Stablecoins are a form of digital currency that has been slowly adopted by the broader financial markets and regulators. Due to technological changes, the traditional financial industry is slow to move when they encounter new products as they do not like disruption.
By the end of the article, you will have a good understanding of what stablecoins are, including strategies that financial regulators are setting in place to avoid playing catch-up.
What are Stablecoins?
A stablecoin is a digital currency that attempts to stabilize its value by holding a basket of other currencies or assets. Since stablecoins try to provide key characteristics of digital currency, including real-time processing, secure transactions, and relatively consistent valuations that fiat currencies have, they have a considerable grip in the finance world.
Stablecoins’ relatively stable value is due to leveraging other currencies or through mechanisms that depend on algorithms that involve the trading of the leverage commodities or even its derivatives.
How Do Stablecoins Work?
The value of Bitcoin is highly volatile. Even the intra-day swings in its price can be savage, hence, its value can shift up or down by 10% or more, all within a very short period.
Due to the high volatile value Bitcoin and other well-known cryptocurrencies are considered to be unreasonable to be used like fiat currencies.
An ideal currency behaves as a means for monetary exchange. The ideal currency serves as a means of holding monetary value, ensuring the stability of its value over time. When the purchasing power of a currency is uncertain, the majority of the public avoids using it.
The Mechanisms of Stablecoins
Stablecoins are divided into 3 categories:
1) Stablecoins that are leveraged on fiat currencies
These stablecoins use fiat currencies as collateral. Precious elements like diamond or gold can also be used as collateral in this category. Even commodities like oil can be used as collateral.
Nowadays, the dollar is the fiat currency that is most used as collateral for stablecoins.
Independent guardians keep these reserves, ensuring they are audited and that they adhere to necessary compliance.
2) Stablecoins that are leveraged on cryptocurrencies
This category of stablecoins is backed by other cryptocurrencies. Due to the high volatility of the value of cryptocurrencies, a situation where a higher amount of cryptocurrencies are used as a reserve for a lesser amount of stablecoins coins.
3) Stablecoins that are based on Algorithms
These stablecoins do not use any currency as reserves. However, they involve a working mechanism, like that used by the central bank, to retain a stable price. This category involves using a mechanism or algorithm to maintain a stable value. An example of such mechanisms is the consensus mechanism used by basecoin to maintain the token supply on a need basis.
Stablecoins in view
Until the launch of Facebook’s Libra stablecoins, there were few thoughts on investing in stablecoins.
After its launch, Libra was feared, by financial institutions, to cause the destabilization of monetary policies and facilitate illegal money transactions.
According to Bank of England Governor, Andrew Bailey, the current regulatory standards in the finance sector have to be updated and gone through in areas necessary with regards to stablecoins. He also requested for a clear G20 mandate stating that bodies in charge of setting standards should make these standards clearer.
Stablecoins launched in Britain and collateralized on the British Pound, had to meet similar standards to those that were applied to banks, Bailey said. He added that the issuer of the coin needed to be based in Britain.
This requirement may have an impact on stablecoins. In April 2020, the Libra Association based in Geneva said that it would offer stablecoins based on several individual fiat currencies. The association which is in charge of overseeing the stablecoin said that although the currencies were yet to be decided, the dollar and euro were possible examples.