Even though cryptocurrency quickly gained popularity and recognition, it has always been associated with a large number of questions and doubts. The main disadvantage and risk of digital money is considered to be its volatility, that is, the instability of the asset price. The more crypto gained popularity and found application in the DeFi world, the more the need to solve this problem was felt. It was then that stablecoins appeared - digital currency pegged to stable assets such as fiat money, precious metals, or other resources. The new class of crypto is created to partially solve the problems of volatility and combines the advantages of blockchain and the stability of traditional assets.
Thus, stablecoins are often referred to as reliable and predictable digital currencies capable of providing price stability, which makes them ideal for trading, storing value, and making fast, low-cost fund transfers. At the moment, stablecoins are used in various areas, including financial services and international payments. Today's article from Notum will help you understand stablecoins and their impact in the DeFi world, and explain how these digital assets can be used in the rapidly developing DeFi space.
What Is DeFi?
DeFi (or Decentralized Finance), is a set of blockchain-based financial instruments and services that provide open, transparent, and decentralized access to financial services. The main point of DeFi is that it seeks to eliminate intermediaries such as banks or financial institutions and provide users with direct access to financial instruments and services through the use of smart contracts on the blockchain. Thus, DeFi aims to become a simpler, open, and secure alternative to the traditional financial sector.
At the moment, the ever-evolving world of DeFi includes a huge number of opportunities, such as lending, exchanging and trading cryptocurrencies, staking and mining, providing liquidity on decentralized exchanges, creating and managing decentralized organizations (DAOs), and much more. Since these operations and services are performed on the blockchain using smart contracts, this allows for the automation and security of transactions.
The most popular blockchain for DeFi development is Ethereum, but there are others like Binance Smart Chain, Solana, Polkadot, etc., that also provide infrastructure for the development of DeFi applications. By reducing the role of intermediaries and providing greater access to financial services, DeFi has the potential to change the traditional financial system.
Advantages of DeFi
- Openness and accessibility. Since DeFi protocols are built on public blockchains (like Ethereum), they are accessible to everyone. Thus, any user who has Internet and owns cryptocurrency can use DeFi platforms, applications and services.
- Decentralization. DeFi protocols are not controlled by centralized organizations and institutions such as banks, government, and so on. Decisions are made using smart contracts, so there is no need to use intermediaries. Thus, decentralization increases security and reduces the risks of fraud or corruption.
- Financial freedom and self-management. With DeFi, users are in complete control of their finances, unlike in the traditional sector where funds can be frozen or confiscated by banks or other authorities. What’s more, users can also participate in protocol governance and be rewarded for their contributions to DeFi.
- Innovative financial instruments. DeFi offers a wide range of financial tools and services, thus expanding the possibilities of traditional finance. This includes lending, staking, liquidity pools, asset swaps, prediction markets, and more.
- Liquidity and globality. As DeFi protocols are famous for being open and accessible, they offer high liquidity and access to the global market. In this way, users can trade assets and exchange them in real-time without having to turn to intermediaries or exchanges.
What Are Stablecoins?
Stablecoin is a type of cryptocurrency designed to provide price stability, which makes it different from other digital assets that have an unstable price (such as Bitcoin and Ethereum). The main idea of stablecoins is to create a digital asset whose price is stable, which can be achieved, for example, by pegging a coin to a specific asset or mechanism. This asset could be a traditional currency (such as the US dollar), or even a metal like gold. “An asset that’s pegged to a more stable currency can give buyers and sellers certainty that the value of their tokens won’t rise or crash unpredictably in the near future.” – Coinbase.
Stablecoins can be devided into 3 main categories:
- Fiat-collateralized stablecoins. Stablecoins of this type are backed by a reserve of fiat currencies as collateral. Fiat-collateralized stablecoins are most often created and controlled by centralized institutions and tend to maintain a fixed collateral ratio of 1:1. For example, Tether (USDT) is backed by US dollars, where one dollar equals one USDT. Other popular examples of fiat-collateralized stablecoins are USDC, BUSD, and TUSD.
- Cryptocurrency-collateralized stablecoins. These digital assets derive their value from cryptocurrencies held as collateral. Such stablecoins are backed by a reserve of other crypto, such as Bitcoin or Ethereum, which provide stability to their value. The collateralization ratio determines the proportion of cryptocurrency reserves required to support stablecoin issuance. One of the most famous crypto-collateralized stablecoins is DAI.
- Algorithmic stablecoins. In this case, price stability is achieved through algorithmic control of supply and demand. An example of algorithmic stablecoins is Frax (FRAX). “The ratio of collateralized and algorithmic depends on the market's pricing of the FRAX stablecoin.” – CoinMarketCap.
Stablecoins have quickly gained popularity and are an integral part of the DeFi world for several reasons. Firstly, they allow users to maintain the value of their funds despite the volatility of the crypto market. Secondly, they provide price stability, making them more predictable for everyday use. In addition, stablecoins facilitate the trading and transfer of digital assets on the blockchain, as they are usually quickly and easily transferred between wallets..
