Unlike fiat currencies, cryptocurrencies by nature are highly volatile, making them unsuitable for regular use. In a financial market, currencies are supposed to serve as mediums of exchange and storage modes for monetary value. This is the reason many users avoid taking payments in cryptocurrencies as it is hard to rely on their purchasing power. Stablecoins, cryptocurrencies either backed by an asset or designed as algorithmic stablecoins set to combine the best of both fiat and cryptocurrency worlds.
For instance, during the 2017 crypto bull run, Bitcoin rose from $5600 to $20000 before falling drastically back to slightly above the $6000 mark. The same trend cuts across the cryptocurrency market. This creates the ground for stablecoins, that are pegged to the prices of fiat currencies like US dollar, and aren’t volatile like other cryptocurrencies. It might also be pegged to the commodities that are less volatile or be controlled by algorithms.
Known for their price stability in a rather shaky market, stablecoins have proven to be worthwhile. By the end of 2020, the overall value of stablecoin assets had surpassed the $20 billion mark. Currently, the stablecoin market is estimated to be worth $100 billion.
The role of stablecoins
Since their inception, stablecoins have been seen as the middle ground between traditional currencies and cryptocurrencies. They provide the best of both worlds by providing the price stability available in traditional markets while also providing convenience and privacy seen in cryptocurrencies.
These underlying assets are constantly regulated and maintained by independent custodians to control prices when required. Traditionally, custodians only move into a market to manage the supply and demand during drastic market movements. The result causes stablecoins valuations to remain free from wild fluctuations caused by inflation.
Notably, the first Stablecoin to enter the cryptocurrency space was Tether (USDT), launched on July 28, 2014. Currently, there are over 200 stablecoins available in the market, including Dai, USDC, True USD, Digix Gold, Havens Nomin, Binance USD, Gemini Dollar, and many more. The rise of stablecoins has helped the growth of Decentralized Finance (DeFi) space. Whether it be lending or borrowing, liquidity pools, yield farming or staking pools, the stablecoins have been at the heart of DeFi.
Type of stablecoins
Usually, stablecoins are pegged to fiat currencies like the US dollar and the euro and commodities like oil, gold, or silver. Others are pegged to trading assets like forex reserves, while others are algorithmic.
Stablecoins can be broadly segregated into four groups:
As the name suggests, these are stablecoins that have underlying fiat currency reserves. These stablecoins are regularly audited to ensure they stay in compliance with the set financial regulations.
These currencies use hard assets such as gold, real estate, silver, oil, and many more. Many projects in the market prefer using gold as their collateralized asset. However, a few projects in the Middle East region use oil reserves to peg their stablecoin.
These stablecoins have other cryptocurrencies in their reserves to serve as collateral. Notably, this type of stablecoins is usually over collateralized. Before issuing any crypto-backed Stablecoin, project managers have to maintain a higher number of the pegged asset in their reserves. This is done to overcome the high volatility of the reserved asset. For example, the Synthetix project demands about 600% over-collateralization for every sUSD Stablecoin issued.
Algorithmic stablecoins are among recent developments within the Stablecoin market. These assets serve the same purpose as other stablecoins in the market. However, unlike their predecessors, they are not collateralized.
A dive into algorithmic stablecoins
Algorithmic stablecoins are pegged cryptocurrencies that automatically adjust their demand and supply and other important details to reduce their volatility. The asset to which the algorithmic asset is pegged could be a fiat currency or a commodity like gold.
As mentioned above, algorithmic stablecoins do not use any reserve. They use an algorithm underneath or codes to mint and burn coins in response to the prevailing market conditions.
For instance, when the price of an algorithmic stablecoin valued at $1 increases above the pegged price, the algorithm mints new tokens, hoping that the new tokens will be sold off and drive down the price. On the other hand, if the price falls below the $1 value price, the algorithm burns some tokens hoping that the remaining tokens are valued higher than the previous price.
Algorithmic stablecoins aim to increase capital efficiency by using codes to maintain prices near the pegged asset. These assets rely on smart contracts to supply tokens to the market if the value increases above the peg or sell tokens if the price falls below the peg.
Notably, algorithmic stablecoins provide true decentralization within the stablecoin market since they remove third-party interference, a popular commonality among traditional stablecoins. These stablecoins also eliminate the struggles that come with raising enough capital needed to serve as the reserve.
Another advantage of algorithmic stablecoins is that they allow more trust between the users and developers since the peg is closely tied to an algorithm and not collateral.
Currently, the longest-running algorithmic Stablecoin is Ampleforth (AMPL). Other Algorithmic stablecoins include DefiDollar (USDC), Terra Money, Basic Cash, Reserve, Debasonomics, Frax (FRAX), and Empty Set Dollar (ESD).
Challenges faced by algorithmic stablecoins
While these assets provide a range of benefits, there are few challenges as well. Creating an algorithmic stablecoin that manages to maintain its peg is more complicated than it looks on paper. Generally, the process creates a few risks that could lead to the destruction of the entire project.
First, algorithmic stablecoins face the risk of increased and decreased supply each time the market shifts. If the asset price goes above the valued price, more tokens are minted by the algorithm. In this case, increased supply raises the question of who gets the new tokens. However, if the price goes below the value price, the algorithm is forced to burn the tokens. In some cases, it reduces the supply by offering bonds to buyers, who only get paid when the price rises above the valued price. Buyers can only hope the system will eventually even out and pay them for their purchases.
Another challenge is the reliance on oracle technologies since blockchains cannot access information outside their protocol. Algorithms use oracles to get prices from exchanges, compare the prices and adjust their system to maintain the balance. In this case, the data needs to be accurate in relation to the current price. Notably, it is always a challenge for developers or project managers to get the oracles right.
The last challenge is the risk of pegs separation (peg break). This occurs when a chain breaks away from the parent chain. A peg break is reportedly the worst-case scenario for any stablecoin. They have the strength to destabilize the algorithmic stablecoins causing price fluctuations that eventually could kill the entire project.
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