While cryptocurrencies technically are superior financial assets than traditional assets, they suffer serious volatility issues. This is mainly because cryptocurrencies, in general, don’t rely on any underlying assets. Additionally, while altcoins have mainly found their way of valuing their network, most cryptocurrencies have not. Other than that, due to their decentralized nature, many countries resist the advent of cryptocurrencies. However, there is another type of cryptocurrency known as stablecoins.
These types of digital assets align in-between cryptocurrencies and traditional assets, employing both characteristics.
Stablecoins are cryptocurrencies that are pegged to real-world assets ranging from fiat currencies, commodities or even another cryptocurrency. Like their name, Stablecoins have a much shorter range of price fluctuations. Moreover, their main aim is to have a stable value with traditional currencies or underlying commodities.
Due to relatively higher distrust in cryptocurrencies, investors tend to use safer options like stablecoins. Thus, they leverage the benefits of cryptocurrencies and blockchain without losing the guarantees of trust and stability that come with using fiat currencies.
As of now, there are more than 200 of them. The top five in terms of market cap are:
- Tether (USDT), Market Cap – $67.59 billion.
- USD Coin (USDC), Market Cap – $27.88 billion.
- Binance USD (BUSD), Market Cap – $12.56 billion.
- DAI (DAI), Market Cap – $6.50 billion.
- TerraUSD (UST), Market Cap – $2.45 billion.
How many types of Stablecoins are there?
In general, there are 4 types of stablecoins:
- Fiat-collateralized – These are the simplest and most common type of stablecoins. They are pegged to fiat currencies like the US dollar or the Euro with a backing of 1:1 ratio. Traders can exchange their stablecoins and redeem their dollars directly from the exchange. Examples include USDT and USD Coin.
- Commodity-collateralized – Commodity assets like precious metals, gold, silver, real estate or oil back them. Examples include PAX Gold, which relies on a gold reserve.
- Crypto-collateralized – These are pegged to other cryptocurrencies as collateral. However, since cryptos have much higher volatility, these stablecoins generally follow set of protocols so that the stablecoin issued remains at $1. Examples include DAI that is pegged to the US dollar in collaboration with Ethereum.
- Algorithmic or non-collateralized – Algorithmic stablecoins use total supply manipulations to maintain a peg. Basically, they operate in the way fiat currencies work. In fact, their way of governance is similar to how a country’s sovereign bank maintains its native currency. Examples include Ampleforth (AMPL) based on Empty & Dynamic Set Dollar.
Use-cases of stablecoins
Since stablecoins is a relatively new but booming segment, there are a growing number of use-cases:
- Switching between cryptocurrencies and stablecoins – They are popularly used to quickly switch between a volatile cryptocurrency and a stablecoin, while trading, to protect the value of holdings.
- Smart contracts – These digital assets allow for the use of smart financial contracts that are enforceable over time.
- Mainstream commerce – Eventually, many expect that due to less volatility of stablecoins, consumers and merchants will effectively start using it as true units of exchange.
- Payments – They also allow uses receive similar benefits like cash. Users can freely transfer it just like cash. In fact, anyone on the blockchain network can receive and send coins.
Are there any risks in cryptocurrencies?
Although stablecoins can greatly enhance the efficiency of financial services, they also generate risks to financial stability. This is especially true if they are adopted at a significant scale. In fact, some of them are much riskier than they look. Some other risks are:
- Asset contagion risk – Rapid growth of stablecoin issuance can implicate the functioning of short-term credit markets. As some stablecoins are equivalent to money-market funds, their practices could lead to lower values, in turn creating significant damage in the broader crypto market.
- Collateral consequences – It is questionable whether stablecoins could liquidate sufficient investments quickly to satisfy the demand if need.
- Lack of accountability – The drawback of fiat-collateralized stablecoins is that no one can audit their functioning which raises doubts. They function kind of like non-bank financial intermediaries, providing services similar to traditional commercial banks, but outside normal banking regulation.
- Systemic risk – Some of these fiat currency-pegged tokens are not backed by actual fiat currencies, but by a combination of riskier assets. This puts not only stablecoin holders at risk but could potentially threaten financial stability in general.
The aspect of regulation
All the issues mentioned above underline the fact that there is a large regulation gap concerning stablecoins. This contributes to weak investor protection and fraudulent activities. Moreover, this lack of regulatory clarity also creates confusion when new products related to stablecoins are brought to market.
While many international regulatory and oversight bodies are working on finding an optimal regulatory approach, there is still uncertainty. As a result, several regulatory approaches are starting to shape how stablecoins might be governed and more narrowly define their use.
All in all, Stablecoins are peculiar challenges that can become a potential case study of cooperation. Moreover, they do not stand for a uniform category but represent various crypto instruments, varying in legal, technical, functional and economic terms. Therefore, to be effective, the stablecoin industry has to work together with the regulators to come up with a framework, helping them while protecting this nascent industry from overregulation.