Stablecoins in DeFi: Use Cases
Stablecoins are an important part of DeFi and provide users with a wide range of applications. So how can stablecoins be used in DeFi? Let's look at the main options:
- Storage of value. One of the main uses for stablecoins in DeFi is to store the value of assets on the blockchain. For example, if during market fluctuations an investor believes that the price of an asset may fall, he can convert it into a stablecoin and thereby save the value. Apart from this, users can also store their savings in stablecoins instead of fiat currency, since, as already mentioned, DeFi eliminates the possibility of locking or freezing their assets.
- Trading on decentralized exchanges. Stablecoins are the underlying assets for trading on DEXs. For example, users can pair them with other cryptocurrencies to buy or sell assets on DEX platforms. Thus, they get access to a large number of trading pairs and participation in decentralized trading.
- Lending. Stablecoins can be used as collateral for loans and borrowing on DeFi platforms. For example, users can pledge their stablecoins in a protocol that provides lending services and borrow them in other cryptocurrencies or stablecoins. This allows them to access financial services without having to sell assets.
- Liquidity pools. Stablecoins can be provided to liquidity pools on exchange platforms to earn rewards. In this way, users can not only contribute and help provide liquidity on the platforms, but also earn passive income without active participation.
- Payment and transfers. Stablecoins can be used for fast and low-cost payments and transfers on the blockchain. Users can send stablecoins to other users without intermediaries like banks and other organizations.
Thus, the use of stablecoins in the DeFi world is quite wide and continues to evolve with the emergence of new platforms and applications. To date, stablecoins have firmly established themselves in the DeFi environment, as they provide the user with stability, availability, and a variety of opportunities that the traditional financial sector cannot offer.
Risks of Using Stablecoins
There are some risks to consider when using stablecoins in DeFi. For example, some stablecoins can be collateralized with other assets, such as fiat currencies or other cryptocurrencies. If a collateral asset decreases in value or does not support the value of a stablecoin, the stability of the asset will be in question. Moreover, many stablecoins use smart contracts on the blockchain to manage issuance and exchange. Since errors are possible in smart contracts, there is always a risk of losing funds. Let's look at the main risks of using stablecoins:
- Centralization risk. Stablecoin holding accounts or wallets are also subject to theft, hacking or access by third parties. Moreover, a stablecoin issuing company can unilaterally remove stablecoins from a user's wallet, mostly at the request of regulatory authorities. For example, if someone steals funds and keeps them in a crypto wallet (for example, USDT stablecoin on Metamask), then Tether Limited can freeze these funds. This rule applies not only to the issuer of USDT, but also to other centralized stablecoins (for example, USDC, BUSD and TUSD).
- Counterparty risk. Such a risk is associated with the possibility that one of the transaction participants may fail to fulfill the contractual obligation. One element of the counterparty risk of stablecoins that is widely discussed in the media is whether one US dollar is really pegged to every stablecoin in circulation.
- Market risk. As stablecoins, unlike other cryptocurrencies, face less volatility, they are associated with low market risk. However, even though they are pegged to fiat, cryptocurrencies or other assets, stablecoins may experience de-pegging for a number of reasons.
- Regulatory risk. Since some stablecoins are linked to fiat currencies, they may be subject to regulatory intervention and restrictions in various jurisdictions. Changes in legislation or regulation may affect the availability and use of stablecoins.
Thus, it is important to remember that although stablecoins are more secure crypto assets, they are still not without risk. That is why it is always important to carefully weigh the pros and cons and follow the updates in the market before using this or that cryptocurrency.
The Role of Stablecoins in the Future of DeFi
It is predicted that stablecoins will still be in demand in the DeFi future. Since cryptocurrencies have a mixed reputation largely due to their volatility, and stablecoins provide price stability, there is a good chance they will help drive the mass adoption of digital assets and DeFi. Preserving the value of their assets will help users more confidently use cryptocurrency in everyday financial transactions.
Also, stablecoins are known to help the development of new innovative financial instruments and services in DeFi that the traditional financial sector cannot provide. It is expected that in the future the number of such services, platforms and applications will only grow, which will make DeFi and stablecoins in particular tools for daily use.
In addition, stablecoins allow the provision of financial services on the blockchain without bank accounts, intermediaries and fiat money. Since not all users have access to banking services or their country has limited banking operations, the DeFi space can be a solution to their problems. Moreover, stablecoins can serve as a bridge between traditional financial systems and the cryptocurrency ecosystem. They allow the user to instantly and easily convert their fiat funds to digital form and vice versa, which will facilitate the interaction between traditional finance and DeFi and accelerate the adoption of cryptocurrencies to the masses.
Stablecoins play an integral role in the DeFi ecosystem by providing stability, liquidity, and the availability of financial services on the blockchain. They allow users to store the value of assets, participate in trading, obtain credit and loans, provide liquidity, and make fast and low-cost payments. In the future, stablecoins will continue to evolve and play a key role in the development of decentralized finance, opening up new opportunities for mass adoption and innovation in fintech.
Disclaimer: Notum does not provide any investment, tax, legal, or accounting advice. This article is written for informational purposes only. Cryptocurrency is subject to market risk. Please do your own research and trade with caution.