The fact that cryptocurrencies have become a transformative force in the global financial system is not a secret for anyone. Everybody knows about cryptos’ high potential as an alternative payment and investment option method. That’s the reason why such a large number of people, be they seasoned investors or simple folk, have chosen to enter the crypto sphere and put their trust and money into one or more cryptocurrency projects. Many businesses, organizations and even governments followed suit and embraced digital currencies as the next logical step in the evolution of money.
But cryptos’ immense potential is overshadowed by and closely linked to their inherent volatility, which serves as both their strong suit and their biggest vulnerability. The risk of experiencing massive losses is the price crypto traders and investors have to pay for the possibility of outsized returns. That makes digital assets a highly speculative type of investment. While some stakeholders are perfectly content with the level of risk involved in trading crypto and willing to actively participate in the market despite the challenges they might face, others would prefer a safer and less hazardous environment.
Enter stablecoins – a new category of digital currencies that aim to provide a solution for the long-standing volatility issues that first-generation cryptos are struggling with. While stablecoins preserve many of the qualities of traditional digital currencies, they have distinct characteristics that give them a competitive edge over their predecessors.
What are stablecoins, and how can they address the volatility issue?
As the name implies, stablecoins are digital currencies that enjoy greater stability than the rest of their altcoin peers. They represent a very distinct segment in the crypto ecosystem due to their reliance on different stabilization methods. In other words, they are either pegged or linked to the value of another asset – be it a cryptocurrency, fiat money, or commodity – or use specific algorithms to reduce volatility. Therefore, stablecoins promise to provide something that other cryptos cannot: price stability.
Does that mean stablecoins can be traded without the risk of major price spikes threatening to wipe out entire investment funds? Not exactly. Unfortunately, the problem is a bit more complex, given that stablecoins are not flawless financial instruments. To begin with, not all stablecoins are created equal. There are four different subcategories of stablecoins, depending on the stabilization tools they use, so obviously, their ability to counter volatility will vary.
First, we have fiat-backed stablecoins that use fiat money, such as the US dollar or euro, to stabilize their value. The fiat reserves that serve as collateral are held by the issuing institutions, like traditional banks, with audits being conducted regularly to guarantee safety and transparency. Gemini Dollar, Tether, Binance USD, and USD Coin are among the most popular fiat-collateralized stablecoins on the market.
Commodity-backed stablecoins are similar to the previous category, but instead of pegging their value to USD or other fiat money, they rely on physical assets like precious metals, oil, or even real estate to keep price fluctuations at bay. They represent a good option for those who would like to invest in these types of assets but find it difficult to gain access to them. Also, commodities have relatively stable values; therefore, commodity-backed stablecoins such as Digix or PAX Gold can provide a safer investment option.
Then, there are cryptocurrency-collateralized stablecoins. These are linked to other cryptocurrencies in the market, which may seem counterintuitive, given that traditional cryptos are subjected to high volatility. That’s why crypto-backed stablecoins are not pegged on a 1:1 ratio, like the previous categories, but are overcollateralized to outweigh possible price variations.
Finally, the last category, algorithmic stablecoins, differs from all the other classes by basing price stability not on financial instruments but on algorithms and smart contracts that control the coin supply entering circulation. When the price drops below a certain level, these algorithms will automatically reduce supply, and when the price increases, they will increase it accordingly to balance demand and supply dynamics.
Why stablecoins matter?
Although Bitcoin remains the king of crypto as the most popular digital asset for investors, its volatility woes are well-known in the crypto sphere. Other popular assets from the altcoin pack are not far in this respect, suffering a very similar fate. Obviously, we shouldn’t place all altcoins in the same category. Ethereum, for example, stands out from the rest through its innovative features and the recent updates that aim to correct many of its previous shortcomings, price volatility included. Therefore, it’s worth keeping an eye on the Ethereum price USD in the months to come.
But the point remains that unexpected price swings plague the majority of traditional cryptocurrencies. And while there may be some investors that can benefit from these constant fluctuations in price, not all of them enjoy the risk this exposes them to. For newcomers and low-risk appetite investors, a more stable market would be much more attractive.
Looking beyond cryptos’ use as an investment option, there’s also the negative impact that these fluctuations can have on everyday transactions. Merchants and buyers are not very thrilled by the idea of using an asset that’s subject to wild swings in value as a medium of exchange. Unless they can provide some sort of stability, cryptocurrencies don’t stand much chance of becoming a mainstream payment method.
Stablecoins seem to tackle both these issues to some degree. They may not be perfect yet, but they outdo traditional cryptos when it comes to price stability, and that is reflected in their growing popularity. The rapid rise of the stablecoins market has already attracted interest from regulators that recognize their value and aim to include them in the existent financial system – obviously, after being regulated. Some central banks are even planning to create their own version of digital money, which further highlights the impact that stablecoins have on the economy.
For now, stablecoins are the closest thing we’ve got to merging the benefits of fiat and digital currencies together. This class of digital assets is also relatively new, so it may take a while for it to mature and reach its full potential. But we’re keeping our hopes high that great things will come from the stablecoins front.