In the cryptocurrency world, the growth in stablecoins is going at a fast pace. Stablecoins are simply digital currencies designed to track a fixed peg (usually the dollar), minimizing volatility and providing a convenient way to transact.

Consider the activities in the cryptocurrency sector for 2021. We will see the creation of many new blockchain apps, trading platforms, and non-fungible tokens (NFT) markets. With such fast paced activity taking place in this space, it was inevitable that the need for stablecoins would increase.

For decentralized finance (DeFi ecosystem), stablecoins are slowly becoming the backbone and are expected to take over other sectors such as remittances and gaming. Stablecoins are designed to avoid violent price swings and let users transact in units they are more familiar with from traditional finance. 

Stablecoins act as an intermediary between traditional and crypto economies. As the role of stablecoins is becoming increasingly important in the decentralized finance industry its best to fully understand the DeFi industry and its increasing reliance on stablecoins.

Understanding DeFi: 

DeFi, or decentralized finance, emulates current financial products and services using decentralized protocols and smart contracts.

DeFi is open-source software that works independently on a blockchain network for anyone with an internet connection to access essential financial services like lending, investing, and borrowing without the need for a middleman.

To earn interest, cryptocurrency holders can place funds into a decentralized lending protocol instead of paying for savings accounts with a bank. Typically, the interest rates on decentralized lending protocols are much higher than those on banks.

Blockchain technology and smart contracts empower everyone to earn interest, take out loans, or make investments in new financial products, all utilizing DeFi apps.

How do smart contracts work?

Smart contracts are computer programs that are coded to be irreversible, self-executing agreements written in computer code and executed on an open-source, permissionless, decentralized blockchain. They allow a decentralized finance protocol to function on code and logic without an intermediary or third party, making smart contracts the heart of the DeFi movement. In addition to Ethereum, Algorand, Solana, Binance Smart Chain, Cosmos, many others have also gained prominence due to offering solutions based on smart contracts.

The History of DeFi: 

In 2009, Bitcoin initiated decentralized finance as it enabled its users to store money online and transfer it in a completely decentralized way for the first time. The current definition of DeFi, however, means a decentralized, smart contract based application designed to replicate  traditional financial services.

Decentralized exchanges (DEXs) were the first use cases of decentralized finance on the Ethereum network. Tokens of the ERC20 standard, such as ETH, can be traded on DEXs.

In late 2018, the DeFi movement took the next step by developing yield-generation savings protocols, with Compound Protocol leading the charge. The following year saw the development of numerous new lending and borrowing applications and many new forms of decentralized financial applications.

DeFi Today

According to CoinMarketCap, the decentralized finance market is estimated to be worth over $78.82 billion. Over 458,000 daily unique wallets across all chains were active in Q1 2021, which was a 639% whopping increase YoY, according to DappRadar.

DeFi is most commonly used for the following three reasons:

  1. Taking out loans and borrowing through cryptocurrencies
  2. Trading of digital assets
  3. Trading derivatives 

Among the additional features of DeFi are:

  • Investing in digital assets baskets
  • Margin trading of digital assets
  • Hedge exposure to digital assets
  • Take out a policy of insurance

Future of DeFi

At present, the DeFi market offers opportunities to experienced crypto investors with an understanding of smart contracts and managing many digital assets. DeFi is not yet accessible to the average retail investor due to the high knowledge barriers. There will be a change in that in the future.

Globally, everyone will access the DeFi market tomorrow, which offers all the services provided by traditional financial institutions. With a decentralized lending protocol, a stall keeper in Zambia can borrow funds at competitive rates using only her smartphone.

Alternatively, a merchant in Turkey who is worried about inflation may invest in yield-generating protocols that earn a higher APR than the inflation rate in Turkey.

The challenges of DeFi

The DeFi industry has enormous potential, but it also faces several difficulties. In the existing systems most DeFi protocols use Ethereum. The number of Dapps saw a significant increase in 2020 due to the rise in DeFi, with the Ethereum blockchain unable to manage the number of transactions.

