
Although there is growing interest in stablecoins, especially with renewed regulatory attention, this crypto asset class is less common than others. In today’s cryptocurrency market, there are several assets people buy for their function as a medium of exchange. There are also a few new crypto coins, as curated by Alan Draper from Cryptonews.com, with extensive utility and long-term rewards for holders. However, most developers prefer to issue native cryptocurrencies instead.
What are Stablecoins?
Stablecoins are a type of cryptocurrency designed to maintain value relative to another asset or a basket of assets. This category of cryptocurrency does not suffer the same volatility as others and is as strong or as weak as its underlying asset. The stability supports its function as a hedge against market price fluctuations and its use in everyday transactions.
Stablecoins are also commonly paired with other digital assets. Traders can easily convert a volatile asset to a stablecoin like Tether’s USDT and later redeem the initial asset when the market stabilizes.
Types of Stablecoins
There are three major types of stablecoins, each with unique features, advantages, and disadvantages. They include fiat-backed, asset-backed, and algorithmic stablecoins. While they are all pegged to the value of other assets, the main difference between the three is how they maintain their pegs and determine their value.
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Fiat-Backed Stablecoins: A fiat-backed stablecoin, like USDT, USDC, or PayPal’s PYUSD, is backed by reserves of actual fiat currency held in bank accounts. This is the simplest and most common type of stablecoin, maintaining a 1:1 ratio backing. In the case of dollar-backed stablecoins, there is a dollar in a bank or other fiat account for every token issued. When users withdraw their assets from exchanges, the platforms pay the users with dollars in the reserves. The exchanges may also burn the assets or find another way to take them out of circulation. Central Bank Digital Currencies (CBDC), like India’s Digital Rupee, China’s e-CNY, and Nigeria’s eNaira, are also examples of fiat-backed stablecoins.
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Asset-Backed Stablecoins: These stablecoins derive value from assets like oil, gold, or precious stones. The assets that provide the value used to determine the prices of these stablecoins are also real-world assets, sometimes piquing the interests of holders who buy the coins. An example is Paxos Gold (PAXG) an asset backed by actual gold reserves held by the Paxos company. Each PAXG token is backed 1:1 to one troy ounce of a London Good Delivery gold bar securely held in London.
Asset-backed stablecoins may also represent expensive items like artwork or real estate. In this case, the asset may be used to distribute its price, democratizing access and allowing people to buy a fraction of the whole.
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Algorithmic Stablecoins: An algorithmic stablecoin maintains its peg using algorithms and smart contracts. These stablecoins have no actual backing from any assets, whether fiat, crypto, or real-world commodities. In many cases, the asset’s stability is largely influenced by market demand. This is risky because the peg may crash if demand falls below a particular threshold. However, since these stablecoins are governed by smart contracts and codes, they are considered potent tools in the journey towards transparency and decentralization.
Advantages of Stablecoins
The essential features of stablecoins offer several advantages to individual users and businesses, including the following:
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Stable Price: Price stability in stablecoins is their most popular and attractive feature. Since prices do not swing, stablecoins are an excellent option for daily transactions and offer utility to merchants and service providers considering crypto support.
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Financial Inclusion: Stablecoins power remittances at cheap rates, while supporting fast transactions. These features encourage the popularity of stablecoins, making them great choices for people in jurisdictions where access to conventional finance options is limited.
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Decentralized Finance (DeFi) Support: Many DeFi protocols ensure support for stablecoins along with several other options. Since the market circulation of major stablecoins is already high, the assets are easily used by the DeFi community to borrow, lend, or otherwise trade without worrying about volatility.
Challenges Facing Stablecoins
Unfortunately, stablecoins face several challenges despite their benefits. Common problems include the following:
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Regulatory Scrutiny: This is a prevailing challenge for most cryptocurrencies, mainly because of their decentralized nature. Nonetheless, there is now a specific focus on stablecoins because of their potential effects on financial stability. Some authorities believe stablecoins not issued by the government may threaten fiat dominance and may see such increased adoption that the government loses control over fiat. In addition, stablecoins trading on a blockchain may easily be used for money laundering and other illicit activities if they do not comply with know-your-customer (KYC) and anti-money laundering (AML) standards.
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Scalability and Performance: Cryptocurrencies suffer technical constraints related to scalability. Many digital assets face scalability problems, sometimes crashing when transaction volume is high. Users pay much higher fees during these periods and must wait longer as confirmation duration increases.
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Legal Implications: Since regulations vary between countries, cross-border adoption of stablecoins could be difficult. One country may have rules and regulations that differ from another, stifling the ease of stablecoin usage for international remittances. There may also be tax issues to consider, as jurisdictions may tax stablecoins differently.
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Possible Centralization: Unfortunately, the widespread adoption of stablecoins poses centralization risks, especially with fiat-pegged options like USDC or USDT. These stablecoins require the issuers to hold sufficient fiat reserves at a 1:1 ratio. The setup also requires holders to trust that the issuer has the reserves it says it does. Unfortunately, some issuers can become very powerful if they control most of the stablecoin market share. This goes against the basic idea of decentralization, which promotes security and transparency.
Conclusion: The Future of Stablecoins
The potential use cases of stablecoins include payments and remittances, risk management, e-commerce, and retail functions, and spreads to entertainment uses, such as playing crypto poker on an online gambling platform. However, issuers of new and existing stablecoins must develop their products, focusing innovation efforts on scalability and interoperability across blockchain networks. As adoption grows, stablecoins could become the go-to option for the global financial system, especially for bridging the gap between the crypto and traditional sectors.