Despite its slow start relative to the previous year, cryptocurrencies continue to be an exciting investment vehicle. The steep decline in the price of Bitcoin, Ethereum, and other altcoins, however, highlight one of the biggest problems in the world of crypto – volatility.
The extreme volatility of the cryptocurrency market makes it difficult to use digital coins for everyday transactions. Imagine buying a new gadget using Bitcoin back in December of 2017 when it reached an all-time high. You’d probably regret your decision now that Bitcoin’s value has plummeted by more than half.
This is where stable coins enter the picture. A stable coin essentially functions in the same manner as other cryptocurrencies, but it is pegged to a stable asset such as gold or the US dollar. It is aptly named “stable” since it doesn’t suffer from extreme volatility, making it a realistic option for paying for things you buy every day. An increasing number of investors are keeping a close eye on stable coins, with crypto exchanges like Switchain reporting that these coins have become one of the most traded assets on their platforms.
Over the past few months, Tether has gained popularity among cryptocurrency investors. This digital coin is fully-backed by fiat currency assets. With a conversation rate of 1 USDto $1 USD, Tether offers an interesting real-world use-case. The platform, however, isn’t fully-decentralized, prompting many critics and investors to question the veracity of Tether’s dollar reserves.
Maker provides an interesting solution to the problem with Tether. Operating as a decentralized autonomous platform, Maker has created a stable coin called Dai that is not only pegged against the US dollar but is completely backed by ETH as well. Each Dai is worth $1 USD, but the primary advantage is that everything can be seen on the blockchain, making it more transparent than Tether.
Rune Christensen, CEO, and founder of MakerDAO explains that their platform uses price stability mechanisms to ensure Dai always hovers close to the target price. Automating the Target Rate Feedback Mechanism (TFRM) in the event of severe market instability adjusts the Target Rate to match Dai’s market price to the Target Price. While this mechanism means breaking the peg of Dai to the US dollar, changing the Target Rate provides incentives to the market participants to help maintain the price of Dai.
If Dai’s market price falls below the Target Price, TFRM increases the Target Rate which makes it more expensive to generate Dai. The higher Target Rate also increases the capital gains from holding Dai, which then compels more investors to want to invest in the cryptocurrency. The decrease in supply paired with the increase in demand causes the market price of Dai to increase closer to the Target Price. The opposite happens if the market price climbs above the Target Price.
The mechanisms that provide the much-needed price stability of stable coins can be technically complex, but ultimately, they offer a bright future for cryptocurrency investors. With countless critics saying that digital coins could never be used for everyday purchases, it’s high time for stable coins to shatter the myth and prove that there’s a working solution for the market volatility.