Stablecoins are digital currencies that reflect the value of another asset. These are mostly fiat currencies , such as euros or US dollars. A stablecoin can therefore mirror the value of another currency. In principle, a stablecoin can represent any asset. Typically, however, stablecoins represent assets with low volatility. As a result, they are relatively stable in value (just as stable as the value to which they are linked) compared to other cryptocurrencies.
This stability makes stablecoins particularly suitable for trading in cryptocurrencies such as Bitcoin. The advantage: exchanging stablecoins for cryptocurrencies is much easier than going through a bank account. Investors looking to buy or sell cryptocurrencies do not need to conduct transactions through their fiat bank account. This usually saves time and fees.
Stablecoins therefore act as a link between the crypto sector and the classic market. By being tied to “stable” values, they thus facilitate the trading and storage of crypto assets. The USDT from Tether is one of the best-known stablecoins. This would like to map the US dollar in a 1:1 ratio.
The quality of a stablecoin is measured by how reliably it reflects the value of an asset. A stablecoin that represents the euro, for example, should deviate as little as possible from the original in order to function as a solid currency and unit of account. There are currently three different methods to achieve this:
Protection through classic assets
Cryptocurrency hedging
Algorithmic validation
Protection through classic assets
With stablecoins of this type, classic assets are deposited for hedging. For example, if you want to buy a classically secured stablecoin that maps the US dollar at a 1:1 ratio, a physical US dollar must be deposited with the respective provider for each coin purchased. When it is resold, it can be exchanged accordingly. This is to guarantee the value of the coin. However, the collateral does not have to be in the form of fiat money. Hedging through assets such as precious metals, such as gold, is also conceivable.
Advantages of hedging with classic assets :
Compared to the crypto market, classic assets such as precious metals and gold have lower liquidity. Stablecoins based on such an underlying should therefore have a similarly low volatility.
Classic assets come from a regulated market environment.
Disadvantages of hedging with classic assets :
There is no investor protection. In the event of Tether's insolvency, there is therefore no deposit protection.
It cannot be 100 percent guaranteed whether the envisaged exchange ratio to the base asset will last.
Cryptocurrency hedging
In addition to hedging with classic assets, there are also stablecoins that guarantee value stability with cryptocurrencies as collateral. This has the advantage of greater decentralization. After all, the deposited deposit can be managed using a smart contract – a middleman like Tether is therefore not necessary.
However, investors have to hedge the high volatility of cryptocurrencies with disproportionately high collateral. Because of the fluctuation in the value of the security itself, situations are conceivable in which the required deposit falls below the value of one US dollar. Investors have to compensate for this.
Advantages of hedging with cryptocurrencies :
Decentralization comes closer to the idea of peer-to-peer systems.
Smart contracts eliminate the intermediary - no single point of failure.
Strong transparency.
Disadvantages of hedging with cryptocurrencies :
overcollateralization required.
Low acceptance, consequently low liquidity.
Smart contracts are fallible.
Protection by an algorithm
In addition to hedging with assets such as fiat currencies, gold or crypto, there is a third option for creating value parity with the base asset. The approach to algorithmic hedging is not to post collateral. Rather, automated buying and selling algorithms should ensure price stability. In principle, this type of "stable cryptocurrencies" works similar to a central bank - just automatically and decentralized. If the market pushes the price above the targeted base value, around one US dollar, the algorithm throws more coins onto the market and thus artificially increases the supply. As a result, the exchange rate should fall back to one US dollar.
Advantages of an algorithmic validation :
Investors do not have to deposit any collateral.
Transparent System.
No intermediaries.
Disadvantages of algorithmic validation :
Price more volatile than other systems in previous attempts.
Algorithm is fallible.
Low acceptance, low liquidity.
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