Fiat currencies such as US Dollar and Euro are sometimes subject to fluctuating exchange rates, inflation and diminishing exchange power.However, the fluctuations are small that it does not affect people using these government-issued currencies on daily basis.
Cryptocurrencies are volatile. Hence, the usage of cryptocurrencies becomes slightly impractical for mainstram use. A person who owns cryptocurrency prefers to buy anything with fiat currency than cryptocurrency because of cryptocurrency’s volatile nature.
We call a cryptocurrency a stablecoin when it becomes stable in its purchasing power or is only slightly inflationary. This incentives for the owner to spend their coins rather than holding them. Cryptocurrency which matures to this stage is usually called “stable coin.”
A stablecoin is a cryptocurrency that is pegged to another stable asset such as gold or any fiat currency. It is a currency that is global, but is not tied to a central bank and has low volatility.
A stablecoin must satisfy three essential properties of a currency. First, it has to achieve ‘medium of exchange’ status i.e, it should have ability to trade goods and services without bartering. Second, it should possess ‘store of value’ which implies that it should be able to maintain wealth over time. Third it should have ‘unit of account’ i.e, to have measurement unit to define and compare market values.
Graph 1: Bitcoin Price Chart Since its Inception
Graph 2: Bitcoin Price Chart from 13 October 2018 to 19 October 2018
Thus, from the above graphs we can understand the degree of volatility of Bitcoin and why it cannot integrate into mainstream usage in current scenario.
Types of Stablecoins
There are three types of stablecoins, namely fiat-collateralized, crypto-collateralized and non-collaterized.
Fiat-collateralized stablecoins is where a a certain amount of fiat currency is deposited as collateral for coins to be issued. It is 1:1 against fiat money. This method requires central party which guarantees the issuance and redeemability of the stablecoin. regular audits are required to ensure that the stablecoin is fully collateralized. Moreover, gold, silver or oil can also serve as pegs.
Crypto-collateralized stablecoins work similar to fiat-collateralized stablecoins. The only exception is that the collateral is not a physical asset but a cryptocurrency. For instance, one needs to deposit $400 worth ETH to receive $100 worth stable coins. If the price of ETH depreciates by 25%, the person will be still holding $300 as ETH collateral backing the value of the stablecoin. If the asset becomes valueless, then the stable coin will also collapse. This event is called black swan event. This method might also lead to over-collateralization. hence, experts discourage this method.
Non-collateralized stablecoins retain certain value despite not being backed by any asset. This method applies smart contracts that algorithmically expand and contract the supply of the price-stable currency. These stablecoins work similar to central banks’s fiat currency. What differentiates non-collateralized stablecoins from fiat currency is that stbalecoins work in decentralized manner.
Tether, MakerDao, Basecoin, TrueUSD are few example of stablecoins that exist today.
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