Crypto Stablecoins: An Overview of Their Function and Mechanism
By Stablecoins, a new kind of cryptocurrency that appeared in 2014, are designed to protect investors from price fluctuations. They get their stability from different sources: reserves of traditional currencies or commodities like gold, as well as complex algorithms that automatically adjust their supply based on market needs.
Stablecoins’ growing popularity is due to the combination of blockchain’s speed and security with protection against typical cryptocurrency price changes. Initially, they were used for buying cryptocurrencies on trading platforms that did not offer traditional currency trading. Now stablecoins are increasingly being used in various blockchain-based financial tools, such as lending services, and even for buying and selling goods and services.
As a link between traditional currencies and cryptocurrencies, stablecoins provide a smooth exchange medium, act as a reliable store of value, and make it easier to trade crypto assets. Many stablecoins’ value is tied to either a government-issued currency like the US dollar or a specific asset like gold, ensuring price stability.
To maintain a stablecoin’s peg, multiple strategies exist. The most common approach is asset-backed stabilization, where the circulating supply is matched by an equal value of underlying assets. Dollar-pegged stablecoins maintain their value as long as they can be exchanged directly for US dollars. If the price deviates significantly, arbitrageurs will actively trade to exploit these differences and restore equilibrium across markets.
Functions of stablecoins
Built on blockchain technology, stablecoins offer a range of benefits. Initially introduced as exchange alternatives to traditional currencies, they provided investors with a safe space to protect their investments from cryptocurrency price fluctuations.
Now borrowers can use stablecoins to take loans with interest rates higher than traditional savings accounts or access cryptocurrency-backed lending in the decentralized finance world. While such coins may offer more attractive returns than traditional savings, it’s important to remember they don’t have government guarantees.
Many blockchain platforms supporting smart contracts host stablecoins, making them integral to decentralized finance (DeFi) and popular on cryptocurrency trading platforms. These platforms enable applications like decentralized exchanges (DEXs), which allow peer-to-peer trading directly between users.
The emergence of stablecoins simplifies paying salaries in cryptocurrency by reducing the costs of international money transfers. Blockchain-based transfers incur only a nominal fee, and cross-border transactions are fast, typically taking minutes to an hour, depending on network technology, congestion, transaction fees, and the complexity of the transaction. In contrast, conventional financial systems often delay international transactions by several days.
Unlike conventional cryptocurrencies known for their price instability, stablecoins provide price stability, allowing investors to protect their assets on the blockchain and reduce financial risks.
Stablecoins’ lasting strength
While government-issued currencies rely on central banks to regulate their value and prevent drastic price fluctuations, stablecoins use different strategies such as being tied to tangible assets like gold, using complex algorithms, or relying on established fiat currencies.
By holding reserves in currencies backed by governments like the U.S. dollar, stablecoins benefit from the steadiness provided by central banks and governmental institutions. To earn profits on these reserves, some of the assets supporting stablecoins are invested in securities with fixed returns, including both corporate debt and government bonds, ensuring the sustainability and adequate collateralization of the funds. The stability of stablecoins is underpinned by a variety of fundamental principles, such as fiat, cryptocurrency, commodity, and algorithmic support, each of which will be discussed in more detail later.
Advantages of cryptocurrencies focused on price stability
Stablecoins offer a significant advantage over both traditional currencies and other cryptocurrencies. By combining the stability of fiat money with the inherent security and transparency of blockchain, stablecoins emerge as a more reliable and transparent alternative to fiat currencies, easily adapted to blockchain-based applications.
Stablecoins operate as a digital currency, providing a cost-effective solution for conducting transactions compared to traditional currencies. Moreover, they unlock a range of applications that offer superior returns compared to conventional savings accounts. Within blockchain ecosystems, users can leverage their coins holdings to access lending and insurance services, protecting their crypto investments across various platforms.
Cross-border payments are facilitated and made more efficient with stablecoins, which are readily convertible to traditional currencies on exchanges due to their popularity among trading platforms and high liquidity.
Another form of stablecoins tied to commodities, such as gold, enhances the practicality of these assets by increasing their transportability and divisibility without diminishing their intrinsic value, which remains directly linked to the underlying commodity. This allows for innovative applications, like using gold as a medium of exchange and even earning interest on it.
Challenges associated with stablecoins
One of the major challenges associated with stablecoins is the risk of counterparty default. This means there’s a possibility that a participant in a stablecoin arrangement might not fulfill their obligations. For example, a crypto provider may not have the actual reserves they claim, or they may decide not to honor redemptions for their stated reserves.
Centralized stablecoins that rely on audits for assurance face the risk of human error, as audits may overlook subtle flaws or emerging problems. Furthermore, stablecoins pegged to fiat currencies often use commercial paper as collateral, a type of short-term, unsecured debt. This reliance on commercial paper increases the risk of default, as the entity issuing the paper may be unable to meet its financial obligations.
In times of market uncertainty or insufficient oversight, investors may face higher risk charges. These charges, essentially extra payments, reflect the increased risk investors take when investing in assets like stablecoins. Consequently, the value of crypto decreases compared to their fixed peg, meaning buying cryptocurrencies with stablecoins becomes slightly more expensive than using traditional currencies.
Algorithmic stablecoins function in a manner akin to fraudulent Ponzi schemes, as their value depends on a continuous influx of new participants providing collateral. Like Ponzi schemes, which lure investors with promised returns funded by fresh investments, algorithmic stablecoins risk instability when the flow of new participants declines, potentially leading to a rapid decline in their value.
In extreme cases, organizations responsible for creating tokens may be able to disable tokens linked to specific user accounts if law enforcement officials make a formal request. This measure could become essential for police investigations involving illegal activities like money laundering, terrorist financing, or other illicit operations.
