Introduction
In the rapidly evolving world of cryptocurrencies, volatility remains the constant and one of the most significant challenges. Unlike traditional assets, these digital assets are highly affected with market fluctuations causing drastic increase or decrease in value. Thus, despite being a powerful financial tool, many are still doubtful with its reliability, most especially when it comes to day to day transactions and other major financial activities.
Not until Stablecoins emerged in the market as a solution to this consistent issue. Furthermore, stablecoins are known altcoins with price stability since these assets' value are dependent on traditional currencies such as USD. As a result, this makes them the most ideal crypto to be used in decentralized finance, popularly known as DeFi.
In this guide, we will guide you through the world of stablecoins and their role in the world of DeFi.
Importance of Stablecoins in Decentralized Finance
As mentioned, stablecoins are a type of cryptocurrency or an altcoin, that's designed to maintain a stable value. Their value is often dependent on fiat currency such as the US Dollar or a commodity like gold. Unlike almost all cryptocurrencies, even the major ones like BTC and ETH, that are highly volatile, stablecoins are built differently as it provides stability which makes it ideal not just for everyday use but also for utilization in DeFi applications. Technically, these assets are what connects the gap between traditional finance and the digital economy by offering a more predictable and reliable alternative for an asset compared with typical and volatile cryptocurrencies.
Type of Stablecoins: Which One is Right For You?
Stablecoins come in four main types where each type highlights distinct mechanisms in terms of maintaining their stability. Let's take a closer look:
Fiat-Collateralized Stablecoins
These are the most common types of stablecoins which are backed by fiat currencies like USD when it comes to their value. These coins technically provide a 1:1 reserve ratio, which means that in every stablecoin issued, an equivalent amount of USD, for instance, will be held in reserve. Thus, aside from it establishing stability it also promotes transparency that further strengthens trust among its investors. Among the most popular types of these coins include Tether or USDT and USD Coin or USDC.
Crypto-Collateralized Stablecoins
Instead of being backed by fiat money, these stablecoins are dependent on cryptocurrencies. However, these coins are usually over-collateralized to cover the volatility of the digital assets. The most popular examples include DAI which uses Ethereum and other crypto holdings as a collateral when minting stablecoins. Basically, when you wish to invest or create $100 of these stablecoins, you will need to secure a $150 worth of ETH or other crypto holdings of your choice to ensure its stability when price fluctuations occur. Furthermore, this type of stablecoin is generally more decentralized than the ones that are backed by fiat money.
Algorithmic Stablecoins
This third type of stablecoin is considered to be the most complex among other options. Instead of being backed by any collateral, algorithmic stablecoins rely on computer programs or algorithms that control the supply of tokens as a response to the current market demand. Technically its main function is to be an automated central bank wherein when the value goes up, the algorithm will create more coins to bring the price down. In contrast, when the value falls below $1, the algorithm will reduce the supply to bring the value up. Evidently, these coins adjust freely during market changes, however they carry significant risks. An iconic example is Terra or LUNA, which collapsed due to algorithm failure. To learn more about the role of stablecoins in the digital world, you can read our article on how USDT and USDC are changing the game in online gambling.
Commodity-Collateralized Stablecoins
As mentioned, stablecoins also depend on their value in tangible assets like gold or other commodities, specifically they are referred to as commodity-collateralized assets which is the last and a hybrid type of stablecoins. The main purpose of these coins is to offer stability of traditional assets while also providing the flexibility of blockchain technology, offering the best of both worlds in the financial landscape. Though this type of stablecoin is still in an ongoing development, they sure have the potential in promoting an innovative approach to stability.
The Role of Stablecoins in DeFi Ecosystem
Here's a breakdown how stablecoins function to ensure a seamless operations within the decentralized finance space:
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Stablecoins keep their value stable by solely relying on a reliable asset such as fiat currencies and tangible commodities.
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In DEXs, stablecoins are used in providing liquidity as well as with other platforms. By pairing stablecoins such as USDC to other crypto assets like ETH, liquidity providers are given the opportunity of earning a portion of the trading fees accumulated in each transaction.
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Stablecoins can be used as collateral in DeFi lending platforms in exchange to fiat currencies or other crypto holdings. Furthermore, it also enables users to earn interest in their stablecoins deposits which reduces the risk of liquidation due to price volatility.
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Another passive income method where users can use stablecoins is yield farming. In this method, users will stake their stablecoins in liquidity pools in exchange for rewards without the need to be exposed to price fluctuations. While this is the most profitable method, it requires in-depth understanding as it also holds significant risks when approached in the wrong way.
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Stablecoins also enable cross-border transactions as it does not rely on traditional banks. As a result, international money transfers are more affordable and much faster.
Conclusion
Stablecoins does play a crucial role in regards to the functionality in DeFi, it offers both stability and liquidity that are essential to numerous use cases, including financial services. And by selecting the right stablecoin, as a user you will be able to engage with DeFi applications with confidence, knowing that your assets are protected from the typical cryptocurrency's volatility.
