Stable coins are cryptocurrencies whose value is pegged or which is tied to another currency such as the US Dollar or gold, a financial instrument, or a commodity. A currency peg means when a national government assigns a specific set exchange rate for its currency with a foreign currency or a basket of currencies.
The goal for stablecoins is to have all of the benefits of a cryptocurrency without the extreme volatility that comes with it. A stable coin would go a long way toward establishing cryptocurrencies as a legitimate means of making purchases. After all, most companies aren't eager to accept a payment method that may lose value the next day. if regular crypto is like investing in a high-risk stock, Stablecoins are like cash withdrawals from an ATM,
How Do Stable Coins Work?
Stable coins are digital currencies that are designed in a way to make a one-to-one peg to an underlying asset that is more stable such as a national currency of a country. Thus, stable coins allow market participants to engage in crypto trades with ease. Moreover, at the same time, it also improves the usability of volatile cryptocurrencies and creates more liquidity in the crypto market as well.
Crypto Collateralised Stable Coins
Crypto collateralized stable coins are the ones that are backed by other cryptocurrencies. The value of cryptocurrencies held in reserves exceeds the value of the stable coins issued as these stable coins are over collateralized.
Fiat Collateralised Stable Coins
Such kind maintains a reserve of fiat currency such as the US Dollar as collateral which ensures the value of the stable coin. Other forms of collateral can also include commodities such as crude oil or even precious metals like gold or silver.
Algorithmic Stable Coins
Algorithmic stable coins' primary aim is to keep their stable coin’s value stable by controlling its supply through an algorithm. These stable coins may or may not hold reserve assets.
Need Of Stable Coins
In the crypto market, a high correlation exists between the prices of all major cryptocurrencies, thus the market is extremely volatile. Apart from the traders making a profit from it, there are still a large number of users who can actually benefit from it as well. They are:
Investors Who Want To ‘Play Safe’
Investors who would want to ‘play safe’ if they stepped foot for the first time in the market, if they are waiting for a new investment opportunity to come across their way, or even during an unfavorable volatility crisis. In all such situations, one can invest in stable coins.
People Who Want To Save Money
Anyone who would want to save money as they would do in USD, but away from the traditional banking system, can invest in stable coins.
People who want to transfer or store money within the crypto space to scape the costs associated with fiat currencies.
There are many stable coins that hold a place of value today in the crypto market but recently, it has also been shown that stable coins also come with their own set of limitations.
Such as, not much time ago, the cryptocurrency TERRA (LUNA) which was one of the most valuable cryptos in the market collapsed to near zero on May 12. After the network’s stable coin TerraUSD (UST) de- pegged from the US Dollar, LUNA dropped about 96% in value in just a period of 24 hours.
Thus, the fall of Luna exposed the weakness that the decentralized stable coin infrastructure carries and the need for improvement in the structure.
Risks involved with Stable Coins
Like all other cryptocurrencies which exist in the crypto market, stable coins also come with their own set of risks. Some of them are-
The reserves backing the stable coins are the key elements of the stable coin ecosystem. Those reserves are the last backstop that ensures the stablecoins value. Without them, the coin issuer cannot guarantee the value of a stablecoin with full confidence.
LACK OF CONFIDENCE
A stable coin needs to be sufficiently backed by hard assets, especially cash. If it is not, it could suffer a run and lose the peg against its target currency. That is exactly what happened with TerraUSD in May 2022.
If one invests in stable coins, then they must be held somewhere, whether it’s one’s own digital wallet or with a broker or exchange. And that presents risks since a given trading platform may not be secure enough or may have some vulnerabilities.
Limitations of Stable Coins
1. Stable coins require a third party. They require trust from an entity.
2. Less Return on Investment. Traders and investors typically desire higher returns and may resort to other means for financial gains.
3. In stable coins external audits are needed to ensure that assets are accounted for.
Future of Stable Coin
It is precisely because of the extremely fluctuating day-to-day value and the volatility which is keeping people away from investing in cryptocurrencies on a large scale. Stability is an important aspect that can be improved upon so that people are more likely to invest in the crypto market without any risks being involved.