How Stablecoins Serve As an Answer to Cryptocurrency Market Volatility
Bitcoin's volatility is estimated to be above 5% over the past 6-8 months
Cryptocurrency With Price Stable Characteristics
In its simplest form, a stablecoin is defined as a cryptocurrency that has a price stable characteristic. A majority of stablecoins are pegged to the US dollar. Some are implemented over a basket of currencies or an index in time. While cryptocurrencies such as Bitcoin (BTC) and Ethereum (ETH) are certainly some of the most disruptive use cases of the blockchain technology and are capable of serving as an excellent medium of exchange, there’s one key characteristic that drives many merchants and users away from them – volatility.
Bitvol.info estimates Bitcoin’s volatility to be above 5% over the past 6-8 months (as of April 9, 2018).
Stablecoins seek to mitigate this volatility and offer price stability. Since the price of stablecoins is pegged to the USD (or a relatively less volatile index or basket), these coins serve to convert an investors’ highly volatile crypto holdings into a low-volatility stablecoin holding. Now, there are three key ways in which stablecoins achieve this, conceptually:
Coins That Collateralize Fiat
In this approach, a central entity holds the money as collateral and issues a token that represents the money held by the investor. Tether is a popular example in this regard.
Coins That Collateralize Cryptocurrency
This approach collateralizes cryptocurrency to issue stablecoins. MakerDAO is a key example of this type of stablecoin structure.
These are price stable cryptocurrencies that do not require any collateral. The concept is based on the Quantity Theory of Money or the popular demand-supply-price function in economics, wherein the general price level of a commodity X is a function of market demand and supply of commodity X. Basecoin and Carbon are popular examples here. In these protocols, the supply of the coin is dictated by the price of the stable coin. Accordingly, the system alters the supply of the stablecoin to create an upward or downward (as the case may be) pressure on the price, in order to keep the price fluctuations within a minimum volatility range.
Basecoin, a stablecoin backed by some of the biggest names in the industry such as Andreessen Horowitz and Metastable Capital, makes use of a three token system: basecoin, base bonds, and base shares in order to implement its architecture. Carbon, on the other hand, is compatible with smart contracts which give it the feasibility to be used in financial applications.