Stablecoins, where stability meets the future. — Cryptum Web 3 Main Concepts
Stablecoins are a type of digital currency designed to have a value that is linked or connected to another currency, commodity, or financial instrument. The purpose of stablecoins is to offer an alternative to the fluctuating prices commonly associated with popular cryptocurrencies like Bitcoin (BTC), which can make them less practical for everyday transactions.
Why they are so important?
Bitcoin, the popular cryptocurrency, can experience large and rapid changes in its value. For example, its price can increase or decrease by significant percentages within a short period of time, making it volatile and unpredictable.
While this volatility may be advantageous for traders, it introduces considerable risk and uncertainty for ordinary transactions like purchases. Individuals who hold cryptocurrencies as long-term investments would rather avoid the scenario of paying an exorbitant amount, such as 10,000 Bitcoins, for something as simple as two pizzas. Similarly, most businesses are hesitant to accept cryptocurrencies as payment due to the possibility of suffering losses if the cryptocurrency’s value sharply declines after the transaction.
To function effectively as a means of exchange, a currency that lacks legal tender status must exhibit relative stability, ensuring those who accept it that its purchasing power will remain intact in the short term. Among conventional fiat currencies, daily fluctuations of even 1% in forex trading are comparatively infrequent.
As implied by their name, stablecoins aim to tackle this issue by providing a guarantee to maintain the value of the cryptocurrency steady through various mechanisms.
How they differ from traditional currencies:
1. Value Stability: Stablecoins are designed to maintain a stable value, typically by being pegged to a specific asset like a fiat currency, commodity, or basket of assets. This stability is intended to mitigate the price volatility that is characteristic of traditional cryptocurrencies like Bitcoin and Ethereum. Traditional cryptocurrencies can experience significant price fluctuations due to market forces and speculative trading.
2. Regulatory Compliance: Stablecoins often strive to comply with existing regulatory frameworks to ensure legitimacy and facilitate wider adoption. They may implement Know Your Customer (KYC) procedures and work towards regulatory compliance to maintain stability and regulatory approval. Traditional cryptocurrencies, while subject to regulatory oversight in some jurisdictions, are often associated with a more decentralized and pseudonymous nature.
And of course, one of the main questions is how they maintain the value stability we are writing about and this is all done by pegging mechanisms.
Simply put, pegging mechanisms in stablecoins are like anchors that keep their prices steady. They achieve this by tying the value of the stablecoin to another asset, like the US Dollar or gold. This connection ensures that the stablecoin’s value stays relatively constant, avoiding the big price swings seen in cryptocurrencies like Bitcoin.
For example, let’s say we have a stablecoin called “CryptumXYZ” that is pegged to the US Dollar. The issuer of CryptumXYZ ensures that for every CryptumXYZ in circulation, they hold an equivalent amount of US Dollars in reserve. So, if you have 10 CryptumXYZ, you can exchange them for $10 worth of US Dollars.
Pegging mechanisms maintain stability by creating a predictable relationship between the stablecoin and the pegged asset. If the value of the pegged asset goes up or down, the value of the stablecoin adjusts accordingly to maintain the set ratio. This makes users of stablecoins feel more confident using them for everyday transactions since they know the value will stay relatively consistent, and that’s not all, they have two different types of mechanisms that keep them stable as they are.
Types of Stablecoins
Algorithmic stablecoins:
These are specific type of stablecoin that doesn’t depend on traditional collateral assets like fiat currencies or commodities to keep their value stable. Instead, they use sophisticated algorithms and smart contracts to automatically adjust the supply of the stablecoin based on changes in demand. This mechanism aims to stabilize the stablecoin’s price. In the case of algorithmic stablecoins, maintaining stability involves a combination of increasing or decreasing the supply of the stablecoin. When the price of the stablecoin goes above its target value, the algorithm takes steps to increase the supply, such as issuing new tokens or providing more rewards to users. Conversely, when the price falls below the target value, the algorithm reduces the supply by either removing tokens from circulation or implementing measures to decrease rewards.
The main objective of algorithmic stablecoins is to achieve price stability by relying solely on the forces of supply and demand, without needing external collateral reserves. The algorithms are designed to encourage market participants to either buy or sell the stablecoin, thereby automatically stabilizing its price over time.
