Stablecoins have become essential in the crypto ecosystem, serving critical roles such as providing stability for investors. According to data from Coingecko, there are over 110 stablecoin assets in the crypto market as of September 2024, with their total market capitalization surpassing $173 billion.
Unlike other crypto assets such as bitcoin (BTC) and Ether (ETH), which are known for their price fluctuations, stablecoins are designed to maintain a steady value. Often pegged to fiat currencies, commodities, algorithms or cryptoasset, their stability has made them an attractive option for a variety of use cases.
In this article, we explore the roles of stablecoins in the crypto ecosystem, their mechanics, types, use cases and associated concerns.
What are stablecoins?
Stablecoins are a type of cryptocurrencies that aim to provide price stability by being pegged to a reserve asset, such as a fiat currency, a basket of currencies, a crypto asset or commodities like gold.
In other words, stablecoin protocols maintain the value of a cryptocurrency relative to a stable asset using mechanisms such as collateralization or supply adjustment.
They are designed to combine the benefits of blockchain technology and regular cryptocurrencies—such as transparency, security, and fast transactions—with the stability of traditional fiat currencies.
Types of stablecoins
There are several types of stablecoins, including fiat-collateralized, crypto-collateralized, and algorithmic stablecoins, each using different mechanisms to maintain their value.
1. Fiat-collateralized stablecoins
These are the most common type and are backed by a reserve of fiat currency, typically the US dollar held in a bank account. For every stablecoin issued, an equivalent amount of fiat currency is held as collateral. Examples include Tether (USDT) and USD Coin (USDC). The value of these stablecoins remains stable as long as the reserve is properly managed and audited.
2. Crypto-collateralized stablecoins
Instead of fiat, these stablecoins are backed by other cryptocurrencies. To account for the volatility of the underlying assets, they are often over-collateralized, meaning a higher value of crypto is held as collateral compared to the stablecoin issued.
DAI, issued by the MakerDAO platform, is a prominent example. Its value is maintained through a system of smart contracts and incentives for users to manage the collateral.
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3. Algorithmic stablecoins
These stablecoins are not backed by any collateral. Instead, they use algorithms and smart contracts to control the supply and demand, maintaining a stable value. The algorithm adjusts the number of tokens in circulation based on market conditions. An example is TerraUSD (UST), although the collapse of the Terra blockchain in 2022 has raised questions about the sustainability of this model.
4. Commodity-backed stablecoins
These stablecoins are pegged to the value of a tangible asset like gold or real estate. Examples include Tether Gold (XAUT) and Paxos Gold (PAXG). They offer investors a way to gain exposure to these assets without physically holding them.
Read also: The Ultimate Guide to Crypto Investing
Roles and use cases of stablecoins
1. Medium of exchange
Stablecoins offer a stable medium of exchange in the crypto ecosystem, making them ideal for daily transactions. Unlike volatile cryptocurrencies, they ensure that the value remains consistent, which is crucial for merchants and consumers alike. This stability is particularly useful in regions with unstable local currencies, providing an alternative means of conducting transactions.
2. Store of value
For investors seeking to avoid the volatility of traditional cryptocurrencies, stablecoins offer a haven. By converting their holdings into assets, they can preserve their value during market downturns without exiting the crypto ecosystem. This makes stablecoins a preferred choice for traders who want to hedge against price fluctuations.
3. Facilitating remittances and cross-border transactions
They enable fast and low-cost cross-border transactions without the need for intermediaries like banks. This is particularly beneficial for remittances, where fees can be high and transaction times long. Stablecoins ensure that recipients receive the intended value without being affected by currency conversion fees or exchange rate volatility.
4. Enabling decentralized finance (DeFi)
These crypto assets are a critical component of the DeFi ecosystem. They serve as the base asset for lending, borrowing, and yield farming. For instance, in crypto lending protocols, users can deposit them to earn interest or take out loans against them. This has democratized access to financial services, allowing anyone with an internet connection to participate.
5. Facilitating arbitrage and crypto market efficiency
In the cryptocurrency market, price discrepancies across different exchanges are common. Traders use stablecoins to quickly move funds between exchanges, capitalizing on these discrepancies to make profits. Stablecoins’ stability makes them perfect options for this purpose, as traders can execute arbitrage trades without worrying about price volatility.
Read also: Memecoins explained: Exploring their risks and how to approach them wisely
Risks associated with stablecoins
Despite their numerous benefits, stablecoins are not without risks. One such risk is their ability to potentially impact financial stability negatively. Notably, stablecoins, especially those widely used for payments and settlements, could pose risks to financial stability if they are not adequately regulated.
A sudden loss of confidence in a major stablecoin could trigger a run, similar to a bank run, leading to systemic disruptions in the crypto markets. Particularly, algorithmic stablecoins face challenges in maintaining their peg during extreme market conditions, as seen with the collapse of UST.
For fiat-backed stablecoins, the primary concern is whether the issuer truly holds sufficient reserves, as there have been controversies regarding transparency and auditing.
Moreover, the widespread adoption of these crypto assets could undermine the effectiveness of the central bank’s monetary policies. For instance, if stablecoins pegged to foreign currencies were to be used extensively in a domestic economy, it could limit the central bank’s control over money supply and interest rates.
Furthermore, the lack of clear regulations around the issuance and backing of stablecoins poses risks to consumers. Issues such as the adequacy and transparency of reserves, operational security, and legal recourse in the event of fraud or collapse are significant concerns for regulators aiming to protect investors and users.
Read also: Cryptocurrencies: Catalysts for Global Economic Development and Financial Inclusion
Final thoughts
The rise of stablecoins has not only offered stability and a bridge between traditional finance and crypto but has also enhanced the growth of decentralized finance, where they play a crucial role in lending, borrowing, and liquidity provision. Their ability to provide a store of value and medium of exchange has made them indispensable for both retail users and institutional crypto investors.
However, their increasing popularity has also attracted the attention of regulators worldwide. Concerns around consumer protection, transparency, financial stability and the potential for misuse place demand for adequate regulation from authorities and compliance from stablecoin issuers.
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