Cryptocurrencies, like any other new asset class, are subject to market forces. As a result, several crypto initiatives are looking into ways to lower risk and increase involvement in the greater crypto ecosystem.
Existing options go well beyond the traditional market sell, buy and stop orders. Price stability is instead incorporated right into the assets themselves. As a result, stablecoins are a completely new segment of the cryptocurrency market. These tokens are designed to function in a stable manner, as their name suggests.
The stablecoin market boomed in 2020 and 2021, nearly tripling its market cap. But why is this appeal being made in the first place? Let’s start with the fundamentals of stablecoin taxonomy.
Taxonomy Of Stablecoins
Stablecoins are digital currencies that are created on the blockchain and have one of four underlying collateral structures: commodity-backed, fiat-backed, algorithmic, and crypto-backed. Stablecoins always aim towards the same goal: stability, regardless of the underlying collateral architecture. Let’s look at the four most common sorts of stablecoins.
Stablecoins With A Commodity Backing
Physical assets such as oil, real estate, and precious metals are used to back commodity-backed stablecoins. Tether Gold (XAUT) and PAX coin, two of the most liquid gold-backed stablecoins, are the most popular commodities to be collateralized. It’s vital to realize, however, that these commodities can and will fluctuate in price.
Those who want to exchange tokens for cash or gain possession of the core tokenized asset can use commodity-backed stablecoins. Paxos Gold (PAXG) stablecoin holders have the option of selling them for cash or taking possession of the underlying gold.
The collateral for algorithmic stablecoins is not cryptocurrency or fiat. Instead, they use data mining algorithms and smart contracts to govern the number of tokens in circulation ensuring their price stability.
When the trade price falls below the value of the fiat currency it follows, that an algorithmic stablecoin system will lower the number of tokens in circulation. Alternatively, if the token’s price exceeds that of the fiat currency it represents, fresh tokens are issued to bring the stablecoin’s value down.
Stablecoins With Off-Chain Collateral
The most widely used stablecoins are backed by fiat currency in a 1:1 ratio. Because the fundamental collateral isn’t another cryptocurrency, this type of stablecoin is characterized as an off-chain asset. Fiat collateral is held in reserve by a central issuer or financial firm, and it must be proportional to the quantity of stablecoin tokens in existence.
For instance, if an issuer has $10 million in fiat cash, it can only distribute ten million one-dollar stablecoins. The Gemini Dollar, Tether, True USD (TUSD), and Paxos Standard are some of the most valuable stablecoins in this category.
Stablecoins With On-Chain Collateral
Crypto-collateralized or on-chain collateral stablecoins, are backed by another cryptocurrency as collateral. This method takes place on-chain and employs smart contracts instead of relying on a central issuer.
When you buy a stablecoin like this, you lock the cryptocurrency into a contract in exchange for tokens of equivalent worth. You may then withdraw your original collateral amount by putting your stablecoin into the same smart contract.
This strategy is used by DAI, the most well-known stablecoin in this category. This is accomplished through MakerDAO’s use of a collateralized debt position (CDP) to secure assets as collateral mostly on the blockchain.
Drawbacks To Stablecoins
Stablecoins have different pain points than some other cryptocurrencies due to the way they are normally set up. Counterparty risk is a vulnerability if the reserves are held by a bank or another third party. Finally, the question is whether the entity has the collateral it claims to have. Tether, for instance, has been constantly questioned regarding whether US Dollars and USDT tokens are truly backed 1 to 1.
In the worst-case situation, a stablecoin’s reserves may not be adequate to redeem all of its units, causing the coin’s credibility to be shattered. Cryptocurrencies were designed to take the place of middlemen who are generally entrusted with a user’s money. Intermediaries, by their very nature, have power over those funds; for example, they can usually prevent a transaction from taking place. The capability to halt transactions has been reintroduced in some stablecoins.
Stablecoins are an interesting adventure in the cryptocurrency realm. The concept of stablecoin may sound confusing at first, but after paying careful attention to its components and its implications, it becomes an idea that’s not only easy to grasp but a potential game-changer for the financial industry.
Where most cryptocurrencies have incredible volatility over short timeframes, stablecoins seek to eliminate this by pegging their value to real-world currencies. They could well be the catalyst that gets cryptocurrency over the hump and into mainstream adoption. If you’re looking for a safe haven for your crypto wealth, now might just be the time to invest.