Stablecoins 101: The Technology and Economics Behind Pegged Cryptocurrencies 

 Stablecoins are digital currencies  aiming to have a stable value dependent on whatever financial instrument or commodity they are pegged on. This article discusses the technology and economics behind pegged cryptocurrencies.

 

While cryptocurrencies and the crypto ecosystem may offer exciting and rewarding opportunities, many investors are still deciding whether to invest in them due to their tremendous volatility. But that’s where stablecoins come in.

 

Another sort of decentralized digital currency that can be bought and exchanged on the blockchain is stablecoins. 

 

Conversely, these coins are linked to real-world assets (such as fiat currency, gold, or U.S. dollar notes) and are intended to be far less volatile than crypto. 

 

Instead of stepping right into the technology and economics behind pegged cryptocurrencies, let us start from the basics to see what stablecoins are all about. After all, pegged cryptocurrencies are a kind of stablecoin.

 

What are Stablecoins?

Stablecoins, as the name suggests, are a sort of digital currency designed to provide stability while leveraging blockchain technology. They’re frequently tied (have a set exchange rate) to a fiat currency, like the U.S. dollar. 

 

“In an ecosystem like cryptocurrencies, where volatility is typically high, this is an important property,” Paul Brody, principal and global blockchain leader at Ernst & Young, explains.

 

“If you want to take advantage of blockchain technology without exposing yourself to the volatility in crypto prices, this is the way to do it.” He explained further.

 

For example, one USD Coin (USDC) is designed always to be worth $1. While the purchase value of the dollar may fluctuate over time, it is far less volatile than cryptocurrencies. 

 

How Stablecoins Work

Stablecoins work similarly to other cryptocurrencies. They are cryptocurrencies produced on a blockchain that users can buy, sell, and trade on an exchange, just like any other crypto coin. 

 

Stablecoins can be stored in hot wallets and cold storage devices like Bitcoin or any other cryptocurrency.

 

To maintain their integrity, most stablecoins are connected to a reserve of external assets, whether a cache of fiat currency, commodities like gold, or debt instruments like commercial paper. 

 

Most of the time, the corporation or entity that creates the stablecoin has reserves equivalent to the number of stablecoins in circulation. 

 

This means that any stablecoin holder should be able to redeem one stablecoin token for one dollar at any time.

 

Types of Stablecoins

There are three types of stablecoins there are;

1. Fiat or commodity-backed stablecoins
2. Cryptocurrency-backed stablecoins
3. Algorithm-backed stablecoins

 

Fiat or Commodity-backed Stablecoin

The primary and most common technique is to back up each stablecoin in circulation with an equivalent value in fiat currency or cash equivalents. This is referred to as a fiat-backed stablecoin. 

 

This means that the match of one USD is held on reserve for every stablecoin in circulation in the issuer’s U.S. bank accounts. 

 

Independent accounting companies frequently examine these reserves every month, and details on their holdings are widely displayed for public observation. Add example

 

Cryptocurrency-backed Stablecoins

Another technique of keeping a stablecoin’s price stable is crypto-collateralization, which involves backing stablecoins with reserves of other cryptocurrencies. 

 

However, because cryptocurrencies are so volatile compared to fiat currency, crypto-backed stablecoins are typically overcollateralized to help keep their peg amid market turbulence. 

 

For example, MakerDAO’s Dai (DAI) stablecoin is collateralized at 150%, which means that every 1 DAI in circulation is backed by 1.5x its equal value in Ethereum (ETH) or other cryptocurrencies.

 

Algorithm-backed Stablecoins

The third and last technique of keeping a stablecoin pegged is to utilize an algorithm, or smart contracts, which execute automatically to modify the circulating supply based on market conditions. 

 

When the price of an algorithmically-backed cryptocurrency falls, the smart contract reduces the circulating pool to promote scarcity and, thus, value. 

 

When a price rises over the peg, the smart contract raises the circulating supply to maintain price stability.

 

In the case of fiat-backed stablecoins, a holder can trade their stablecoins at any moment for an equivalent amount of dollars and vice versa. 

 

Some stablecoins are backed by other commodities such as precious metals, oil, and even real estate, but 1:1 redemption of your tokens for these assets is more complex, if at all.

 

Now, that’s enough stablecoin to get down in one read. Let’s see pegged cryptocurrencies. 

