DeFi needs to continually evolve like any other innovative technology in its early days. The immediate path for DeFi might be regarding its regulatory compliance. But applying regulatory compliance on DeFi might not be that easy, and it would be critical that such a solution would need to address any user privacy concerns as well.
Stablecoins: The Underrated Factor in DeFi
To an extent, stablecoins have been effective in eradicating the anxieties about the volatility of crypto investments. With the emergence of DeFi, Stablecoins will have an even more significant role to play in the future.
The Cryptocurrency asset class often comes under scrutiny for its volatility and price swings. The perceived instability of crypto markets is one of the primary reasons many customers of the traditional financial system are reluctant to invest in the crypto market.
People tend to forget that volatility is quite common to any market. Besides, the whole crypto industry is still in its relative infancy, when compared to the broader, traditional financial sector.
Even though the popularity of crypto has steadily grown, notions of volatility continue to prevent many from entering the space. Also, volatility can be a good thing – especially for active traders.
However, to an extent, stablecoins are a viable solution created to solve issues surrounding volatility, and in turn, is helping DeFi in gaining prominence.
What are Stablecoins?
Almost all cryptocurrency coins available on the market are subject to price changes, which in turn results in price volatility.
The assets that are the only exception to such behavior are those pegged to fiat currencies and are often uniformly referred to as stablecoins.
There are different types of stablecoins in the market, and these are pegged to other assets like fiat currencies or commodities, although they can be backed or collateralized by crypto (on-chain) or fiat or commodities (custodied off-chain)
One of the most common types of stablecoins that are common in the crypto and DeFi markets are the ones that are pegged to the fiat currencies. Such stablecoins are developed to retain one-one value against fiat currencies like US dollars, Euros, etc. That is, a stablecoin like USDC or USDT should always have a value of approximately equal to US$1.
Such stablecoins achieve this consistent pricing through the backing of fiat currency reserves. These currency reserves are often held by independent custodians and may undergo periodic audits for transparency.
However, other stablecoins that do not have a fiat currency reserve, but still retain a one-one value against fiat currencies are also available in the market. Such stablecoins are backed by other cryptocurrencies like Ethereum. An example of such a stablecoin is Dai.
Dai is also one of the most popular stablecoins used in the DeFi ecosystem. Dai is pegged to the US dollar such that 1 Dai would always be equal to US$1. However, unlike fiat-backed stablecoins like USDC and USDT, Dai is not backed by a fiat currency; rather it is backed by Ethereum reserves.
Dai retains its US$1 value with the help of a system of smart contracts that execute automatically when its price fluctuates too much above or below the US$1 mark. To achieve the constant price Dai utilizes a unique smart contract named Collateralized Debt Position or CDP.
Dai is created when a user takes a loan from the MakerDao platform and is a key component of the MakerDao lending system, one of the largest DeFi lending platforms.
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Role of Stablecoins in the DeFi Ecosystem
As mentioned earlier, price volatility has been an influencing factor that has stalled many people from investing in crypto. By negating the volatility factor and retaining a one to one value with other assets, stablecoin has effectively helped in eradicating such anxieties. Furthermore, the fiat-backed stablecoins have acted as a bridge between fiat currencies and cryptocurrencies.
The increase in popularity of DeFi has provided stablecoins with a lot more use-cases.
The reason for the increased usage of stablecoins is primarily due to the steady yield on the investments of a user, similar to the traditional financial industry, where fiat currencies are used.
In addition to this, users are getting yields in the range of 10-12% (sometimes more) from DeFi platforms, which is in stark contrast to traditional investment methods, which are, for the most part, only generating yields in the range of 0-%(and sometimes less, or even negative yields).
Moreover, stablecoins play a significant role in liquidity pools, which is an integral part of the decentralized exchanges as well as the DeFi ecosystem.
Liquidity pools are a pool of tokens that help in providing the liquidity for a token pair. Users can participate in these liquidity pools by depositing their tokens, which are then bound by a smart contract. To encourage user participation in liquidity pools, DeFi platforms incentivizes users from the trading fees obtained from the pairs in that liquidity pool.
Liquidity pools eliminate the need for market-makers, who are essential for the centralized exchanges, and in effect, reduce the chance of market manipulations.
The lion’s share of liquidity pools is often a stablecoin, which ensures better liquidity for the token pair because users don’t want the price volatility.
Decentralized finance is evolving into one of the most used products to ever come out from the crypto industry.
With each passing day, more people are starting to use the DeFi services, which has paved the way for more DeFi platforms as well. SelfKey users can access the SelfKey Marketplace from the SelfKey Identity Wallet to find and compare the best DeFi platforms available.
The introduction of stablecoins has been a game-changer for the crypto industry. Moreover, with the rise in popularity of DeFi, stablecoins will have an even bigger role to play as the industry continues to gain ground.
Market volatility and price swings are a common phenomenon in all markets and not just crypto markets. However, users have often cited price volatility as a reason to not invest in crypto, and to an extent, stablecoins have effectively negated such user anxieties.
Stablecoins can therefore be instrumental in providing a different option to risk-aversive users.
Even though most people compare them to fiat currencies, stablecoins are essentially cryptocurrencies, and hence come with levels of security and transferability that go beyond that of fiat currencies. These qualities undoubtedly mean that stablecoins have a bright future and will play a pivotal role in the crypto industry.