What are stablecoins and why are they so popular?

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NEW DELHI: The cryptocurrency gamble and volatility isn’t for everyone where prices of coins rise and plummet abruptly, making investors rather jittery. Enter: Stablecoins. They are also digital currencies with a similar technology to traditional cryptocurrencies but are backed by real-world assets such as the US currency, gold or other cryptocurrency. This makes them less prone to significant drops in value and keeps the prices stable.
What are stablecoins?
Stablecoins are a type of cryptocurrency that offer more stability than other cryptos because they are backed by assets. Other cryptos, such as bitcoin, aren’t pegged to a stable asset. Their value is derived from a combination of peer-to-peer technology and software-driven cryptography. “Like other cryptocurrencies, stablecoins move around on the same online ledger technology known as blockchains. The difference is that their value is pegged 1:1 to a financial asset outside the world of crypto, usually the US dollar,” explains Jean-Philippe Serbera Senior Lecturer, Sheffield Hallam University. He adds that these 1:1 ratios are not automatic. “They depend on stablecoin providers having reserves of financial assets equivalent to the value of their stablecoins in circulation, which adjust with supply and demand from investors.”
In short, stablecoins achieve their price stability via collateralization or through algorithmic mechanisms of buying and selling the reference asset or its derivatives.
The biggest USP
The biggest USP of stablecoins is that they are built to withstand volatility in a way that other cryptocurrencies aren’t. This feature makes stablecoins an ideal safe haven asset because, unlike cryptocurrencies like Bitcoin that can fluctuate dramatically in price every day, an individual using stablecoins to store value see no risk of loss, especially because they have custody of their assets. For example, if there are 500,000 USD-pegged coins in circulation, there should be at least $500,000 sitting in a bank. Examples of the best-known stablecoins include tether (USDT), trueUSD (TUSD), gemini dollar (GUSD), and USD coin by Circle and Coinbase (USDC).
Though Bitcoin is still the most popular cryptocurrency, suffers from high volatility in its valuations. For instance, it rose from $5,000 at the height of the pandemic sell-off in March 2020 to almost $65,000 in April 2021 before plunging by over 50% to around $30,000 in June 2021. The price has since exceeded $65,000 in November 2021. This kind of short-term volatility makes Bitcoin and other popular cryptocurrencies unsuitable for everyday use.
How do they work?
Stablecoins attempt to bridge the gap between fiat currencies and cryptocurrencies. There are three categories of stablecoins:
Fiat-Collateralized Stablecoins: These stablecoins use a specific amount of a standard fiat currency, like the US dollar, as collateral to issue crypto coins. Other forms of collateral can include precious metals like gold and silver and commodities like oil. With the number of cryptocoins issued in a 1:1 ratio against the pegged fiat currency, this method is one of the simplest ways to create and operate a stable cryptocurrency. Tether (USDT) and TrueUSD are popular crypto coins that have a value equivalent to that of a single US dollar and are backed by dollar deposits.
Crypto-collateralized stablecoins: Here the underlying collateral is another cryptocurrency instead of a tangible commodity or a fiat currency. A higher valued cryptocurrency is used to issue lesser valued-stablecoins. For instance, $1,000 worth of bitcoins may be required to issue $500 worth of stablecoins. Even if bitcoin loses 30% of its value, the stablecoins will be covered. One crypto-backed stablecoin is dai, which is pegged to the U.S. dollar and runs on the Ethereum blockchain.
Algorithmic Stablecoins: These stablecoins don’t use any reserve but include a working mechanism, like that of a central bank, to retain a stable price. These stablecoins use a computer algorithm to keep the coin’s value from fluctuating too much. If the price of an algorithmic stablecoin is pegged to $1 USD, but the stablecoin rises higher, the algorithm would automatically release more tokens into the supply to bring the price down.
Why have they become so popular?
The likes of Bitcoin and Ether have become more popular as an asset to book profits rather than as tokens that people can actually spend, due to their constantly fluctuating value. By being anchored to a stable currency like the USD — which is monitored by a central bank, stablecoins are the most preferred option in the form of digital cash rather than a speculative investment.
“The market passes through various cycles. During a bear cycle, when the market keeps falling, it might be a good idea to hold stablecoins than other random tokens. Similarly, during a bull run, it might be prudent to book some profits and convert those profits into stablecoins. The stable coins would help in writing the volatility of the crypto market. Stable coins can also be transferred across exchanges at a much cheaper fees than other cryptocurrencies. News about regulations around the use cases of crypto are flowing around. Stablecoins are easily the ones with the most proven use case. Hence, stablecoins are an integral part of the crypto ecosystem,” said Edul Patel, CEO& Co-founder of Mudrex, A Global Crypto Investing Platform.
What’s the risk?
The credibility of stable coins such as tether has been the subject of controversy because the issuer of the coins may not actually hold fiat currencies against the tether or may not hold them in sufficient quantities. The providers promise they have reserves worth 100% of the value of their stablecoins, but that’s not quite accurate. “Tether holds 75% of its reserves in cash and equivalents as of March 2021. USDC has 61% as at May 2021, so both are some way short of 100%. A large part of the assets of both operations are based on commercial paper, which is a form of short-term company debt. This is not cash equivalent and poses a solvency risk in the event of a sudden collapse in the value of these assets,” explains Serbera.
Another issue is the ‘e-dollarisation’ probable: Since most stablecoins are likely to be pegged to the US dollar, the US might actually see that as an advantage to strengthen the reach of the dollar. It will “therefore be disinclined to regulate them. What then is to prevent such stablecoins, operating beyond regulatory gaze, to delink from the reserve peg, become independent creators of money and dent the domestic monetary policy of emerging and developing countries?”, writes D Subbarao, the former governor of Reserve Bank of India, in a column on Times of India.
How can this play out in India?
Cryptocurrencies are based on decentralized ledger platforms which are not governed by any centralized authority such as central banks. Some of these cryptocurrencies are already pegged to USD (such as Tether).
“Though India may patronize the use of a digital rupee as a legal tender and peg it to Indian rupee, banning other cryptos as asset classes may not be completely feasible as it may delink India from the rest of the world using other popular / widely used crypto currencies. At best, from a regulation standpoint, India may need to allow the conversion of other cryptocurrencies (in soft wallets) into a digital rupee (in India wallet as proposed) for regulating the same in the Indian market. This could bring in the required certainty (though not complete flexibility) if the digital rupee is compared to USD in the international market in the same way as the physical rupee,” says Yashesh Ashar, Partner, Bhuta Shah & Co LLP.
And what about the cryptos already in circulation in India?
As India’s crypto bill goes up for discussion in Parliament, the crucial question the government will have to answer will be the implications of the law on the cryptos already in circulation by Indians.
“The transition provision of 90 days to declare and dispose as in the 2019 Bill, may not be feasible as the platforms won’t be able to process the required volume of transactions. We already witnessed a crash in the crypto prices overnight on the Government’s intention to ban private cryptos. Other important questions could be the fate of the private cryptos vis-a-vis. digital rupee in India and the consequent licensing and regulations for crypto exchanges, regulatory body for the cryptos, addressing money laundering concerns, overseas investments (include under LRS) in cryptos, taxation aspects such as characterization of income, point and trigger event of taxation etc,” added Ashar.
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