Cryptocurrency, the word which created a lot of buzz in the financial market, tends to be a permanent headline these days. From Elon Musk’s tweets to surging demand because of an increase in popularity, everything seems to affect the value of the cryptocurrency, making it highly volatile.
Bitcoin and other prominent cryptocurrencies are unsuitable for everyday use by the general public because of their short-term volatility.
However, despite this volatility, cryptocurrencies like Bitcoin remain extremely popular because of their unmatched benefits like low transaction fees, no third-party verifications or involvements like banks, and pseudonymous transactions, to state a few.
But even after all these advantages, the stability of these kinds of cryptocurrencies have always been a significant concern.
And so, to save the day came the concept of Stablecoin. A currency should essentially serve as a medium of monetary exchange and a means of storing economic value, remaining relatively steady over extended periods.
Users will be hesitant to accept it if they are unsure about its purchasing power in the future. In an ideal world, a crypto coin would preserve its purchasing power while also having the lowest possible inflation, encouraging people to spend their tokens rather than save them.
Stablecoins offer a means of achieving this desirable behaviour.
Stablecoin is a cryptocurrency that combines the goods of both the physical and the digital currency market. Stablecoin refers to the cryptocurrency whose value is linked to another asset class, thus giving it stability.
It addresses the issue of volatility and also allows its investors the benefits of digital currency. Stablecoin is usually linked to fiat currency like the US dollar or reserve metals like gold and silver. Thus, Stablecoins are cryptocurrencies that attempt to peg their market value to some external reference.
Now that we know Stablecoin in strict finance terms, let’s understand it in layman’s language. Let’s take the example of fiat collateralized currencies like the Tether or the TrueUSD, which are backed by the US dollar.
The issuing firms must hold a reserve of an equal quantity of fiat currency to issue fiat collateralized Stablecoins. One Stablecoin is equal to one US dollar, and the corporation typically retains audited accounts of US dollars to cover all of the Stablecoins it issues.
As a result, if a Stablecoin’s worth is $1 million, its issuing firm must own $1 million in the form of US dollars. Stablecoins backed by reserved metals like gold and silver also functions similarly.
But sometimes, a Stablecoin is pegged to another cryptocurrency or even to an algorithm. The ones pegged to an algorithm are known as non-collateralized Stablecoins.
As for those collateralized against other cryptocurrencies, one might wonder, what is the point of Stablecoin if it is ultimately linked to a volatile cryptocurrency like Bitcoin. How will such Stablecoins dodge the banes of volatility?
Well, the answer to this question is over-collateralization. The issuing authorities of such Stablecoins embrace the concept of over-collateralization and keep an excess reserve of cryptocurrency they pegged to issue the Stablecoin.
This means that they hold cryptocurrency worth $2-3 to give a Stablecoin worth $1, thus keeping the extra value acting as a buffer for volatility, making it a safer option.
Now that we know, what Stablecoins are, let’s look at the advantages. Cryptocurrencies were created to decentralize banking and extend the reach and convenience of spending money.
However, due to their continuously shifting value, assets such as Bitcoin and Ether have grown more popular as assets than tokens that individuals can spend.
Stablecoins offer a more reliable avenue of digital transactions by being tethered to a stable currency like the US dollar, overseen by a central bank that can keep its value from experiencing excessive swings.
Apart from these benefits, advantages like the lack of the need to have a bank account to transact and the ease of transferring money with meagre transaction costs compared to the traditional methods like banks have made it an even attractive option. And so, Stablecoin already has a market of $125 billion.
But, even with all of these benefits, it’s important to remember that Stablecoin is still a cryptocurrency, which means that, by its very nature, cryptocurrencies are controlled by private companies. They can contribute to systemic risk and financial crime, and so they should be used discreetly.