Cryptocurrencies are performing many functions in the global economy. Even some governments, which previously were sceptical about cryptocurrencies, are appreciating their contributions to their national economies.
Recently, El Salvador accepted bitcoin as a legal tender. Apart from this, other countries have created their own cryptocurrencies called central bank digital currencies (CBDC). China and Marshall Islands take the lead on this.
However, cryptocurrencies have one major weakness, price volatility. In practice, prices of many cryptocurrencies can change highly within a short space of time, affecting the economic statuses of individuals within a short time. For example, when the price of certain cryptocurrencies, such as bitcoin rises, many people can become millionaires, whereas if the price falls, many crypto holders may lose their wealth in a significant way.
It is this price fluctuation of cryptocurrencies which inhibited them to become legal tender or medium of exchange in many countries. Rather, many people use them for speculative purposes. Nonetheless, price volatility has not reduced digital assets to waste. Instead, developers have come up with solutions to this challenge, in the form of stable coins.
What is a stable currency?
A stablecoin is a cryptocurrency which is backed or collateralized by a valuable asset. There are different types of assets which can back the value of a cryptocurrency such as precious minerals and fiat currency. Since the value of stablecoins remains constant, they become a secure medium of exchange which is also decentralized and scalable.
As the value of stablecoins is not greatly affected by inflation, many people and businesses readily accept them as a means of payment. This is because stablecoins function in a similar way as fiat money which is generally stable in value.
Types of stablecoins
We have explored what stablecoins are, now it is time to understand their types.
Fiat collateralized stablecoins
These are stablecoins which are backed by fiat currencies such as US dollar or EURO, among others. In this case a fiat currency which collateralizes a certain cryptocurrency is banked. In the end, when a crypto holder converts his/her stablecoin to fiat currency, an equivalent amount of the associated currency is sent to the individual’s bank and the cashed out stablecoins are withdrawn from circulation.
USD, EUR and GBP are the common fiat currencies which back some stablecoins. Usually, the cryptocurrency and the fiat money are pegged at a ratio of 1:1. Examples of fiat currency backed stablecoins include Tether USDT and USDC, both backed by the US dollar.
Commodity collateralized stablecoins
There are several precious commodities such as minerals, oil and real estate which back some stablecoins. The good thing about this type of stablecoins is that they have the potential to appreciate in value. This is because as prices of the associated commodities increase so does prices of the related stablecoins.
For instance, when the price of gold rises, the value of the gold backed stablecoins will also increase and vice versa. DIGX GOLD (DGX) is an example of such a stablecoin, as physical gold collateralizes it. SwissRealCoin (SRC) and TCX are other commodity collateralized stablecoins.
Crypto collateralized stablecoins
As the name suggests, these are stablecoins which are backed by other top cryptocurrencies such as ETH and BTC. The collateralization helps to reduce the price volatility of the associated stablecoins. However, with such stablecoins the ratio is not 1:1.
An instance of this stablecoin is DAI, which is backed by ETH, despite the face value being pegged in US dollars. In this case, a certain amount of ETH is locked in a smart contract which MakerDAO developed.
Non collateralized stablecoins
This fourth type of stablecoins is unique as there is no collateral of any form. Instead, there are software rules that control the supply of the coins in circulation thereby maintaining their prices at a reasonable level. How does this work? When the demand of the coin rises, the supply of the coin increases, whereas if the demand decreases their supply also decreases.
This positive relationship between the demand and supply of the stablecoins results in their constant prices.
What is the importance of stablecoins?
First, crypto holders use stable coins as safe havens when prices of other cryptocurrencies fall. In this case, when prices of other cryptocurrencies start to fall, individuals convert their holdings into stablecoins. For instance, on the onset of a market crash individuals can exchange other cryptocurrencies with stablecoins. Thus, they do not lose out when the market finally crashes.
With advanced price prediction tools that exist in the market, cryptocurrency holders can get alerts on possible fall in prices of some coins and tokens. This enables them to convert their crypto holdings into stablecoins.
Supporting DeFi infrastructure
Stablecoins support various DeFi functions such as lending and borrowing of cryptocurrencies. As a result, they promote a reliable environment for peer to peer transactions, as people have confidence that the value of their assets is maintained. For example, lenders know that they will get their principal amount plus interest.
Enabling efficient cross border payments
Definitely, stablecoins promote cross border payments as people can access them without first converting them into their domestic currencies. For example, people in Russia and the United Kingdom, alike, can get stablecoins without any currency conversions.
Hedging against domestic inflation
People can use stablecoins to deal with inflation. Instead of keeping their local currencies, individuals can convert them to stablecoins immediately before using their currencies of choice.
Stablecoins have transformed international payment systems as well as helping people to maintain values of their digital assets. In addition, they have resulted in greater adoption of cryptocurrencies than ever before.