Collateral-backed Stablecoins:
On the other hand, collateral-backed stablecoins are supported by specific assets held in reserve as collateral. These assets can be fiat currencies, cryptocurrencies, or tangible commodities like gold. The stablecoin issuer ensures that they hold a reserve of these assets in a proportion that corresponds to the stablecoin’s value.
For instance, if a collateral-backed stablecoin is pegged to the US Dollar, the issuer would maintain a reserve of US Dollars or assets that are equal in value to the circulating supply of the stablecoin. This collateral acts as a guarantee that holders of the stablecoin can redeem it for the underlying assets whenever they wish.
The stability of collateral-backed stablecoins is directly linked to the value of the collateral assets. Significant fluctuations in the value of the collateral can impact the stability of the stablecoin. To mitigate this risk, collateral-backed stablecoins often require over-collateralization, where the value of the collateral assets held exceeds the total value of the stablecoins in circulation.
The use of collateral-backed stablecoins offers a more concrete and tangible assurance of value stability since the price of the stablecoin is tied to the value of the underlying collateral assets.
The full transformative potential of stablecoins in a secure and sustainable manner is one thing, but have you heard about digital currencies? Real Digital (Brazilian currency) is one of the most advanced currencies now and it will be launched in 2024, they are not far from what a stablecoin is, let’s dive into it more…
CBDC vs Stablecoins
So CBDCs and stablecoins are digital currencies, but they have different structures and issuers. CBDCs represent a country’s fiat currency and are typically issued and regulated by the central bank. Their purpose is to enable secure and efficient digital transactions while maintaining the stability and control of the national currency. On the other hand, stablecoins are privately issued digital currencies designed to maintain a stable value by linking them to a reserve asset, such as fiat currency or a group of assets. Although private entities can issue stablecoins, they can also be issued in cooperation with or under the supervision of central banks. As a result, stablecoins can be considered a subset of CBDCs, acting as a bridge between traditional fiat currencies and fully government-backed digital currencies. The relationship between CBDCs and stablecoins is intricate and evolving, as central banks explore different models and partnerships to incorporate stablecoins into their digital currency frameworks.
In Brazil an upcoming CBDC is entering into the financial ecosystem, Real Digital, this is a digital representation of Brazil’s national currency, the Real, issued and regulated by the central bank of Brazil. The Digital Real will provide a secure and efficient means of conducting digital transactions using the national currency. With Digital Real, people will be able to make payments, transfers, and other financial transactions electronically, leveraging the benefits of digital technology. It will offer a modern and convenient way to use money, ensuring stability and reliability through the oversight and regulation of the central bank.
We invite you to stay tuned to Cryptum’s blog, and social media accounts because we are preparing for the upcoming Real Digital adoption.
So as with everything in life, everything comes with a risk:
1. Price Volatility: While stablecoins aim to maintain a stable value, price volatility is still possible, especially in algorithmic or partially collateralized stablecoins. External factors, market conditions, or technical issues could impact the stability of the stablecoin’s value, potentially resulting in losses for users.
2. Liquidity Risk: Stablecoins heavily rely on liquidity to maintain their stability and utility. If there is a lack of liquidity in the market, it can impact the ability to buy or sell stablecoins at their desired value, potentially leading to price deviations from the pegged asset.
3. Regulatory Compliance: Concerns around regulatory compliance, centralized control, and the need for robust audits and transparency to maintain trust in these decentralized currencies: Regulatory compliance is a significant concern when it comes to stablecoins. As these digital currencies gain prominence, regulatory bodies are paying increased attention to ensure that they adhere to existing financial regulations, including anti-money laundering (AML) and know-your-customer (KYC) requirements. Failure to comply with these regulations can lead to legal consequences, reputational damage, and potential disruptions to the stability of the financial system.
“ Transparency is essential for stablecoins to demonstrate accountability and build trust. “
Overall, maintaining regulatory compliance, mitigating concerns about centralized control, and ensuring robust audits and transparency are vital to instilling trust in decentralized currencies like stablecoins. Adhering to regulatory frameworks, implementing transparent reporting mechanisms, and embracing decentralized governance can foster confidence among users, regulators, and the broader financial community.