Stablecoins have started gaining a lot of steam since 2020-21 due to the unique market proposition offered by them. Stablecoins have emerged as an asset class that offers “fiat currency” like features but it also maintains the mobility and utility associated with cryptocurrency.
What are stablecoins
All asset classes come with a probability of high risk and cryptocurrency isn’t an exception. Since its inception cryptocurrency has been susceptible to various market forces resulting in cryptocurrencies becoming associated with heavy risk. To reduce the risk sentiment, cryptocurrency projects have been trying to look for various ways to cut down on the risk. As a result of such an exercise “stablecoins” emerged in the market.
Although the market had various solutions for combatting the market risk, these solutions were always limited to the buy, sell and stop orders belonging to various conventional markets; however, stablecoins emerged as a completely new market segment in the cryptocurrency markets with inbuilt stability features. The name suggests that these tokens are meant to function stably.
The stablecoin taxonomy
These digital currencies which are minted on the blockchain have four types of collateral to back them up and subsequently, these stablecoins are bifurcated with the help of these collaterals. The collateral structures are as follows
- Fiat Backed
- Commodity backed
- Crypto backed
Fiat backed: Some of the most trending stablecoin projects are fiat-backed. These stablecoins are backed 1:1 by fiat currency. Fiat-backed stablecoins are termed “off-chain assets” because the collateral which is fiat in nature will always remain with the central issuing authority or any kind of financial institution. The stablecoin projects have to keep in mind that the fiat collateral should remain in proportion with the total number of tokens being circulated in the market
Commodity backed: Stablecoins backed by commodities use physical assets such as oil, gold, etc. for collateral purposes. The most popular commodity used for this purpose is gold. Tether Gold (XAUT) and Paxos Gold (PAXG) are examples of commodity-backed assets with liquid gold being the collateral behind these coins. However, these stablecoins turn out to be much more volatile and susceptible to market forces because commodities are more prone to rapid market movements and affect the stablecoin which end up turning volatile.
Crypto backed: Crypto-backed stablecoins used cryptocurrency as collateral. Due to the asset class backing the stablecoin is a crypto based, these stablecoins have been termed “on-chain assets”. However, there is no role of any kind of central issues or financing authority in the backing up process. Smart contracts have employed that lock in your cryptocurrency and provide you with tokens of equal representative value. In case you wish to withdraw your collateral back the stablecoin should be put back into the smart contract.
Algorithmic stablecoin: These stablecoins don’t have any underlying assets to back them up; instead, it uses a combination of algorithms and smart contracts which are solely responsible for the supply and management of active tokens in the market. The decision on circulation and supply are completely dependent on the algorithm which reviews the market conditions and decides accordingly.
Benefits of stablecoin
- Medium of exchange – Stablecoins have emerged as a prominent medium of exchange which is trying to bridge the gap between fiat and cryptocurrency while trying to minimize the risk associated with cryptocurrency-based assets.
- Store of value – Stablecoins use collaterals for stability purposes however the collateral itself is a value-based asset. Therefore stablecoins can also be used for various transactions due to their value being inherent to it.
Stablecoins have emerged as a flag bearer for the integration of traditional market forces with decentralized finance (DeFi). Stablecoins are also being used by various credit companies to issue loans to customers due to their stable nature
Disclaimer: The opinions expressed in the Blog are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product. It is only intended to provide education about the financial industry. Please do your own research.