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Stablecoins are a hot potato these days.

Apart from investors involved in the crypto world, even the top regulators seem to be talking about stablecoins.

So what are stablecoins and why are they in focus of late?

What are stablecoins?

Cryptocurrency prices tend to vary a huge amount in a short span of time and people find this volatility exciting.

Take for example Bitcoin. Its price goes up or down as much as 15-20% even with a single tweet by billionaire Elon Musk.

Stablecoins are cryptocurrencies without the volatility. They share a lot of the same powers as other cryptos, but their value is steady, more like a traditional currency, i.e. the US Dollar, Indian Rupee, etc.

With stablecoins, you can maximise your chances of protection from market fluctuations.

What keeps the prices stable?

How do stablecoins stay clear of the volatility seen in the crypto markets?

There are two types of stablecoins depending on the collateral: national currency backed, and cryptocurrency backed.

Collateralised stablecoins are attached to another asset, like the US dollar. Their issuers back up the value of their coin by holding on to that asset.

Other stablecoins are linked to the price of crypto assets like Ether or, in certain DeFi apps, collections of coins put up as collateral.

Some stablecoins also employ algorithms to manage supply and demand of the coin so what’s in circulation matches what’s held in reserve.

But why do people use stablecoins even though the US dollar can serve its purpose directly?

There are institutional features that excite investors to use stablecoins.

The first is added costs when trading cryptos for dollars. On some exchanges, there are longer processing lags for dollar withdrawals. Fees are also often imposed when dollar withdrawals are frequent or large.

Another feature favoring stablecoins is their usage across a greater cross-section of crypto exchanges.

Crypto exchanges that have trusted volume do not provide investors with any on-ramp for trading dollars. They only accept stablecoins as a medium of exchange.

How do stablecoins affect crypto prices?

Since there are no firm rules or regulations affiliated to cryptos, they can be quite volatile.

The volatility is both a driver and result of the lack of public trust in cryptocurrency as a reliable and balanced currency option. People have mixed opinions due to the lack of a structured framework.

Therefore, they view it as a speculative investment.

To avoid this, investors tend to resort to safer options like stablecoins.

However, people with large holdings in bitcoin play an active role in influencing the prices of cryptocurrencies.

If the people who hold a huge sum of bitcoin want to convert their crypto assets into stablecoins, the price of cryptocurrencies enters a downward trend. The opposite is also true.

Simply put, price of cryptocurrencies is highly dependent on stablecoins.

Popular stablecoins

Although there are several stablecoins today with a lot of variety, by far and away the main narrative is around Tether.

Tether is the third biggest cryptocurrency in the world by market value.

While other cryptos often fluctuate, tether’s price is usually equivalent to $1. This isn’t the case always though.

Crypto traders often use tether to buy cryptos as an alternative to the US dollar. This essentially provides them with a way to seek safety in a more stable asset during times of sharp volatility in the crypto market.

Tether holds the US dollar in a bank account and the amount held must be equal to what they issue to maintain the order of the system.

The rise of US dollar collateral on popular exchanges has made tether the biggest player in crypto trading.

Yes, you read that right…tether, not bitcoin.

According to reports, approximately 60% of all volume is denominated in tether and another 4% in other stablecoins.

However, there are controversies about tether. Many believe that tether’s issuer doesn’t have enough dollar reserves to justify its dollar peg.

In May 2021, tether broke down the reserves for its stablecoin. The firm revealed that only a fraction of its holdings or 2.9% to be exact, were in cash.

The vast ma -ity was in commercial paper, a form of unsecured, short-term debt.

At present, tether has more deposits than many US banks with more than US$60 bn worth of tokens in circulation.

Apart from tether, here’s a list of other popular stablecoins by market capitalisation.

Stablecoins by market capitalisation.
View Full Image
Stablecoins by market capitalisation.

Will stablecoins replace the US dollar?

Since the start of 2019, stablecoins turnover has boomed, rising from a few bn dollars a day to an average of US$100 bn in April 2021, setting a record of $250 bn in mid-April.

Big companies are adapting stablecoins on their platforms. Recently, PayPal and Visa announced that they would allow payments with stablecoins. Mastercard and eBay are also reportedly considering it.

With the help of blockchain, stablecoins cut out the layers involved in today’s expensive payment system. International money transfers in stablecoins involves less friction than via a bank.

Just like bitcoin, you hold the private key to the stablecoin wallet. You are the only entity that has access to it. When a payment is made, it goes directly to the recipient's wallet.

The settlement time is also faster and it's available 24/7.

Of course, there are certain risks involved.

For stablecoins to replace the US dollar, at least some kind of regulation is needed. Ensuring that the issuer actually has the assets to back up its coins can be a start.

Top US financial regulators met earlier this month to discuss stablecoins.

A notice announcing the meeting promised that the group, which includes Treasury Secretary Janet Yellen, among other, would publish recommendations for stablecoin regulation within the next few months.

Last week, Fed Chair Jerome Powell had told lawmakers that stablecoins are growing incredibly fast and pointed to their lack of appropriate regulation as a point of concern.

Equitymaster's take on cryptos

We don't get cryptos. Honest.

It's something that has caught our imagination but we just can't figure out a way to value it. Fundamentally speaking.

Chartists like our very own Brijesh, study prices and suggest various levels. That makes sense to us.

Having said that, our 'fundamental' take on cryptos is simple. It's in line with the approach anyone should have when dabbling in a space one does not understand.

Invest only what you can afford to lose. Nothing more.

Happy Investing!

(This article is syndicated from Equitymaster.com)

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