The extreme instability of cryptocurrency prices is an acknowledged factor. Upon observing the charts of cryptocurrencies, it becomes evident that their prices are rapidly increasing every second. It is an undeniable fact that a financial market cannot grow without a dependable currency.
Stablecoins are an essential part of the cryptocurrency world despite the popularity of Ethereum and Bitcoin. In this article, we’ll explain why by delving into what stablecoins are and how they maintain their stability amid the unpredictable crypto market fluctuations.
Function: What Are the Uses of Stablecoins?
Stablecoins are tokens that maintain a constant value by being connected to a specific trading instrument, traditional or non-traditional, including digital currencies. In the latter’s case, stablecoins replicate a particular cryptocurrency and work on different blockchains. When stablecoins are connected to other cryptos, crypto enthusiasts refer to them as wrapped tokens.
When talking about stablecoins, most people refer to crypto tokens linked to regular fiat currencies rather than manipulated tokens. If a stablecoin’s value is tied to a fiat currency, like the US dollar, its value will always stay close to $1, will not exceed $1, and fluctuations will typically be less than a penny. The question now is, what is the method used to maintain this standard?
How Do They Maintain Equilibrium?
As we have previously discussed, stablecoins are cryptocurrencies linked to the value of several currencies to maintain a stable value. The largest stablecoin, USDT, is an excellent example to illustrate this point. Whenever USDT is issued on the blockchain and circulated, the equivalent amount of USD is held in a bank account. This effectively stabilises the value of each USDT token by allocating $1 from the bank for every USDT in circulation. This contrasts with most other cryptocurrencies, which are speculative assets not linked to tangible cash or assets.
Some stablecoins are designed to maintain a value of $1 by utilising mathematical algorithms to match market demand with other digital coins.
It is possible for algorithms to malfunction or for those responsible for them to take advantage of the situation and withdraw a large amount of money. The collapse of the UST stablecoin last year, which caused users to lose hundreds of millions of dollars, is a recent example of such an occurrence.
Are Stablecoins Necessary?
You might be wondering about the purpose of stablecoins, especially the ones that are supported by conventional assets. The answer to this question lies in their practicality.
Cryptocurrency transactions are simple as you only require the recipient’s wallet address. However, using volatile cryptos for payments can get complicated at times. For instance, companies generally do not accept Bitcoins due to their instability.
Selling a product for 1 BTC can be lucrative on one day, but on the next day, its value can significantly decrease. Stablecoins offer a solution to this issue since companies can rely on 100 USD as payment. Even if the cryptocurrency market experiences a crash, the value of 100 USD remains the same.
The Practical Value of Stablecoins in the Volatile Crypto Market
Investors often require stablecoins for a critical reason- they provide a safety net. Cryptocurrencies are known to be highly volatile, and their prices can fluctuate significantly in a short duration, as mentioned earlier. This unpredictability can prompt investors to rebalance their portfolios, and there can be situations where it’s best to withdraw specific cryptocurrencies from their portfolios.
However, what can the investor do if the market is unstable and buying any cryptocurrency could result in a mistake? Selling the extra funds and cashing out is an option, but there are better choices than this one for most investors. They would rather avoid the fees involved in depositing the money back into cryptocurrencies. In this case, the second and more practical option is to transfer the extra funds into stablecoins. This move will ensure the safety of the investor’s money and enable it to remain on the blockchain.