The Perfect Hybrid of Crypto and Fiat
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The Perfect Hybrid of Crypto and Fiat

What Are Stablecoins? All about the Purpose of Stablecoins in Business and DeFi

According to a report by the research company Messari, in the first quarter of 2021, the capitalization of stablecoins exceeded $65 billion. By the end of 2021, this figure has already reached $156 billion, according to Fitch Ratings. The value and market share of stablecoins continues to grow at an accelerating pace, and there is nothing surprising in this. After all, stablecoins are an amazing mixture of the freedom that cryptocurrencies give, with the reliability of the fiat money exchange rate.

There has been a lot of hype around stablecoins lately, for crypto investors are increasingly turning their eyes towards this type of coin. Wild volatility does not contribute to the mass adoption of cryptocurrencies, and in this regard, the emergence of this kind of virtual coins is an interesting trend in the digital money market. Stablecoins are designed to reduce market volatility, and this property significantly increases the usability of digital currencies.

Stablecoins are tied to the value of other assets, fiat or even precious stones and are considered by business as a kind of hybrid product of the cryptocurrency and fiat economies.

The Gaps That Stablecoins Fill in

The idea behind stablecoins is that they are designed to contain the inherent volatility of cryptocurrencies through the collateral behind them – this means that the number of coins in circulation is based on a certain reserved asset. If a stable coin of 1000 yen circulates in the market, the same amount should be in the bank behind the stablecoin.

The cryptocurrency market is prone to crashes and takeoffs, and it is against this background that the appearance of stable coins comes in handy. They give the investor additional confidence in market conversion rates. This increases the convenience of using cryptocurrency and makes it more practical when buying goods and services.

How Do Stablecoins Work?

Stablecoins are specifically designed to offer a constant price or value proposition. They act as a bridge between fiat money and decentralized virtual currencies. Moreover, they act as intermediaries and are used as collateral for obtaining loans, since they absorb the risks associated with cryptocurrencies.

This partly explains the fact that employers who pay their employees in virtual currencies prefer to use stable coins, which prices do not experience huge jumps when the crypto market suddenly falls. At the moment, there are three types of stable coins.

The first type is coins that use fiat money as collateral; for each coin on the market there is the same number of coins in the reserve bank. They are easily exchanged without any risk of being affected by the volatility associated with virtual currencies.

The second type of stablecoins uses cryptocurrencies as collateral - their reserves amortize volatility. As a rule, one stablecoin is backed by minimum two coins of the corresponding cryptocurrency. The risk associated with such a bundle is that the supporting coin may suddenly drop in value.

The last type of stable coin is one that does not require collateral and instead runs on smart contracts that control market demand and overall supply. Thus, the prices of such coins remain stable in tandem with fiat or the asset which they are linked to.

What Is the Secret of Stablecoins Popularity?

There is still a lot of uncertainty in the cryptosphere, especially when it comes to cryptocurrency conversion. The new generation of virtual coins offers the investor a predictable asset similar to traditional money. Stablecoins have proven useful in the fight against hyperinflation in Venezuela, and cases of their use are growing day by day.

Crypto investors believe that stable coins are the most reliable way to preserve their assets. These coins offer a reliable way out of the problems associated with the unstable nature of the cryptocurrency market.

The Advantages of Stablecoins

Fiat and cryptocurrency are no longer as far apart as they originally were. If the first crypto, bitcoin, was conceived by its creator as opposition to fiat, over the years, it has become clear that for the ease of daily calculations, a currency that has all the properties of cryptocurrencies, except volatility, is more appropriate. This property alone wholly negates the possibility of risk-free use of cryptos in business on a massive scale.

When your goods or services can theoretically decrease in price by 10-15% in one day, your crypto enthusiasm cools instantly. In business calculations, volatility is unacceptable.

The market always responds to a request with an offer, which has arrived. A few years ago, stablecoins, electronic currencies that have the properties of both fiat and crypto, became a part of the crypto market. The advantages of stablecoins are as follows:

  • They are backed with a fiat/crypto reserve of the same or excess value as the issued coins;

  • You can send them to any distance in seconds;

  • The transaction fee is minor and does not increase depending on your transfer amount;

  • The exchange rate of the coin is stable since it is pegged to generally recognized monetary units, usually fiat.

What Is the Purpose of Stablecoins in DeFi?

The important question for us is why stablecoins are an integral part of the ecosystem in DeFi, because without stablecoins it is impossible to imagine a market for decentralized finance. First of all, stablecoins are needed in DeFi so that investors can receive income from their decentralized crypto assets without damage, which inevitably entails negative consequences of market volatility.

For example, if an investor places crypto in the DeFi protocol to receive interest, there is a high probability that the fall in the price of the pledged asset will equal or exceed the entire yield received. As a result, the investor will be left with nothing or even at a loss.

At the same time, if you use a stable coin the value of the underlying asset will remain stable. This means that taking advantage of DeFi and cryptocurrencies, the investor, nevertheless, can remain calm about the main drawback of the crypto market: its volatility. When using stablecoins, the volatility of the crypto market will not affect the profitability of assets placed in the protocol.

How Stablecoins Are Used in DeFi?

Most often, stable coins are used for decentralized financial activities, such as liquidity mining, lending and borrowing. They can also be used to generate returns — currencies such as ADAI pay interest on DAI deposited in Aave. Stablecoins can also act as an alternative to fiat currencies. Since transactions with them take place on the blockchain, they are faster and more accessible than fiat money. The last property is especially relevant for the Velas blockchain: transactions there already surpass Mastercard and Visa in speed.

Types of Stablecoins and Their Purpose

  • Fiat backed is the most common type of stablecoin. An equivalent amount of fiat money can always be obtained for stablecoins linked to traditional currencies. The inconvenience of storing an equivalent amount of fiat is obvious: it requires the presence of a custodian, as well as regular checks that guarantee compliance with the promises of the issuing company and the sufficiency of its reserves. Placing a cryptocurrency as an asset for the issued stablecoin, which more than covers its cost, is more than justified and excludes any fraud attempts.

  • Stable crypto-backed coins work differently than fiat—backed tokens: they are secured with crypto assets, and they should be secured in excess, since cryptocurrency is a volatile phenomenon, and it is possible to ensure price constancy only in this way.

  • Stable coins backed by raw assets are backed by gold and other valuable resources. This type of stablecoin is less common, but for a certain type of investors, such security is almost the only acceptable one and provides, in their opinion, protection against the volatility of crypto and fiat. For such coins, an issuer is required, so at the same time with the reliability that the security itself gives, they also have a weak point — centralization. The organization issuing the stablecoin can simply go bankrupt. leaving investors with nothing. An example of a stable coin backed by gold is DGX.

The Bottom Line

Stable coins have become an essential component of the cryptocurrency ecosystem, and the crypto community's need for them is constantly growing. Stablecoins are more than just a useful form of security in DeFi. This form of money proved to be an effective saving asset, for example, in the conditions of crisis and hyperinflation in Venezuela, where a stable cryptocurrency literally saved local residents from the devaluation of their money that was growing like a hurricane. We are confident that as the crypto market grows, stable coins will become widely distributed around the world.