June 11, 2024

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Understanding the Role of Stable-Value Cryptocurrencies in the Market

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But stablecoins have quickly become a necessary part of the crypto-asset ecosystem, facilitating trades on crypto exchanges, and offering less volatile digital assets than the more volatile cryptocurrencies.

Less volatile than free-floating cryptocurrencies, stablecoins are digital currencies backed by physical assets – most often national currency – and so more suited to day-to-day transactions and storage.

Stability

Most people using stablecoins with business partners want to protect their purchases from volatility, especially in the case of e-commerce transactions (ie, sales via the internet). Stablecoins mean that buyers and sellers are protected from price movements in other, more volatile cryptocurrencies such as bitcoin that could otherwise halt a transaction.

But stability comes at a cost. To maintain the peg, stablecoin systems must induce their users not to sell their coins in the resale market but to exchange them instead against assets that the system has pledged as collateral – arbitrage between stablecoin systems and the resale market might feed back to generate instability Negative feedback loops amplify price instability.

Some stablecoins, like MakerDAO’s Dai, are over-collateralised, meaning that they hold more underlying reserves to back the number of stablecoins circulating than is necessary. This ensures that the coin is safer and more useful than those that are under-collateralised; the under-collateralised coins can run out of assets if every user redeems at once, but the upkeep and capital costs are more expensive.

Security

Actually, these digital assets are called stablecoins, and came into existence due to the necessity of a priced-stable medium of exchange. Stablecoins are anchored to tangible commodities such as gold and lesser volatile cryptocurrencies.

Given their unwavering links to the dollar, they offer the decentralised, distributed world of cryptocurrencies a formal entry to the conventional world of traditional finance and, from there, a way to bring blockchain’s potential for value based on programmable logic into bigger chunks of the global economy. While greatly appreciated by enthusiasts of blockchain technology, the high volatility of stablecoins has made them a favourite target for regulators who want to see them well insured against market shocks.

Whether their stability is designed or robustly supported by their backers – stablecoins have a range of designs, with some linked to a fiat currency or held in reserve, while some operate algorithmically, with their supply controlled by economic incentives or smart contracts to stabilise their price rather than exposure to the assets in reserve – stablecoins work on a range of principles, with some closer to the mechanism of central banks than companies when it comes to stabilising economic value.

Privacy

Stablecoins are, in many ways, the white whale of crypto – the thing that’s widely considered to be the most important next step at bridging the gap between traditional finance and the newer world of blockchains and programmable money. However, the occasional inspired (and sometimes uninspired) ineptitude of markets can turn price volatility into a drag.

For many regulators, stablecoins are viewed as a ‘canary in the crypto-coal mine’, suspected of undermining the global financial system. Can it be classified within existing asset categories, or is it a potentially novel asset better suited to a different approach to regulation?

Stablecoins run the gamut from those pegged to existing assets such as the US dollar to others whose supply is algorithmically adjusted to hold to a certain price, despite being highly volatile. Yet extremely volatile or not, stablecoins continue to offer investors and businesses a wide range of benefits: from the transaction efficiency value of cross-border payments and other expensive transactions priced in free-floating cryptocurrencies; to dramatically lower transaction costs when processing cross-border payments or transactions in stable coins versus their free cousins. These benefits make stablecoins appealing investments.

Transparency

For the cryptocurrency market in general, volatility remains chaotic, and between the hucksters and scammers, investors often don’t even know which projects are building something substantive versus just riding the grift train. It’s time for regulators to start working together across international boundaries to set clear rules that root out the bad actors in the space. Strong regulations might include requiring stablecoins to be backed by actual assets and transparency over premining practices.

While regular fiat currencies are always fluctuating, stablecoins achieve their name by generally maintaining a stable price relative to real assets, or sometimes by virtue of adjusting their supply and demand via algorithms. If you wish to understand the mechanism by which stablecoins maintain their price, then it’s important to recognise such vital differences between different kinds of pegs – whether backed by real assets, or alternatively adjusting supply and demand algorithmically, as well as being vital for a successful stablecoin, investor confidence is also key for stablecoins (TerraUSD was a ‘algorithmic stablecoin’ that lost its equivocation to dollars early in May 2022 and then sustained a ‘death spiral’ as confidence in the coin left, causing its price to plummet).

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