Discussing the stability of a stablecoin can be quite an oxymoron. An unstable stablecoin might be even more so. This misconception around stablecoins always being stable causes many investors to lose a lump sum of money while investing in stablecoins. It is essential to understand the different aspects of stablecoins before venturing into that aspect of cryptocurrency. This article talks all about stablecoins including its advantages and disadvantages.
What is Stablecoin?
Across several economies around the globe, cryptocurrencies are used to buy services and goods. Bitcoins have been a popular cryptocurrency for a while now. However, decentralized cryptocurrencies such as Bitcoin show high volatility that is well above the average volatility of the market. This is one of the reasons that causes many investors to shy away from cryptocurrencies.
The reason that stablecoins were introduced into the cryptocurrency space was to solve this problem of high volatility. Stablecoins are essentially digital currencies that have prices attached to stable assets. In essence, stablecoins carry the same value as that of the US dollar. In simple terms, stablecoin is a cryptocurrency whose value may vary from coin to coin. Most stablecoins are pegged on a 1:1 ratio with certain currencies such as the Euro or the US dollar. These are traded on exchanges. There are other stablecoins that can be used on other assets such as gold or other cryptocurrencies.
Why Use Stablecoins?
One of the reasons why investors use stablecoins is that it does have extreme price volatility compared to other cryptocurrencies. For instance, in 2010, a software programmer purchased a pizza worth 10,000 bitcoins which was roughly around $30. In 2018, the same order with the same amount of bitcoins would have a value of $82 million. This is a clear example of how volatile bitcoins can be. This volatility caused many businesses to halt accepting bitcoins as acceptable currencies.
On the other hand, stablecoins have several benefits such as decreased volatility, increased transparency, more security, availability of digital wallets, lower fees, faster transactions, and improved privacy. In the beginning, crypto traders and holders used stablecoins as a backup plan where they could safeguard their investments in case of a market crash. For instance, if the bitcoin prices were to crash incessantly, the investor would be able to convert their bitcoins to stablecoins. This would help prevent financial losses for the investor.
Stablecoins essentially enable a decentralized system that is both stable as well as secure. It can ensure that the environment for peer-to-peer transactions is reliable without being affected by significant volatility like bitcoins. The multitude of benefits is one of the key reasons why many investors have shifted to holding stablecoins.
Types of Stablecoins
When it comes to the types of stablecoins, there are 4 main types that you should know about. Let us dive deep into each type of stablecoin.
1. Commodity-Collateralized Stablecoins
These stablecoins are typically backed by several interchangeable assets like precious metals. The most common interchangeable asset is gold. However, in many cases, these assets can also be real estate, oil, and other precious metals. Investors who hold commodity-backed stablecoins typically hold a tangible asset that has actual real value. This is uncommon among most cryptocurrencies.
2. Fiat-Collateralized Stablecoins
This type of stablecoins is the most common type of stablecoins in the market. They are backed by currencies such as GBP, USD, or EUR. These stablecoins are backed with a 1:1 ratio. For example, 1 stablecoin would be equivalent in value to 1 currency (EUR, USD, or GBP). This is similar to the currency that is invested or being held in a bank.
3. Crypto-Collateralized Stablecoins
This type of stablecoin is backed by other cryptocurrencies. The advantage of this type of stablecoin is that it is more decentralized compared to other types of stablecoins. These stablecoins are typically over-centralized in order to reduce volatility risks. Therefore, they can absorb the price fluctuations and lead to lesser overall volatility.
4. Non-Collateralized Stablecoins
These types of stablecoins are not backed by anything at all. They use an approach that is algorithmically governed to control the supply of stablecoins. When the demand increases, new stablecoins will be generated. If the coins are trading too low, then the circulated supply will be reduced.
Advantages of Stablecoins
Let us have a look at some of the advantages of stablecoins here.
– The fees charged to trade stablecoins are very low.
– You can carry out secure transactions with stablecoins and do not have to worry about data privacy.
– Anonymity will be maintained throughout all of your stablecoin
– Stablecoins are asset-backed and are stable.
– They have strict fiat-related regulations thereby making them a reliable choice.
Disadvantages of Stablecoins
While stablecoins may have plenty of advantages, there are a few downsides to it. Let us have a look at them.
– Stablecoinsrequire a third-party to facilitate the process.
– They required external audits to ensure that the assets are accounted for.
– While being less volatile, the returns they provide on investments is comparably less when compared to other cryptocurrencies.
How Stable Are Stablecoins?
Volatility is the main concern for investors who are planning to invest in stablecoins and hold them. In addition to volatility, it is also essential to be aware of governance. In contrast to other decentralized cryptocurrencies, the reserve of underlying assets have to be managed by an entity. So, the stability of stablecoins rely on both governance as well as volatility.
In a Nutshell
If you are looking to invest in stablecoins, it is important to understand blockchain technology. Stablecoins can be a less volatile option compared to other cryptocurrencies and can help you minimize risks to a certain extent. Nonetheless, ensure to have all of your research performed in advance to stay financially smart with your investments.
