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A Deep Dive Into Stablecoins

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Published Date: 29 May 2024Updated Date: 17 Jan 20256 mins readBy MOFSL

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Introduction:

Cryptocurrency has emerged as a captivating new domain in the world of finance. It has drawn the attention of both seasoned investors and newcomers. It particularly appeals to the latter, as young investors seek disruptive and innovative investment opportunities. Stablecoins are a type of cryptocurrency. Before you explore stablecoins, knowing whether they live up to their name and truly deliver the promised stability is imperative. Let’s find out!

What are stablecoins?

Stablecoins represent digital currencies that are tied to stable assets. Most stablecoins are anchored to a 1:1 ratio with specific currencies like the Euro or the US dollar. They are actively traded on specialised exchanges, akin to digital marketplaces. Some stablecoins also derive their value from other diverse assets, including gold or other cryptocurrencies.

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The growing significance of stablecoins in the digital economy has attracted much attention. In fact, the collective market capitalisation of stablecoins has been steadily on the rise and is presently estimated to exceed $180 billion.

Types of stablecoins

There are four main categories of stablecoins:

1. Commodity-collateralised stablecoins: Commodity-collateralised stablecoins derive their value from interchangeable assets, with precious metals such as gold being the most common. However, these assets can extend beyond gold to include real estate, oil, and other valuable commodities.

2. Fiat-collateralised stablecoins: As the name suggests, fiat-collateralised stablecoins are backed by traditional currencies like GBP, USD, or EUR. Operating on a 1:1 ratio, these stablecoins maintain an equivalent value to their fiat currency counterpart. They are the most prevalent type of stablecoin in the market.

3. Crypto-collateralised stablecoins: Backed by other cryptocurrencies, crypto-collateralised stablecoins offer a more decentralised approach compared to other types. This decentralisation helps mitigate voltility risks, as these stablecoins are designed to absorb price fluctuations.

4. Non-collateralised stablecoins: In contrast to the collateral-backed models, non-collateralised stablecoins operate without any backing by tangible assets. Instead, they employ algorithmic governance to control the stablecoin supply. When demand increases, new stablecoins are generated, and when the coins are trading below a certain threshold, the circulating supply is reduced. This innovative approach provides stability without the need for traditional collateral.

Advantages of stablecoins

Here are some benefits of stablecoins:

The cryptocurrency market is inherently unstable with price fluctuations. Stablecoins provide a hedge against this. They help mitigate the risks associated with sudden and drastic market movements.
Stablecoins are built on blockchain technology, which ensures enhanced visibility and traceability of transactions. This increased transparency makes it easy to verify and track transactions.
Stablecoins can be seamlessly stored on and transferred through digital wallets.
Transactions involving stablecoins often incur lower fees compared to traditional banking methods or some other cryptocurrencies.
While providing transparency, stablecoins also offer a level of privacy. The decentralised nature of blockchain ensures that personal information is not concentrated in a central authority.

Are stablecoins really stable?

The answer to this can be a bit tricky. The stability of these digital currencies depends on two things - how well they are managed or governed and how much their value jumps around, also known as volatility.

Unlike other decentralised cryptocurrencies, stablecoins necessitate the management of their underlying asset reserves by an external entity. The stability of these digital assets is tied to effective governance and the ability to navigate market fluctuations. External audits play a pivotal role in instilling confidence among investors by ensuring that the assets backing stablecoins are accurately accounted for, offering a layer of transparency crucial for trust.

While stablecoins aim to be less volatile in value compared to other digital currencies, the trade-off is that they might make you less money in return. They are stable in the sense of being less risky, but the rewards might not be as high as some other digital currencies.

To sum it up

As stablecoins continue to gain prominence, their role in the digital economy becomes increasingly significant. While stablecoins provide a layer of stability in the volatile cryptocurrency market, you must carefully weigh the potential benefits against the associated risks before investing your money.