 

What are Pegged Cryptocurrencies?

A pegged cryptocurrency is one whose value is tied to the value of a specific bank-issued currency, financial instrument, or marketable commodity. 

 

Because the bank-issued money is fiat, a pegged cryptocurrency is also known as a fiat-pegged cryptocurrency.

 

The pegged cryptocurrency, regardless of whatever fiat currency or commodity it is linked to, is an encryption-secured digital means of trade. The exchange rate of the two currencies determines the link or peg. 

 

Once this exchange rate is established – usually one-to-one – the cryptocurrency’s value changes in the same direction and to the same extent as the fiat currency it is tied to.

 

The cryptocurrency’s pegged price refers to the price it tries to achieve to limit volatility. In actuality, trades can occur at any market price, which may differ from the tagged price. 

 

However, the ultimate goal of pegging is to guarantee that the pegged price and market price are as closely linked as feasible.

 

Most pegged cryptocurrencies are pegged to USD because it is the dominant currency in the global financial sector and one of the most stable fiat currencies in the world. 

 

Cryptocurrencies can also be linked to commodities such as gold or currencies other than the U.S. dollar. For example, the Digix cryptocurrency is linked to gold, with one DGX token equal to one gram.

 

Pegging the cryptocurrency to a fiat currency or commodity helps to stabilize it by keeping its value relatively stable. 

 

Such consistency is required if cryptocurrency is used as a medium of exchange for real-world transactions such as purchases or payments.

 

Pegged cryptocurrencies do not appreciate and do not typically make their holders wealthy.

 

However, their stability guarantees those who spend the cryptocurrency (e.g., shoppers) and those who accept the cryptocurrency (e.g., merchants) that it will preserve its short-term purchasing power and protect them from volatility-induced losses.

 

How Pegged Cryptocurrencies Work

In contrast to Bitcoin and other conventional cryptocurrencies, a pegged cryptocurrency is engineered to maintain a constant and less erratic value. As mentioned earlier, it can hold its peg in three different ways. 

 

First, it keeps a stockpile of liquid assets, such as cash or fiat currency. These assets are worth about as much as the stablecoin that is now in circulation.

 

Additionally, it keeps a stockpile of cryptocurrency. Their reserves exceed the value of their stablecoins. Overcollateralization mitigates the risk associated with the reserve cryptocurrency’s volatility.

 

Finally, the pegged cryptocurrency has the potential to function as a stablecoin based on algorithms.

 

Advantages of Pegged Cryptocurrencies

Investing in pegged cryptocurrencies has numerous advantages for an investor or trader looking to maximize their portfolio. 

 

1. The first and most obvious advantage is the ease of tracking volatility. 

 

1. The cost of popular flavors such as Bitcoin can be perplexing and difficult to time for any beginner crypto trader. A tiny trading mistake could result in a considerable loss. 

 

1. Because a pegged cryptocurrency is linked to an asset, the intrinsic value of the asset is determined by market conditions, which can be timed or monitored to maximize profits. 

 

1. Pegged cryptocurrencies are designed to transmit fiat currency rapidly and at a lower cost than a regular cross-border transfer, providing significant benefits to early traders. 

 

1. Pegged cryptocurrencies enable businesses to move money without fluctuation, improve security, lower financial transaction costs, and provide an inflation hedge.

 

Disadvantages of Pegged Cryptocurrencies 

The benefits of pegged cryptocurrencies appear appealing to many young individuals, but they are not without drawbacks. 

 

Pegged Cryptocurrencies are blockchain-based, and we are all aware of one significant advantage of this technology: decentralization. 

 

A pegged cryptocurrency provides a more centralized structure by setting the peg in favor of another financial instrument. 

 

For example, a crypto mechanism based on the value of gold is likely to be influenced by gold miners, U.S. Federal Reserve policy moves, and market demand. 

 

Moreover, there needs to be more transparency associated with such crypto instruments due to excessive centralization.

 

Final Thoughts 

Stablecoins allow individuals and institutions to stay in the crypto world without the danger typically connected with cryptocurrencies. 

 

The unique and essential thing about stablecoins is they represent the bridging of two worlds — cryptocurrencies and traditional finance.” 

 

However, remember that risk is still involved if you consider purchasing pegged cryptocurrencies or using them to borrow money via a DeFi platform.

 

Do your research, make findings, consult experts when needed, and make investment decisions.