Is Stablecoin the answer to all cryptocurrency problems?

Stablecoins are a new kind of cryptocurrency gaining popularity due to their commitment to minimizing price volatility, which limits the use of BTC bitcoins and other digital currencies as a medium of exchange.

Since Tether USDT was launched in 2014 as the first stable coin, the list has expanded to include Dai (DAI), USD Coin (USDC), True USD (USDT), Digix Gold, Havven's Nomin, Paxos Standard and Binance USD (BUSD).

* Stablecoins are cryptocurrencies designed to provide stable value.

* Stable currencies are more useful as a means of savings and a means of exchange.

* Stablecoins minimize typical cryptocurrency volatility by maintaining collateral in the form of reserves, often in U.S. dollars.

* Algorithmic stabelcoins seek to provide stable value by regulating supply based on predetermined rules.

What are stabelcoins?

Whether it's the U.S. dollar or Dogecoin, the currency is most useful as a medium of exchange and a means of savings. Price stability is critical to these functions. For this reason, policymakers strive to keep the prices of traditional national currencies generally stable. When trading fiat currencies on forex, a move of 2% a day is a collapse.

Not so in the world of cryptocurrencies. The world's most popular cryptocurrency, bitcoin , rose from less than $6,000 to more than $19,000 between mid-November and mid-December 2017, and then fell to about $6,900 by early February 2018. More recently, it rose from less than $5,000 in March 2020 to more than $44,000 by August 2021. Even over the course of a day, it's not uncommon for cryptocurrencies to jump or fall 10% in a 24-hour period.

Fluctuations of this magnitude are not characteristics of a stable currency. They have more in common with the volatility of speculative trading instruments such as derivatives. This has led to serious questions about whether popular cryptocurrencies have a function beyond speculation.

Enter a new class of cryptocurrencies called stabelcoins, which aim to provide the price stability necessary to encourage wider use. Stablecoins promise cryptocurrency devotees the best of both worlds: stable value without the centralized control attributed to fiat.

How Stablecoins support valuation

Historically, some currencies have been tied to gold. Today, there is no . Britain abandoned the gold standard in 1931, and the United States followed two years later.

The modern substitute for the gold standard is the U.S. dollar as a reserve currency . At least 14 currencies are pegged to the dollar. The countries that issue them rely on the dollar peg to limit currency volatility that could otherwise undermine their economies.

Similarly, some stablecoins seek to tame volatility by pegging their price to the U.S. dollar and supporting the value of their tokens with liquid collateral reserves. Stablecoins can be divided into three groups based on how they strive for price stability.

Fiat Secured Stablecoins : The value of these stablecoins is secured by fiat currency, such as the U.S. dollar. The collateral may also consist of precious metals such as gold and silver, and commodities such as crude oil.

The collateral must be held by the custodian and checked regularly to ensure the redemption of the StableCoin tokens.

Tether and TrueUSD are popular stackablecoins tied to the U.S. dollar at face value and backed by dollar reserves.

Cryptocurrency-backed stablenecoins: Cryptocurrency-backed stablecoins are similar to fiat-backed stablenecoins, except that their underlying collateral is another cryptocurrency or basket of cryptocurrencies rather than fiat currency or commodities.

To compensate for the adverse impact of the volatility of the collateralized cryptocurrency, staplecoins backed by other cryptocurrencies tend to be "overcollateralized," meaning that the collateral value exceeds the value of the issued tokens by a predetermined ratio.

For example, this stable $500,000 coin may require a $1 million bitcoin reserve to issue. That way, even if Bitcoin loses 30% of its value, the stable coin will have enough collateral to pay off in full. More frequent audits and regular replenishments when there is a lack of collateral value can protect stable coins backed by the cryptocurrency.

Stablecoin Dai uses a basket of crypto-assets as collateral at a ratio of 150% to the value of its tokens. It is pegged to the U.S. dollar.

It is not a perfect system. If the collateralized cryptocurrency goes completely broke, or there are procedural problems with the audit process, or demands for additional collateral replenishments are not met in time, the value of the stablcoin will plummet, defeating its purpose.

Algorithmic Stablecoins: Whether collateralized or not, algorithmic stablecoins rely on an algorithm or set of rules to manage token delivery, thereby maintaining a stable value.

For example, an algorithmic stablcoin may rely on a rule that requires changes in the supply of tokens sufficient to maintain the value of the stablcoin. This is somewhat similar to a central bank's role in raising or lowering interest rates to ensure price stability. The difference is that central banks, such as the U.S. Federal Reserve, set monetary policy based on commonly understood parameters and back up that policy with an unlimited amount of legal tender. Algorithmic steblecoins, such as Basis and TerraUSD, lack such advantages.

Stablecoin's Potential

The growing adoption of stablcoins could help popularize the use of cryptocurrencies as a medium of exchange for routine financial transactions as well as for other applications.

Such applications could include the use of staplecoins for trading goods and services over blockchain networks, in decentralized insurance solutions, derivatives contracts, financial applications such as consumer credit and predictive markets.

Volatile cryptocurrency is not suitable for these purposes, as volatility poses a risk of loss to transactors.

Stablecoins combine the decentralization of cryptocurrencies with the promise of stability similar to that offered by fiat. How they try to deliver on that promise is important, as the TerraUSD collapse strongly suggests that sufficient collateral in a liquid form, such as U.S. dollars, offers a much better guarantee than a bare promise to maintain value by relying on an algorithm.

Investing in cryptocurrencies and initial coin offerings "ICOs" are very risky and speculative, and this article is not a recommendation by Investopedia or the author to invest in cryptocurrencies or ICOs. Since each person's situation is unique, you should always consult with a qualified professional before making any financial decisions.