Ever wondered how a stablecoin remains ‘stable’? Here is how
Cryptocurrency has brought a paradigm shift to the financial industry. Many have decided not to take such a risk for its volatility as it’s not in the same value as the FIAT currency. But a stablecoin, which is a new class of cryptocurrency, attempts to offer price stability and is backed by a reserve asset.
In this way, stakers of the cryptocurrency will be assured that their US dollar is still within the value of the stablecoins.
The Stablecoins have gained traction as they attempt to offer the best by pegging their market value to some external reference. It may be pegged to a currency like the US dollar or to a commodity’s price, such as gold.
Categories of Stablecoins
There are three categories of stablecoins, which are all based on their working mechanism. They include:
These categories maintain a fiat currency reserve, like the US dollar, as collateral to issue a suitable number of crypto coins. Other forms of collateral include gold, silver, and oil. It should be noted that most of the present-day fiat-collateralized stablecoins use dollar reserves, which are maintained by independent custodians and are regularly audited for adherence to the necessary compliance. For instance, Tether (USDT) and TrueUSD are among the popular crypto coins with a value equivalent to that of a single US dollar and are backed by dollar deposits.
Other cryptocurrencies back this category. They are over-collateralized because the reserve cryptocurrency may also be prone to high volatility. Therefore, many cryptocurrency tokens are maintained as a reserve for issuing a lower number of stablecoins.
Non-Collateralized (algorithmic) Stablecoins
This category uses no reserve but includes a working mechanism, like that of a central bank, to retain a stable price. The Stablecoins here uses a consensus mechanism to increase or decrease the supply of tokens on a need basis, which is related to actions taken by a central bank by printing banknotes to maintain valuations of the fiat currency. Once a smart contract on a decentralized platform has been implemented, it can be achieved as the system runs autonomously.
How does a stable coin achieve stability
Now coming to the purpose of the article, Stablecoins have achieved price stability via collateralization (backing) or through algorithmic mechanisms of buying and selling the reference asset or its derivatives.
The number one cryptocurrency, bitcoin, tends to suffer from high volatility in its valuations alongside others that operate a similar system. It rose from around $5,950 in November 2020 to above $19,700 in December of the same year, then declined by about two-thirds to the level of $6,900 by early February 2021. This shows how its intraday price swings can be wild. This has become the common thing in the cryptocurrency business as value moves in excess of 10 percent in either direction within a few hours.
As a result of the short-term volatility, bitcoin and other popular cryptocurrencies have been seen as unsuitable for everyday use by the public.
Stablecoins then stole the occasion to provide stability. Although a currency is a medium of monetary exchange and a storage mode, its value is expected to remain relatively stable over longer time horizons. In a situation where users are not sure of their purchasing power tomorrow, they will refrain from adopting it.
The ideal thing is that a crypto coin should maintain its purchasing power and with the lowest possible inflation sufficient to encourage spending the tokens instead of saving them. This why Stablecoins have stepped in to provide a solution to achieve this ideal behavior.
Two primary reason for price stability
There are two primary reasons for price stability with Stabelcoins. The first is that fiat currencies are the reserves that back them, and the second reason is timely market actions by the controlling authorities, like central banks.
Fiat currencies are pegged to an underlying asset, such as gold or forex reserves which act as collateral. Thus, their valuations remain free from wild swings. Moreover, in a situation where a fiat currency’s valuations may move drastically, the controlling authorities step in to manage the demand and supply of currency to maintain price stability – this is absent with the bulk of cryptocurrencies due to lack of a reserve backing their valuations. Since there is no central authority to control prices when required, things could be extreme.
For instance, a tweet from Elon Musk, Tesla CEO, about his company’s withdrawal from the use of Bitcoin for payment of service led to a reduction in the value of the number one cryptocurrency. This has made many lose their life savings.
Stablecoins have therefore stepped in to bridge the gap between fiat currencies and cryptocurrencies.
Stablecoins have created a credible system that welcomes its use by those not ready to risk other cryptocurrencies because of their high volatility rate.
Thus, if others can at least be pegged to value closer to some currencies, the aim of the digital currency will be achieved in no time, avoiding a situation where the market will be determined by speculation on someone’s comment or tweet.
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