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Stablecoins And Their Importance in DeFi

| November 17, 2023

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Stablecoins And Their Importance in DeFi

Cryptocurrencies have emerged as one of the sought-after investment instruments as they have the potential to offer great returns in the shortest possible time due to its inherent volatility. On the flip side, this very feature can also make it lose significant value in no time. As a result, cryptocurrencies have been more ideal for trading than an instrument of value exchange or savings instrument.

The introduction of decentralized financial instruments paved the way for more utilities of cryptocurrencies, and the similarities most of these instruments share with their counterparts in the traditional financial space called for assets that possess all the advantageous features of cryptocurrencies minus the volatility. The need-based demand created by the evolving industry led to the introduction of stablecoins, a new breed of crypto assets with a fixed value and negligible volatility.

What Are Stablecoins?

Stablecoins are cryptocurrencies that maintain stable values by being pegged to fiat currencies or their denominated assets, precious metals like gold, other cryptocurrencies, or through algorithmic means — thereby becoming an exception to the assumption of every cryptocurrency’s volatility. By attaining stability, stablecoins bring the best of fiat currencies to the blockchain — enabling users to store value without the fear of their crashing asset prices. This brings about highly anticipated use cases like transacting with decentralized blockchain assets for daily purchases, as stablecoins provide the same purchasing power as the fiat currencies they are pegged to. USD is often the preferred fiat currency to which most stable coins like USDT, USDC, BUSD, DAI and others are pegged amongst all leading fiat currencies. One can also find stablecoins that are pegged to EUR, GBP, KRW and others.

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By addressing the volatility issues prevalent in the crypto industry, stablecoins have not only pushed the use of crypto assets for day-to-day transactions. It has also provided people with a viable hedging option, especially for those in economies affected by hyperinflation, allowing them to convert their local currency to stablecoins pegged against reserve currencies to prevent the value of their earnings from being eroded.

The Impact of Stablecoins On DeFi

Stablecoins, while solving real-world problems as intended by the creation of blockchain technology, are concurrently also an important application within several, if not all, DeFi protocols. For obvious reasons, stable cryptocurrencies ensure high convenience, allowing for quick cryptocurrency trades and swaps by eliminating the need for fiat currencies.

More importantly, however, stablecoins play a paramount role within DEXs, specifically the provision of liquidity for the availability of tokens on the exchange. Stablecoins are predominantly chosen as one of the tokens staked in liquidity pool pairs. Due to cryptocurrency volatility, users are known to experience impermanent loss, which is often drastic when both currencies in the pair are volatile. Stablecoins are negating the decrement of funds due to impermanent loss — all while earning interest and trading fees as rewards.

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Of course, staking in DEX liquidity pools are complex investment strategies for those just beginning to indulge in DeFi protocols. A simpler way by which stablecoins can generate large returns without the risk of drastic price fluctuations that new investors often dread is by staking in DeFi lending protocols — which are known to offer large yields.

Stablecoins Are Driving DeFi Adoption

By bringing the stability associated with fiat currencies to blockchain and decentralized finance, stablecoins are offering familiarity and safety to those wanting to embark on their cryptocurrency journey. This is pushing users to experiment with DeFi protocols, leaving behind the worry of the losses brought about by volatility.

As DeFi is growing, stablecoins find themselves at the core of the ecosystem, finding use cases in all protocols. Their popularity is beginning to transcend DeFi itself as central banks from all over the globe look to implement their features into CBDCs. Obviously, an unintended consequence — their fear leading to the development of centralized, stable digital currencies implies that stablecoins can replace fiat currencies very soon.

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