive tokens with an equal representative value, you must lock your cryptocurrency into a smart contract when you buy this form of a stablecoin. After that, you can withdraw the initial amount of your collateral by adding your stablecoin back into the same smart contract. The most well-known stablecoin in this category that uses this approach is DAI. It is accomplished by securing assets as collateral on the blockchain using a collateralized debt position (CDP) through MakerDAO. Stablecoins with cryptocurrency collateral are also over-collateralized to protect against changes in the price of the necessary cryptocurrency collateral asset. For instance, a deposit of $2,000 worth of ETH is required to purchase $1,000 worth of DAI stablecoins or a 200 per cent collateralized ratio. The excess collateral stabilizes the price of DAI if the market price of ETH declines but stays over a predetermined threshold. However, collateral is returned into the smart contract to liquidate the CDP if the price of ETH falls below a predetermined level.
Cryptocurrency or fiat money is not used as collateral for algorithmic stablecoins. Instead, they use sophisticated algorithms and smart contracts to control the amount of in-use tokens that stabilize their prices. When the market price declines below the price of the fiat currency, an algorithmic stablecoin system will lower the number of tokens in circulation. Alternately, if the token's price is higher than the value of the fiat currency, it follows that additional tokens are inserted into the market to reduce the stablecoin's value.
Physical assets such as precious metals, oil, and real estate are collateral for commodity-backed stablecoins. Gold is the most common commodity to be collateralized, and two of the most liquid stablecoins backed by gold are Tether Gold (XAUT) and Paxos Gold (PAXG). It's crucial to remember, though, that the value of certain commodities could decrease due to price fluctuations, which are more likely to occur. Stablecoins backed by commodities make it possible to invest in assets that might otherwise be out of reach for local investors. For instance, finding a gold bar and a safe place to store it can be difficult and expensive. As a result, holding physical goods like gold and silver is not always practical. However, people who wish to convert tokens into cash or acquire the underlying tokenized asset might also benefit from using commodity-backed stablecoins. Paxos Gold (PAXG) stablecoin holders can sell their coins for cash or claim the gold they represent. However, as each token represents one ounce and London Good Delivery gold bars range in price from 370 to 430 per ounce, users need to own at least 430 PAXG to redeem tokens. After being redeemed, token owners can collect their gold at vaults throughout the U.K.
Similarly, Tether Gold holders who complete the T.G. Commodities Limited verification process and own a minimum of 430 XAUT can redeem their XAUT tokens for real gold. This minimum represents the typical 430 oz gold bar used by the London Bullion Market Association (LBMA). Holders of XAUT may pick any location in Switzerland to take ownership of their gold when it has been redeemed. Although all active platforms allow for the redemption of gold-backed stablecoins for physical gold, the same functionality is not available for other commodity-backed stablecoins. For instance, a barrel of oil cannot be redeemed for Venezuela's test-market Petro stablecoin.
Although stablecoins backed by other commodities, like real estate, have recently gained attention, it is impossible to draw any additional comparisons because there aren't many active projects.
Uses and advantages of stablecoins
The most immediately evident benefit is the utility of stablecoin technology as a medium of exchange, effectively bridging the gap between fiat and cryptocurrency. Stablecoins can reach a benefit entirely apart from the ownership of legacy cryptocurrencies by reducing price volatility. Stablecoins are encouraged to be used in regular transactions because, as their name suggests, they are intrinsically stable assets that make good candidates for value storage. Stablecoins also increase the mobility of digital assets across the network. Stablecoins show how to combine the rapidly developing decentralized finance (DeFi) sector with conventional financial markets. Stablecoins, which inherited much of the utility formerly held for just fiat currency, serve as the main route for cryptocurrency adoption in the loan and credit markets while acting as a force for market stability.
Thats all for stablecoins! Stay tuned for more informative cryptocurrency articles.