Benefits of Stablecoins: Why They’re Important and How They Work

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The cryptocurrency market is known for being volatile and unpredictable. The value of digital tokens can rise or fall quickly, making it difficult to use them as a reliable medium of exchange or store of value. As a result, some cryptocurrencies are seeing limited adoption because users don’t feel they can trust them as a long-term store of value. Fortunately, solutions exist that make cryptocurrencies more stable. Stablecoins are digital tokens aiming to maintain a fixed price. Using this technology, developers can create digital tokens with stable prices that make them suitable for storing value or making purchases. This article will discuss the benefits of stablecoins and how they work.

What is a Stablecoin?

A stablecoin is a type of cryptocurrency that maintains a fixed price. Typically, the price of each cryptocurrency token rises or falls based on the overall market. Unlike other cryptocurrencies, stablecoins hold a fixed price by pegging their value to another asset, such as gold or fiat currency. Most stablecoins are pegged to the U.S. dollar, making them a good option for individuals who don’t want to deal with volatility. Stablecoins are also called “crypto-collateralized tokens” or “cryptocurrency escrow.” These tokens are a medium of exchange and a store of value. Most stablecoins are on the Ethereum blockchain, the second most popular crypto network by market cap.

How do Stablecoins Work?

Stablecoins maintain a fixed price by pegging their value to another asset, minimizing volatility by design. Fiat currency or gold is the “peg” that backs the most popular stablecoins. Let’s take a closer look at how each works. 

Fiat-backed stablecoins

A central authority deposits the required fiat currency into a smart contract. The money is held in the contract until someone wants to exchange the stablecoin for the underlying asset. Suppose a user wants to redeem their stablecoin. In that case, the contract will pay them the fiat value it was initially supposed to represent. If a user wants to exchange their stablecoins for fiat money, the contract will pay them. Tether (USDT) and USD Coin (USDC) are fiat-backed stablecoins with a 1:1 ratio of $1 cash or $1 cash equivalent for each USDT or USDC token in circulation.

Gold-backed Stablecoins (aka. Commodity-backed)

Gold-backed stablecoins allow for a safe and convenient way to preserve some of the wealth that citizens have built over generations. Instead of physically carrying gold, digital encryption protects the value of the gold, making it easy to transport digitally. Pax Gold is one example of a stablecoin that pegs its value directly to the market price of gold, holding the equivalent amount of gold for each stablecoin issued.

Crypto-backed stablecoins

Some crypto investors unsatisfied with the centralized nature of most stablecoins have opted to hold crypto-backed stablecoins instead. Crypto-backed stablecoins are tokens backed by collateral composed of other cryptocurrencies. To mint these stablecoins, users deposit crypto into a smart contract which locks it up and issues a certain amount of stablecoins in return. One example is MakerDAO’s DAI, which allows users to mint Dai tokens by depositing collateral to a decentralized Ethereum smart contract. Dai tokens are “soft pegged” to the U.S. Dollar, meaning there is always a higher amount of cryptocurrency collateral deposited than Dai tokens in circulation. All information about the Dai smart contract, transactions, and total tokens in circulation are publically available for inspection here.

Stability through Anchoring

The main idea behind the fiat-backed model of stablecoins is that they will maintain a fixed price through an “anchoring” process. Assume that a stablecoin is pegged to the U.S. dollar, so the price of each token is worth $1. Now, let’s say the price of stablecoin falls to $0.90. This means it has depreciated by 10%. The stablecoin will have to increase in price to $1.10 to “snap back” to its original value. This process is known as “analogous regression to the mean.” In other words, the stablecoin’s price will eventually return to its initial $1 value through an oscillating process. 

Because market participants will use the stablecoin’s previous price as a reference point, they will buy tokens when they see they are trading at a discount. They will then sell the stablecoin when they know it is trading at a premium. This continuous buying and selling should push the stablecoin’s price back to $1. For this to happen, there has to be enough liquidity in the market for people to buy and sell tokens. It’s also essential for stablecoins to have a large enough market cap to prevent people from flooding the market with sell orders.

Benefits of Stablecoins

There are several benefits to using stablecoins over other cryptocurrencies. Here are a few: 

– Stablecoins are more suitable for daily and cross-border transactions. 

– One of the primary reasons people use cryptocurrencies is to make online purchases.

– High yield deposit opportunities for stablecoins

Unfortunately, the price of some digital tokens, like Bitcoin, can swing by more than 10% in a single day. Any merchant who accepts Bitcoin as payment can see their profits drastically change in a brief period. E-commerce companies that accept Bitcoin must adjust their prices frequently to account for these fluctuations. These adjustments are inconvenient and costly, significantly if the value of Bitcoin is declining. Stablecoins are less volatile, which means merchants can set a single price and know that it won’t change. Businesses benefit from the non-volatile stablecoin price when they accept cryptocurrencies as payment. 

– Stablecoins could become the next global currency. 

– Another way to describe stablecoins is that a “store of value backs them.” 

A stable store of value means the tokens store wealth and have the ability to make investments. Stablecoins have many of the same characteristics as gold, the oldest and most widely accepted store of value. These coins are easy to store, divisible, and fungible, similar to the qualities of gold. Because stablecoins can make investments, they have the potential to become the next global currency. When more people start using them for everyday transactions and storing their wealth in digital tokens, stablecoins could reach mass adoption.

-Stablecoin transactions settle in seconds.

Imagine sending $10,000 worth of stablecoins worldwide to pay for merchandise in seconds. Stablecoins make this possible with minimal friction by avoiding legacy financial systems, lightning-quick transaction speeds, and fast settlement. Welcome to the future of business conducted in seconds rather than hours or days.

Drawbacks of Stablecoins: The Problem of Centralization

One of the primary issues with fiat-backed stablecoins is that they depend on the central authority to maintain the peg. If the provider of the fiat money decided to break the peg, the stablecoin could become worthless. Stablecoins backed by gold face a similar issue; since there is a finite amount of gold in the world, these stablecoins may become worthless if the gold supply runs out. Some people also have concerns about the fact that centralized authorities manage stablecoins. Suppose the company issuing the tokens goes out of business or gets hacked. In that case, there could be severe consequences for the stability of the tokens.

Conclusion

Developing new technologies that make digital tokens more stable as the cryptocurrency market matures is essential. Stablecoins are actively being developed and could help make cryptocurrencies more viable as a medium of exchange and store value. Still, there are potential drawbacks to using stablecoins, including centralized management. If the company managing the tokens gets hacked or goes out of business, users could lose the value they had stored in the tokens. Even with all the drawbacks, stablecoins have the potential to transform the way we conduct business and create a superior digital currency ecosystem.