Stablecoins have been around for a long, but only recently have the people from the rest of the world been aware of them. Stablecoins aren’t only popular among crypto enthusiasts. Stablecoins are attracting attention from traditional market participants and other authorities alike. As a result, the desire for detailed knowledge of the various stablecoin varieties has risen dramatically.
Stablecoins are cryptocurrencies whose value is linked to a stable asset like precious metals or fiat currencies like the US dollar. The various stablecoin categories are based on the assets that back them up. Therefore, a thorough grasp of the multiple kinds of stablecoins might aid in the development of potential foundational knowledge on stablecoins.
What is Stablecoin, and how does it work?
A stablecoin is a cryptocurrency designed to reduce the volatility that investors face while trading cryptocurrency. Stablecoins are generally linked to another stable asset, although they may alternatively be backed by an algorithm.
Consumers buying or selling non-currency products and services may see a significant price difference during or after the transaction. Stablecoins level the playing field without requiring either side to return to fiat currency.
Why did stablecoins become necessary?
The answer to this question is where the ultimate knowledge of the entire concept of stablecoins and the many sorts of stablecoins lies. First, you must be aware that the value of money fluctuates in various ways that are beyond comprehension. The value of money is primarily determined by the economy’s health, posing significant financial risks to everyone. People often want to preserve their riches by investing in rare metals, valuable assets, or exclusive real estate.
Market forces have impacted cryptocurrencies, just as they have on every other growing asset class. Various crypto initiatives are presently investigating techniques for lowering risk and increasing involvement in the larger crypto ecosystem. The wide stablecoin varieties demonstrated the feasibility of directly adding stability to crypto assets.
Types of Stablecoins
Fiat-backed, crypto-backed, commodity-backed, and algorithmic are the four main kinds of stablecoins distinguished by their underlying collateral structure.
Fiat Backed Stablecoins
Stablecoins that are backed by fiat currencies, such as the Chinese yuan, maintain a reserve of that currency as collateral. Precious metals like platinum and silver, as well as commodities like grain and oil, are examples of fiat.
The majority of fiat-backed stablecoins are backed by dollars. The currency reserve is managed by an independent custodian, who is audited on a regular basis to guarantee compliance.
Compared to fiat-collateralized stablecoins, crypto-collateralized stablecoins provide more decentralization. Furthermore, stablecoins are often over-collateralized in order to withstand price swings.
Crypto may also be used to back up other cryptos. Stablecoins backed by crypto are one example of this. The currency will maintain an overcollateralized position to offset the increased relative volatility of backing stablecoins with crypto.
Physical assets like precious metals, oil, and real estate are used to collateralize commodity-backed stablecoins. Gold is the most often collateralized commodity. Stablecoins backed by commodities make it easier to invest in assets that might otherwise be out of reach locally. In addition, those who wish to swap tokens for cash or acquire control of the underlying tokenized asset will find commodity-backed stablecoins helpful.
The collateral for algorithmic stablecoins is neither money nor cryptocurrency. Instead, the use of specialized algorithms and smart contracts to govern the number of tokens in circulation ensures their price stability. For example, when the market price falls below the cost of the fiat currency that it follows, an algorithmic stablecoin system will lower the number of tokens in circulation. Conversely, if the token’s price rises above that of the fiat currency it represents, more tokens are released to lower the stablecoin’s value.
Practical uses of stablecoins
Stablecoins offer a wide range of possible applications in the real world. Here are a few such instances.
- Stablecoins that are well-designed have the potential to be utilized in trade just like any other money.
- Stablecoins may potentially provide security in times of global market turbulence.
- Stablecoins also make it possible to employ smart financial contracts that can be enforced over time.
- Stablecoins enable exchanges to circumvent this barrier and provide crypto-fiat trading pairings by simply substituting a USD-backed stablecoin for real cash.
There are many ways in which one may use the numerous stablecoin kinds. Stablecoins now use four different models, each of which follows a different collateral structure. Stablecoins are classified as fiat-backed, commodity-backed, crypto-backed, or non-collateralized, depending on the kind of collateral they utilize. Each stablecoin variety has its distinct feature, namely the collateral used to support the stablecoin.
There are, however, some minor variations to be aware of. Crypto-backed stablecoins, for example, have superior liquidity, but fiat-backed stablecoins are simpler to grasp and use for newcomers. As a result, it’s critical to broaden your understanding of stablecoins by reflecting deeply on the universe of stablecoins and its many versions.