What are stablecoins, and are these digital assets the future of fiat currency?
Although cryptocurrency has been around since 2009, it has only begun to gain mainstream traction in recent years. In the past year alone, the total market capitalization of all cryptocurrencies has grown from $7 billion in 2018 to $2 trillion in the first months of 2022.
This explosive growth is due in part to the increasing awareness of cryptocurrency and its potential uses and the proliferation of Initial Coin Offerings (ICOs), which have allowed projects to raise millions of dollars in funding through the sale of digital tokens.
However, despite this impressive growth, cryptocurrency remains a relatively niche asset class with growing real-world usage. Slow adoption can be tied to the highly volatile values of popular cryptocurrencies such as Bitcoin and Ethereum, making them difficult to depend on for everyday transactions.
Yet many countries have begun to experiment with using cryptocurrency to transmit money and as a possible way to dethrone the US dollar as a leading global currency. China's launch of its digital yuan at the 2022 Bejing Olympics raised eyebrows as to the future of the dollar's status as the world reserve currency. Now the US government is looking deeper at digital assets and how the US could use the existing cryptocurrency framework to create a new type of digital dollar.
While many balk at the concept of cryptocurrencies such as Bitcoin and Ethereum supplanting traditional fiat currency, the idea of a digital dollar has been met with much more enthusiasm. The reason is tied to another type of cryptocurrency known as a stablecoin.
Let's take a closer look at stablecoins and how they differ from traditional cryptocurrencies - and how you can use them to enhance your trading and transaction strategies.
Fiat-collateralized stablecoins are the simplest and most popular type of stablecoin. They are backed by a fiat currency reserve, which is held in a bank account. In layman's terms, for every stablecoin in circulation, there is an equivalent amount of USD (or EUR, or JPY, etc.) held in a bank account. This one-to-one ratio ensures that the value of the stablecoin is pegged to the fiat currency and therefore remains relatively stable - thus the name stablecoin.
Stablecoin stability and liquidity have helped increase interest in this digital asset type for more common fiat transactions.
How Do Stablecoins Differ from Traditional Cryptocurrencies?
Most people know that cryptocurrency is a digital or virtual currency that uses cryptography to secure its transactions and control the creation of new units. The first and most well-known cryptocurrency, Bitcoin, was created to be an alternative to fiat currency (i.e., government-backed currency, such as the US dollar).
Bitcoin and other cryptocurrencies are often referred to as "digital gold" because they are seen as a store of value, like gold. However, unlike gold, which has a relatively stable price, the prices of cryptocurrencies can be quite volatile. This volatility makes Bitcoin and other cryptocurrencies less than ideal for everyday transactions, as the price of a good or service could change significantly between the time you make a purchase and the time you receive your goods or services.
Like cryptocurrency, stablecoins are digital assets that use cryptography to secure their transactions and control the creation of new units.
However, unlike cryptocurrency, which is not pegged to any real-world asset, stablecoins are backed by a physical asset, such as the US dollar, gold, or a basket of assets. This peg helps to stabilize the price of the stablecoin, making it less volatile than traditional cryptocurrencies.
One popular example of a stablecoin is Tether (USDT). Tether is a cryptocurrency that is pegged to the US dollar, meaning that 1 USDT equals 1 USD. According to Tether's white paper, around 85% of Tether's assets include cash, commercial paper, short-term deposits, and cash equivalents. This means that there is an actual US dollar sitting in a bank account for every Tether minted. This helps to ensure that the price of USDT remains relatively stable, as it will always be worth around $1.
Another example is USD Coin (USDC) - a stablecoin launched by Circle and pegged to the US dollar. USDC is an ERC20 token built on the Ethereum blockchain. One USDC equals one US dollar, and Circle holds actual dollars in reserve to back up all of the USDC in circulation.
Other examples of stablecoins include:
So far, stablecoins have been relatively successful in achieving price stability. Yet, as the stablecoin market grows, so too does the controversy regarding how policymakers should regulate these assets to protect investors.
Given the recent volatility in the cryptocurrency markets amid inflation and geopolitics, it's no surprise that policymakers are starting to pay more attention to stablecoins. These digital assets are designed to maintain a consistent value, and as such, they have the potential to provide a greater degree of stability in the crypto markets.
One primary concern is that if a stablecoin issuer were to go bankrupt, it could trigger a run on the coin, which could, in turn, lead to broader chaos in financial markets. Similarly, lawmakers have expressed concern regarding the potential of manageable redemptions becoming unmanageable in times of crisis - especially if the stablecoin's backing firm lacks cash or other easily sellable assets to cover the loss.
In response to these concerns, the President's Working Group on Financial Markets proposed in November 2021 that only firms supervised by the Federal Deposit Insurance or National Credit Union Administration should be allowed to issue stablecoins. This proposal would help to protect consumers and ensure that stablecoins are issued by firms with a proven track record of financial stability.
However, it remains to be seen whether this proposal will be enacted into law - and if enacted, what impact it will have on the stablecoin market.
Understanding how stablecoins differ from traditional cryptocurrencies is vital for anyone considering investing in these digital assets.
By investing in stablecoins, you can gain exposure to the crypto markets without worrying about the volatility typically associated with digital assets. Most times, stablecoins offer an excellent bridge for trading between cryptocurrencies that operate on separate blockchains.
However, it's important to remember that stablecoins are still a relatively new asset class, and as such, they come with their own risks.
As regulators and policymakers continue to scrutinize stablecoins, new rules and regulations could be enacted that could impact the value and accessibility of these assets.
Before investing in any digital asset, it's essential to do your research and understand the risks involved. If you are ready to start investing in digital assets or want to learn how to equip your company to begin utilizing cryptocurrency transactions, visit Sequoir today.
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