Most cryptocurrencies including Bitcoin were created to serve as a medium of exchange and not just a store of value. However, digital currencies still have a small market cap compared to fiat currencies. Therefore, even the most popular cryptocurrency – Bitcoin – tends to be very volatile thus, experiences a wide range of price fluctuation.
The smaller the market is, the more volatile it is. Imagine throwing a piece of rock in a pond. Taken the same rock and throw it in the sea. The rock will have much more effect on a pond than on a sea. Similarly, the total cryptocurrency market is still a “small pond,” and is affected by daily buy and sell transactions. No one will want their currencies to fluctuate in value. Imagine how it feels to use bitcoin on daily transactions when one day it is worth X value and the next day it is half that value. That is where stablecoins come in.
What is a Stablecoin?
A stablecoins are a new class of cryptocurrency that offers price stability and is pegged on reserve assets. As a result, they allow for stability alongside faster settlement, low transaction cost, and fewer regulatory hurdles. The most obvious use case would be to use them as a medium of exchange for daily purchases. However, the coins are not yet very popular at the moment, few people accept them as a payment method. Therefore, the major usage of these coins is on cryptocurrency exchanges.
Traders trade cryptocurrencies for stable cryptocurrencies if they want to lower the risk. For example, if I am trading Bitcoin and I fear that the price of Bitcoin against USD may drop, I can just exchange them for USDT (Tether), which is pegged on USD, and retain my dollar value. When I want to hold Bitcoin again, I can just exchange my USDT back to BTC.
Stablecoins also allows traders to move funds across exchanges relatively quickly, since crypto transactions are usually faster, easier, and cheaper compared to fiat currencies. The faster settlement between exchanges makes arbitraging more convenient and closes the price gaps that are seen between Bitcoin exchanges. For now, stablecoins are used more as utility coins rather than as an actual medium of exchange.
Let us consider how they are made.
There are two ways of creating Stablecoins peg: Collateralized Stablecoins and Algorithmic Stablecoins. The former involves creating a trust that the cryptocurrency is actually worth what it is pegged to. For example, if people doubt that a USDT is worth a dollar, they may dump it thus its prices will fall drastically. To maintain trust, the company backs the digital coin of the actual asset. The collateral is proof that the company is good for its words thus can be trusted. In the case of Tether, each USDT is backed by an actual USD or other assets that Tether holds as collateral.
Algorithmic Stablecoin pegging involves manipulating the coin supply in the market (algorithmic peg). It involves writing a set of automated rules (smart contracts) that increase or decreases the amount of Stablecoins in the market. Consider a coin that is pegged to the USD through an algorithmic peg. If a lot of people were to start buying the coin, its prices will definitely shoot and the peg will be broken. The solution to this challenge is increasing the supply of coins to the market hence keeping the supply-demand relationship stable. If many people start selling their coins, the supply of coins to the market will be reduced to maintain the demand-supply relationship hence stable pricing. The whitepaper, therefore acts as a central bank, controlling the supply of currencies to the market.
Stablecoins offers a solution to the greatest challenge facing cryptocurrency – volatility. However, these type of digital coins has not yet been accepted as payment methods. However, with the growth in popularity of cryptocurrency, these digital coins will likely come to be accepted for use outside cryptocurrency exchange.