A leading international asset manager predicts that the stablecoin market will grow to $3 trillion in the next four years, a 22-fold increase from its current size.
To understand this growth better, one needs to first understand how stablecoins fit in the financial markets. This will cover the practical uses of blockchain, how its applications are transforming financial services, and how the blockchain-based nature of cryptocurrencies is driving innovations in the banking sector.
Stablecoin is a kind of digital currency privately generated to maintain a steady value by being tied to a fiat currency like USD or EUR or a commodity such as gold. It may also be due to the combination of assets. Its stability stems from its capacity to replicate the values of the underlying assets. When compared to other cryptocurrencies, it provides a more predictable and less volatile digital currency.
Stablecoins come in three main types, each differing in how they maintain their stability:
- Fiat-Collateralized Stablecoins: Bank deposits in USD or EUR serve as collateral for these stablecoins. The amount of fiat currency held in reserve matches the amount of stablecoin issued for each individual case, which is why these tokens are considered stable and reliable.
- Crypto-Collateralized Stablecoins: Stablecoins that are crypto-collateralized are supported by additional cryptocurrencies. These stablecoins typically hold excess reserves of the underlying crypto to maintain the peg even during the volatility of the collateral, given that the reserve-backed crypto can also be volatile.
- Algorithmic Stablecoins (Non-Collateralized): These stablecoins have no external backing from any physical or digital assets. Unlike algorithms and smart contracts, stablecoins rely on regulation to maintain a stable supply that aligns with the target price, akin to a fiat currency.
The reserves of fiat currencies that support fiat-collateralized stablecoins are in the form of fiat currency. Therefore, upon the issuance of a stablecoin, the safe and secure storage of fiat currency remains equal. This direct tie to fiat currencies allows these stablecoins to be redeemable for their cash equivalents, thus strengthening their stability and maintaining their value at a constant rate.
Crypto-collateralized stablecoins provide full backing of other cryptocurrencies instead of fiat currencies. The volatility of cryptocurrencies being the key factor, these stablecoins usually use an “over-collateralization” approach. This suggests that they possess a larger portion of the reserve cryptocurrency compared to the stablecoin they issue through conversion, sometimes reaching up to 200% of the reserve asset to safeguard against fluctuations in its value.
Only algorithmic stablecoins, also known as non-collateralized stablecoins, possess this ability due to their lack of physical or digital asset security. However, the value of the coins is ensured by the algorithms and programmable smart contracts, which are programmed to adjust the number of coins based on the demand in the market.
The essence of these stablecoins is to have a stable value, which is obtained by either increasing or decreasing the supply in line with demand changes, in the hope of maintaining a constant peg, which is often tied to fiat currencies such as the US dollar. The algorithmic stablecoin can dynamically vary the coin supply without requiring reserve assets. Popular algorithm-based stablecoins, such as USDD and USDX, are notable in terms of market capitalization.
The world financial ecosystem in the future seems to be very optimistic, and some innovations, such as stablecoins and Central Bank Digital Currencies (CBDCs), have been playing a key role in how value is transacted. These technologies are ushering in a number of upgrades, like cashless payments, innovative consumer goods, faster transactions, increased market interoperability, and simplified financial tasks. Despite numerous challenges yet to be overcome, the concept of a seamless exchange of value is progressively becoming a reality.