Why do people need to use stablecoins? What are stablecoins? Which factors affect the stability of stablecoins? This article helps crypto beginners learn more about stablecoins and their role in the crypto market.
The extreme volatility of cryptocurrencies keeps people from using their coins in the way they use fiat currencies. People and companies can't use crypto for tax return purposes or financial statements because the crypto price swings may be big. Also, merchants who accept crypto can lose their profit if the price of coins decreases after receiving payment. Also, customers do not want to pay crypto for goods or services because crypto prices can go up.
Stablecoins were created to avoid volatility risks and help cryptocurrencies work together with the traditional financial system.
What is a stablecoin? In short words, stablecoins are cryptocurrencies with stable value for use in transactions. To make crypto coins stable their value is pegged to fiat currency, another cryptocurrency, commodity, and other assets.
There are many ways to peg or collateralize a token. One of the well-known versions is a USD stablecoin backed by USD.
Stablecoins can be traded as quickly as any other crypto-to-crypto trade that allows a holder effectively turn fiat currency and other assets into cryptocurrencies.
Usually, fiat-collateralized stablecoins are minted on a 1:1 basis. But if you check the prices of some USD stablecoins, you can see that prices are higher or less than $1 at any given time. Why?
First, let's consider the process of fiat-collateralized stablecoin issuance and redemption. Users can exchange fiat money for stable coins on a stablecoin issuer's site. To create an account, the user should be verified by KYC (Know Your Customer) and AML (Anti-Money Laundering laws) checks. Then user deposits USD and purchases fiat-collateralized on a 1:1 basis. The user can redeem stablecoins by an account on a stablecoin issuer's site. Stablecoin issuer "burns" these stablecoins and credits the user's account for USD at a 1:1 ratio. Now the user can send stablecoins to buy other cryptocurrencies, pay subcontractors, or buy goods.
In practice, fiat-collateralized stablecoins always end up in marketplaces. Users buy or sell their stablecoins on an exchange at the market price rather than redeem or purchase them from the stablecoin issuer. The changes in supply and demand of stablecoin affect its prices. This is why users trade the USD stablecoin higher or less than $1.
Also, stablecoin volatility depends heavily on cryptocurrency price fluctuations and other stablecoins volatility. Even if it is a gold-collateralized stablecoin, gold price swings will have a slight effect on this stablecoin. But bitcoin's price fluctuations will significantly affect the prices of gold-collateralized or fiat-collateralized stablecoins.
Additionally, the irrational behavior of the crypto market players and rare, unpredictable events also affect stablecoin prices.
Surprisingly,stablecoins can be more susceptible to volatility than other assets and cryptocurrencies.
Anyway, stablecoins play their role in the cryptomarket and people use these coins for transactions. But if you want to invest in crypto in a bear market, you should avoid buying stablecoins. It’d be better to buy bitcoin or Ethereum.
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