What’s the difference between BTC and altcoins?
Stablecoins are an innovative solution to the issue of cryptocurrency volatility. Digital currencies have experienced wild fluctuations in their value, making it difficult to use them as a reliable means of payment or a store of value. This problem led to the development of stablecoins, which are cryptocurrencies designed to maintain a stable value by pegging them to a fiat currency.
For instance, stablecoins may be pegged to the US dollar at a 1:1 exchange rate. This means that the value of the stablecoin is always equal to one U.S. dollar, providing stability to cryptocurrency transactions. Stablecoins strive to offer reliable value while providing several benefits, including faster transaction times and lower fees.
This innovation continues to gain traction in the world of cryptocurrency, with more stablecoins emerging to support greater diversity in payment options and increased consumer confidence in digital assets.
HOW IMPORTANT ARE THEY?
Stablecoins, which are a type of cryptocurrency, have been making waves in the market despite being a relatively small part of the crypto space, with a market cap of around $170 billion out of the overall value of around $1.2 trillion. This fast-growing trend has caught many people’s attention as it provides an alternative solution for ventures such as hedging against bitcoin’s price or storing idle cash.
According to CoinMarketCap data, Tether is currently the largest stablecoin, with a market cap of $80 billion. Within the past year, Tether has surged in popularity and grown significantly from just $4.1 billion at the beginning of 2020. Meanwhile, the second-largest stablecoin, USD Coin, has a market cap of $49 billion.
Experts suggest that stablecoins are increasingly being used in international trade as a way to avoid capital controls, with Tether in particular being used for trade in China and South America. Despite their growing popularity, the US Federal Reserve warns that they are increasingly being used to facilitate leveraged trading in other cryptocurrencies.
HOW DO THEY WORK?
Stablecoins come in two broad categories: those that rely on reserves that are composed of certain assets like fiats, bonds, or other cryptocurrencies, and those that are algorithmic and decentralized. The foremost stablecoins such as Tether, USD Coin and Binance USD rely on reserves: they maintain that they hold sufficient assets in denominations of dollars to ensure a 1:1 exchange rate.
These corporations affirm that their stablecoins can always be exchanged for one dollar. Asset-backed stablecoins have been under pressure lately to be more transparent about the assets in their reserves and whether there are enough funds to back up the digital coins in circulation. In contrast, TerraUSD relies on algorithms that require swapping TerraUSD coins with a floating cryptocurrency referred to as Luna to regulate supply instead of having reserves.
WHAT CAN GO WRONG?
TerraUSD, which is one of the most popular asset-backed stablecoins, has been facing some difficulties lately. Investors’ confidence in the underlying digital asset, Luna, has taken a hit, leading to a broader downturn in the cryptocurrency markets. This has impacted TerraUSD’s stability mechanism and the price of the coin has plummeted to as low as 30 cents.
This comes as a surprise, as asset-backed stablecoins are designed to maintain their value despite market volatility. However, even Tether, which has the highest market capitalization among stablecoins, witnessed a similar situation when it broke away from its 1:1 peg to the US dollar, dropping to as low as 95 cents. Despite the dip, Tether has assured its investors that they can still redeem their tokens at the promised rate.
WHAT DO REGULATORS SAY?
The regulatory landscape surrounding cryptocurrency continues to evolve globally, as authorities seek to establish firm rules around its operation and ensure that it remains safe and secure for all involved. However, some have identified stablecoins as a key area of concern when it comes to financial stability.
While providing a means of stability for investors by being backed by assets, these coins are equally vulnerable to investor runs – particularly if too many people attempt to cash them out simultaneously.
The Federal Reserve highlighted this issue in a recent stability report, warning that the underlying assets supporting stablecoins could become illiquid or lose value during market stress, thereby creating a ripple effect that could impact the wider financial system. It is, therefore, important that careful consideration is given to the management of stablecoins, in order to minimize the risk of such scenarios occurring.
Why Are Stablecoins So Important?
Bitcoin, a cryptocurrency that reached the pinnacle of popularity, undoubtedly displays a significant issue with its volatile exchange rate, which, in turn, leads to instability in its price. For instance, in March of 2020, this cryptocurrency was valued at approximately $5,000, and in a matter of a year, its worth increased substantially, reaching over $63,000 in April 2021.
However, its value soon plunged dramatically in the next two months by nearly 50%. What is even more complicated is that Bitcoin’s value often witnesses wild swings, and it can move more than 10% in a few hours. While the high volatility of Bitcoin potentially benefits daring traders, it can lead to disastrous outcomes for routine transactions, such as purchases, converting them into risky speculations.
Holding cryptocurrencies for long-term appreciation can also be dangerous, as exemplified by the case of an individual who spent 10,000 Bitcoins on buying two pizzas. Additionally, merchants who accept cryptocurrencies as payment for their goods or services may find themselves suffering losses if the value of those cryptocurrencies falls dramatically after they receive payment.
Fiat-Collateralized Stablecoins
Fiat-collateralized stablecoins are issued to assure their users of a stable and steady store of value. These coins are unique as they maintain a reserve of fiat currency or other assets such as precious metals or crude oil that assure their value against the fluctuations of the market. Popular stablecoins like Tether (USDT) and TrueUSD (TUSD) are backed by a reserve of U.S. dollars and maintained by third-party custodians who conduct regular audits to ensure their accountability and accuracy.
The practice of keeping a reserve of traditional currency or other assets as a collateral to stabilize the value of stablecoins is a game-changer for the crypto industry. It provides confidence to users who are hesitant to enter the highly volatile cryptocurrency market. Fiat-collateralized stablecoins assure renewed hope in a market that has seen wild fluctuations in the past. Trustworthy stablecoins backed by reserves provide a safe haven for users who are wary of the risks associated with the crypto market.
