Taming crypto price volatility – Stablecoins offer a solution

By Dr. Kwami Ahiabenu, II

Cryptocurrencies were designed to operate without central control. That is to say they  operate as a self-governing digital currency. Like any other currency, cryptocurrency pricing is dictated by supply and demand plus user sentiments, government regulations, hype and news.

At the end of December 2023 for instance, the price of the most popular cryptocurrency Bitcoin (BTC) was US$42,265.19.  As of February 2024, the price is US$51,434.96.  Evidently, Bitcoin has seen a lot of price fluctuation, making it more volatile than other investments.

To deal with the magnitude of price changes experienced by cryptocurrencies, the market has evolved a stable coin. As the name implies, stablecoins promise a higher level of stability in comparison with traditional cryptocurrencies, and offers a relatively stable store of value for users and investors who do not have an appetite for price volatility.

Stablecoins marry digital and traditional financial systems by pegging their value to a fiat currency like the US dollar, holding reserves of the fiat currency as collateral and using algorithmic formulae to manage supply and demand.

Thus, stablecoins are attractive in our information society; enabling users to undertake day to day transactions and international remittances, offering a stable source of value and overcoming the weaknesses of traditional cryptocurrencies which lack intrinsic value because their price is determined by market forces of demand and supply.

Types of Stablecoins

There are three types of stable coins, classified by the mechanism which provides stability for their value. The first type is Fiat-Collateralized Stablecoins which are linked to one or more reserves of fiat currencies such as the U.S. dollar, Euros, Ghana Cedi, Rand, or Naira which serves as its collateral.

In addition, some stable coins rely on other forms of collateral such as precious metals like diamond, gold or silver, and commodities including crude oil as an assurance of their stable value.

Globally the most popular form of fiat-collateralized stablecoins are linked to U.S. dollar reserves. Tether (USDT) and TrueUSD (TUSD) are popular stablecoins denominated at parity to the US dollar. In practical terms, such reserves are held by independent custodians, who are periodically audited. Currently, Tether (USDT) is the world’s third-largest cryptocurrency with a market capitalization of USD 97.91B.

The second type of stablecoin is known as Crypto-Collateralized Stablecoins, here this currency is backed by other cryptocurrencies. Since the reserve is based on cryptocurrency which is subject to high price volatility, Crypto-Collateralized Stablecoins are over-collateralized to provide some level of stability.

For example, Crypto-Collateralized Stablecoins valued at US$4 may be backed by cryptocurrency worth US$4 million thereby insuring against the price decline of the reserve cryptocurrency. One example of Crypto-Collateralized Stablecoins is MakerDAO’s Dai (DAI) stablecoin, which though pegged to the U.S. dollar, is backed by Ethereum (ETH) and other cryptocurrencies.

The third type of Crypto-Collateralized Stablecoins is algorithmic Stablecoins. As the name implies, it is not backed by any reserve assets since it’s stable value is achieved using an algorithm based on a preset formula to achieve optimum supply and demand required for price stability. Overall, algorithmic stablecoins suffer more from price than Crypto-Collateralized Stablecoins and Fiat-Collateralized Stablecoins. For example, in May 2022, the largest algorithmic stablecoin USD Terra (UST), worth US$18.7bln, crashed from US$1 to 10 cents overnight.

Stablecoins are significant because they offer the mechanism for mitigating the high price volatility of cryptocurrency while at the same time offering a realistic option for integration of cryptocurrency into the traditional financial system.

Another important value of stablecoins is their application in the decentralized finance (DeFi) space, which is an emerging innovation in digital finance where secure distributed ledgers, are used to power smart contracts for lending, borrowing and other financial services. Although the main promise of stablecoins is price stability, stablecoins are not totally immune to price slippage and a decrease in market capitalization during a crisis, therefore users are expected to exercise caution as they interact with this innovative currency.

In terms of regulations, traditional cryptocurrencies and stablecoins have different levels of acceptance and regulations across countries. Still, there are concerns about traditional cryptocurrencies in terms of security, legitimacy and impact on a country’s financial stability.

Cryptocurrencies, face a more restrictive regulatory approach in comparison to stablecoins due to their underlying reserve management transparency, mechanism for compliance with existing financial regulations and the resulting perception that they do not pose a risk to the broader financial system.

In conclusion, cryptocurrency market price volatility is a double-edged sword, offering high rewards for speculative traders while at the same time presenting major risks to persons looking for stable digital currency. The emergence of stablecoins  is great as it offers the best of traditional fiat currency and digital currency combined, making it an innovative, efficient, fit-for-purpose, secured means of payment in the fast-growing digital age.

>>>the writer is a Tech Innovations Consultant. He can be reached via [email protected]

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