What are stablecoins?
Stablecoins are a particular class of cryptocurrency that mimic other assets. The coins are supposed to control the unstable nature of using cryptocurrency. Stablecoins are pegged to an asset that has a stable value. In addition to being backed by an algorithm rather than 1:1 reserves, some stablecoins, like Wrapped Bitcoin (WBTC), are tied to other volatile cryptocurrencies.
Investors believe cryptocurrencies are some of the best investment instruments but have the most volatile prices. Vendors and merchants may see prices increase or collapse. Because of these shifts, using cryptocurrencies for even the most basic goods and services can be problematic.
With stablecoins, there is no need for either party to change back into fiat. You can avoid price swings by creating a currency pegged to a regular fiat currency with a fairly stable price, such as the US dollar.
Following the 2017 craze, the popularity of stablecoin started to increase. Investors were looking for a less volatile cryptocurrency store of value after Bitcoin reached almost $20,000 before sinking by more than 50%. The Federal Reserve, along with other governments and central banks, announced a full investigation into its digital coin in reaction to the success of crypto-based coins.
How do stablecoins work?
The fiat-backed stablecoin is the most well-known and widely used stablecoin currently available. Stablecoins backed by fiat money are kept in reserve by a regulated entity like a bank. Investors favor the weighted combination of cash and cash substitutes because they appear moderately stable.
Thanks to this backing, they can rest easy knowing their tokens will always be sold for a dollar. It also means that this backing ‘guarantees’ the prices won’t fall. Based on the theory that an investor’s beliefs will determine the stablecoin price, the price should reflect that belief even if an investor believes their stablecoins are worth and backed by one dollar each.
Because of the long- and short-term volatility of cryptocurrencies, stablecoins are viewed primarily as speculative investments. Markets are more confident in stablecoin prices when funded by conventional investments. Because of this, stablecoins are frequently the alternative for monetary decisions among businesses who use cryptocurrencies.
Many exchanges only allow traders to buy and sell cryptocurrencies; they will not let them purchase fiat money. This can be challenging for investors to cash out their cryptocurrency holdings quickly in difficult times. They may have to wait for a few days or transfer currencies like EUR, USD, or GBP between several exchanges to cash out.
For each existing stablecoin, there is fiat currency stored in the Treasury, backing it up. The goal is to produce a stablecoin with a fixed price using real fiat in real bank accounts.
Cryptocurrencies also back stablecoins. They operate just like a fiat-backed stablecoin, but instead of using the fiat as collateral, cryptocurrencies back up the stablecoin.
To maintain decentralization, a crypto-collateralized stablecoin will compromise capital efficiency. The collateralization ratios may decline as the cryptocurrency market ages and the volatility drops. Before you buy stablecoin or any cryptocurrency, potential investors should do their homework because investing in cryptocurrencies entails a risk that may not be affordable for all investors.