While Cryptocurrencies have attracted huge investments in recent years and challenged the existence of financial markets, it is yet to replace fiat currency in its entirety. Every currency needs to simultaneously act as a medium of exchange, a unit of account, and a store of value. However, due to its inherent characteristic of volatility, cryptocurrency does not acquire all the functions of a proper currency. This leads to the necessity for stability and certainty. The right alternative is the emergence of Stablecoins.
The market price of a Stablecoin will be pegged to popular assets such as the US dollar or gold etc. The price would be stable in the long run, and there is an absence of fluctuations.
Understanding the problem with volatility
Currently, the cryptocurrency industry is dominated by two prominent currencies, Bitcoin and Ethereum. But due to its extreme fluctuations, it can lead to a false sense of speculation.
Businesses and consumers who are averse to risk would not prefer to deal with cryptocurrencies. Those who want a stable asset with a store of value to escape risks such as currency control, local banking regulations, and a downturn in the economy would look to avoid investing in Bitcoin or Ethereum.
Discovering the importance of stability
Stablecoins are pegged to highly traded assets such as the US Dollar, other major fiat currencies, or the consumer price index. Its value does not depend much on market behavior. Some of the questions which supporters of Stablecoins need to answer are regarding the volatility that the peg can withstand, the cost of maintenance, analysis of its behavior and transparency available for traders to know the market conditions.
The extent to which an asset can be pegged must be made clearly available to the market participants by the stablecoin developer. If they do not know how to identify when a peg is weak or strong, it can lead to the spread of fake news and cause a market crash. A transparent peg is more resistant to changing sentiments and market manipulation.
Hence, a stablecoin should stand steady amidst market volatility, must be affordable to maintain, easy to monitor the vital parameters, and transparent enough to traders.
Knowing the different types of Stablecoins
- Fiat-collateralized stablecoins – It is a type of stablecoin that is pegged to a major fiat currency such as the US Dollar. This is very flexible as those investors who want to exit stablecoins can do it by getting back US dollars. However, it involves centralization as trust is needed in the custodian. Fiat-collateralized stablecoins are resistant to extreme market conditions, and the price levels are quite consistent. It is also regularly monitored and audited by authorities. There are no threats of hacking as no collateral is held on the blockchain network. However, transparency can be ensured only through regular audits. Popular examples of Fiat-collateralized stablecoins are Tether and TrueUSD.
- Crypto-collateralized stablecoins – The stablecoin would be over-collateralized with reserves of cryptocurrencies to absorb price fluctuations. Whenever the price witnesses a dip, the stablecoins get automatically liquidated. The operations will be managed through decentralized blockchain technology. A price feed mentioning the value of the US Dollar or Ethereum needs to be mentioned. Investors would benefit as everyone can inspect the collateralization ratio of stablecoin at any time. It can also be used to magnify profits by creating leverage. Crypto-collateralized stablecoins have certain limitations as they are prone to price instability and depend heavily on the health of cryptocurrencies. It is not resistant to market crashes as investors expose themselves to currency risk despite liquidating their stablecoins. It requires higher capital spending from investors to overcome this disadvantage. Some examples of Crypto-collateralized stablecoins are BitUSD and Dai.
- Non-collateralized stablecoins – Stablecoins not backed by any collateral are better known as non-collateralized stablecoins. The best example is the Seigniorage shares. There will be a private issue of currency at a certain price. Supply will be managed by minting new coins and auctioning them in the open market. Ultimately the optimum price of $1 will have to be maintained by increasing or decreasing the supply. The disadvantage is that many investors view it as a pyramid scheme. The promises issued are unsustainable in the long run. If there is a downturn or a crash in the market, it will not be able to maintain its peg. This will create a situation where there is a drastic price fall, and traders will lose confidence. It is difficult to analyze the results as its movement heavily depends on sentiment swings in the market. Hence to reach a state of healthy equilibrium, it requires an adequate infusion of liquidity. Non-collateralized stablecoins can survive in the long run as it is an effective store of value. An example would be the decentralized token, Basecoin.
Though there are some limitations in Stablecoins, it is a much needed innovation to keep the cryptocurrency industry active in the long run. Amidst the regulatory uncertainty and government controls, Stablecoins presents a promising investment opportunity. Investors would choose them depending on their requirements and risk appetite. With volatility abundant amongst cryptocurrencies, stablecoins are safer and provide a sense of certainty. It all depends on how a stablecoin developer designs a scheme keeping the interests of various stakeholders in mind.