Stablecoin - an invaluable building-block of defi

Introduction

One big challenge of cryptocurrencies is that their values are always fluctuating. The has been a major hurdle that keeps on hurting its speed of adoption. Enterprises and other institutional investors are really afraid of putting huge resources into something that is vastly unstable. This is also a problem that would have stopped decentralized finance were it not for Stablecoins.

A special type of cryptocurrency whose values are often reliable, stablecoins play a very prominent role in all the products of any defi protocol. With much steadier market values even over a long period of time, Stablecoins enable enable the smooth functionalities of defi instruments, helping participants to retain the value of their investments and profits.

In this article, we will look out the challenges of cryptocurrencies with regards to price reliability and see how defi has been the biggest beneficiary of stablecoins.

Stability is crucial in defi loans

In decentralized finance, different products are available for users to explore. Almost all of them need stability of value to operate adequately. Consider for example, how lending and borrowing digital assets work in defi.

For a user to access the loan, they have to provide some form of digital collateral. The collateral is often a little higher in value than the loan. To begin with, defi loan collaterals needs to have a specific, reliable value. This is important because it is held as a security for the loan. If the borrower defaults, the collateral could be sold in order to recover the loan.

Throughout the period of the loan, the collateral is locked in a smart contract. If a fluctuating value asset is accepted as collateral, what happens within all the time the loan was held? The value of the collateral might fall way down below the loan worth. As such, this could lead to liquidation and losses on the part of the defi platform. So it is important for defi loans to only accept collateral in form of assets whose value could remain stable over a long period of time.

Another example is in when defi loans are repaid. The borrower needs to know the value of the loan they are taking so that when repaying, they also know how much to return and what interest to add. Stable coins make it easy to calculate loan amounts and interests. Using other cryptocurrencies might cause a huge loss on the defi platform or the borrower overpaying because of price flunctions.

Unfortunately, other types of cryptocurrencies always have their prices going up or down except stablecoins. The reliability of stablecoins made them ideal for lending and borrowing money in a defi protocol as well as the collateral that must be provided to secure the loan.

Saving assets long-term and volatility

Storing digital assets long-term on defi platforms often happen from time to time. Consider what happens during periods of high volatility. Crypto assets might have their values washed out in a matter of no time. Investors and traders find a way to protect the value of digital assets by converting them to an asset that can maintain stability.

So when the prices of other assets are rapidly going up and down, crypto traders often switch their assets to stablecoins so that they can ride out that period of price uncertainty. When the market normalizes or when the volatility is no longer so vigorous, traders can return back their assets to the preferred crypto for investment. So stablecoins in defi serve as a hedge to protect the value of assets and investment in periods of high volatility.

Sometimes too, participants in the defi space might not be fine with current market conditions. For example, interest rates might be high or their preferred crypto for investment lacks liquidity. They might decide to wait until the desirable products or cryptos become available. During this time, it would be dangerous to leave their assets on cryptos that are highly volatile. It is often a best practice in situations like that to convert those portfolios that might lie idle for time into a stablecoin to be sure of their value.

Savings is also a defi product that is popular in the space. With savings, users are expected to lock away their assets for a period of time and earn interests at the end. More often than not, such freezing of assets to earn interest is done with stablecoins. The reason again is obvious. The frozen portfolio retains their value no matter how long the smart contract excutes. When it is unlocked and returned to the owner, the value remains the same as it was at the beginning.

Governance in defi

Most defi protocols enable decentralized governance using any of the popular DAO models. To participate in such governance, users are expected to hold some tokens. Often, the power of their votes are determined by how much stake they hold. Usually, stablecoins are preferred in most defi community governnance.

The reason is that with a fixed value, the community can maintain a fixed power for all stakeholders. Even in times of deep market volatility, governance tokens based on stablecoins retain their value. Hence, holders do not have votes that are of lesser worth because of the state of crypto markets or volatility.

While there might also be native token holders that are part of the community governnance mechanism, stablecoin holds represent a diverse set of users and interest which often reflects the concept of decentralization. Their presence ensures that the community governance model accomodates everyone, both those that hold native tokens and others that hold stablecoins. In some systems, stablecoin holders are allowed to participate in some special governance activities within the ecosystem which is not open to native token holders.

Conclusion

Stablecoins play a very important role in the crypto ecosystem as a whole. But in no other space are they more important and prominently featured than in defi. Every defi product and feature is built around stable coins. Smart contracts that automate most of the products require stablecoins to perform. Lending and borrowing, yield farms, liquidity providers and other features of defi are all built around stablecoins. To this day, stablecoins still play a foundational role in the smooth-running of any defi protocol.