Crypto

Stablecoin—Crypto's answer to price volatility

For the past several weeks, we have been covering the world of cryptocurrencies. While Bitcoin and Ethereum both offer unique characteristics that make them independently desirable, one weakness they have for certain investors is their price volatility.

There are plenty of businesses that would love to offer crypto payment options, but the wildly fluctuating price of bitcoin and ethereum make everyday transactions a challenge. It is impossible to price things in something that is constantly changing significantly in value. Imagine pricing something using bitcoin. It’s like using a rubber band as a measuring stick!

To solve this dilemma, a new class of cryptocurrency was introduced. Enter stablecoins. Stablecoins attempt to offer price stability, and are backed by a reserve asset. Stablecoins have gained traction as they attempt to offer the best of both worlds—the instant processing, security, and privacy of payments that crypto normally offers, along with the volatility-free stable valuations of fiat currency. The market cap of stable coins has increased 10-fold in just the past year.

Price stability is important for a variety of reasons. One way that a fiat currency like the US dollar remains as stable as it does is because of the timely market actions of the Fed. Outside of the dollar, many currencies are tied to an underlying asset such as gold or other forex reserves. This keeps their valuations tame and free from most wild swings, most of the time.

Even in extreme cases when a currency’s valuation fluctuates drastically, the Fed can be expected to jump in and manage demand and supply until price stability returns. With crypto, there is no such controlling authority to manage its value.

Stablecoins bridge this gap between fiat currencies and cryptocurrencies. There are three categories of stablecoins, depending on their working mechanism.

First, there is fiat collateralized stable coins. Fiat collateralized stable coins maintain a fiat currency reserve such as the USD. Tether is a good example of a fiat-collateralized stable coin. Fiat reserves are maintained by independent custodians, and are regularly audited for adherence to the necessary compliance.

Next, there are crypto-collateralized stable coins. These are similar to fiat-collateralized coins, but they are tethered to crypto currencies instead of fiat currency. Since the reserve currency may also be prone to high volatility, crypto based stablecoins are “over-collateralized”. In other words, a large number of cryptocurrency tokens are maintained as reserve for issuing a lower number of stablecoins.

Finally, there are non-collateralized, algorithmic stable coins. These types of coin don’t use a reserve, but include a working mechanism, like a central bank, to retain a stable price. The dollar-pegged basecoin uses a consensus mechanism to increase or decrease the supply of tokens as needed to maintain a stable value.

This acts very much like a central bank that prints more cash to maintain the valuation of their fiat currency.

Regardless of which method is used to maintain a stable value, a look at the chart of Tether below shows how it manages to reduce the volatility that is normally present in crypto currencies. While non-tethered cryptocurrencies rally and decline on a daily basis, Tether has managed to maintain a fairly stable value since its inception.

One thing that cryptocurrencies are going to need in the future, to become as useful as fiat currency, is stability. Whether stablecoins will be the answer to that stability remains to be seen, but undoubtedly they are providing some useful use cases today.