This has resulted in an increase in the cost of transactions – known as “gas” fees – as well as longer processing times on the Ethereum network, reaching their highest level since 2017.

Due to the high gas fees associated with moving between DFI protocols, absolute returns are reduced for DeFi users. DeFi is likely to become a multi-chain system in the future, even though the Ethereum developer community has all but resolved these issues through future network upgrades. Blockchain networks other than Ethereum will support DeFi protocols.

Global stablecoins will therefore be able to function as multi-chain digital currencies as well. With plans to expand to many more blockchains, several stablecoins today have started integrating this feature within them.

Role of Stablecoins

When risk-off moments in the market arose, and users sought safety, stablecoins became a kind of digital cash that they could use as an alternative to fiat. Users also embraced leveraging strategies. In March, the near-collapse of a cryptocurrencies lending platform demonstrated the potential of stablecoins in the ecosystem. The fact that they are stable makes them an attractive diversification tool and a solid collateral asset.

Due to the high correlation between altcoins, stablecoins offer a way to reduce collateral pool risk. Stablecoins, however, gained another significant advantage with the surge in DeFi yield farming.

The decentralized lending apps started rewarded users with tokens for lending and borrowing assets based on yields (at first). It proved that stablecoins were highly popular with farmers, and the proposition was even profitable with high-interest rates. A significant factor for this was stable assets underlying the loans and borrowings. In response to the rise of volatile tokens, the distribution strategy had to change.

As a result of this yield farming strategy, stablecoin activity accelerated. Dapps began to link in farming transactions as users took advantage of their composability to maximize farming yields. 

Stablecoins fuel DeFi’s growth

Messari Research notes that “stabilized monetary base reached over $65 billion in Q1, and continues to grow at an accelerating pace. Transaction volume was over $1 trillion in Q1, more than the previous four quarters just combined. Investors can earn returns on their crypto assets while reducing the adverse effects of market volatility by using global stablecoins.

When an investor deposits ETH into a DeFi protocol to earn interest, it is conceivable that the price of ETH may decrease, thus canceling the income gained. When someone keeps their money in a stablecoin, their return remains stable regardless of the crypto market volatility. 

When it comes to higher-yielding funds, investors who want to earn greater returns than those offered by conventional fixed-interest investments may explore digitizing their funds to get better rates on DeFi marketplaces. Converting US money into stablecoins is probably the simplest and safest way to deposit them into DeFi systems.

The availability of digital dollar stablecoins in the DeFi lending market has been increasing. With lending rates ranging from 0.15% to 11.82% APY, stablecoins are becoming one of the most popular lending assets on DeFi platforms.

Final Thoughts

It is believed that the influx of Generation Z investors into conventional financial markets and cryptocurrency trading platforms over the past two years have led to the rapid rise in stablecoin popularity. New traders and investors in the cryptocurrency trading markets quickly converted their stimulus cheques into stablecoins as soon as they were made available.

When it comes to the cryptocurrency industry as a whole, the year 2021 has been a roller coaster ride, with unprecedented adoption of cryptocurrencies occurring. The enormous rise in the cryptocurrency industry has been felt at all points of the market, and it is fair to say that stablecoins have been the driving force behind this expansion.

For these reasons, the crypto sector has identified stablecoins as one of its most important asset classes. With a market capitalization surpassing Bitcoin forks like Litecoin and Dogecoin, remittance-focused projects like XRP and even Ethereum are experiencing mainstream acceptance. At some point, the latter could become a problem since it would undermine the incentive principles that ensure the security of the network.

A unique phenomenon is that stablecoins have been vital to fueling the exponential growth of the DeFi ecosystem. Additionally, the introduction of new and exciting ideas in the cryptocurrency sector can expand the field’s evolution drastically. As stablecoins play a significant role in the DeFi, and it will take some time for them to solidify their position since the industry is still in its infancy.