Understanding the Four Types of Stablecoins

In the last articles, we had explained what is stablecoin and their pros and cons. (Read the article : What is Stablecoin and why do they matter). 

Stablecoins, in the form of digital money aim to mimic traditional, stable currencies and are much more fixed than cryptocurrencies. This is because their values are pegged to other assets such as the US dollar or gold. Hence, Stablecoins are not subject to the extreme price volatility that other cryptocurrencies are affected by.

There are 4 main categories that Stablecoins can fall into.

The most common type of stablecoins are collateralized or backed by fiat currencies such as USD, EUR, or GBP.

Fiat-backed stablecoins are backed at a 1:1 ratio, meaning 1 stablecoin is equal to 1 unit of currency (like a dollar). So for each stablecoin that exists, there is (theoretically) real fiat currency being held in a bank account to back it up. 

When someone wants to redeem cash with their coins, the entity that manages the stablecoin will take out the amount of fiat from their reserve and it will be sent to the person’s bank account. The equivalent stablecoins are then destroyed or taken out of circulation.

Fiat – collateralized stablecoins are the simplest structure a stablecoin can have, and simplicity has big advantages. It’s easy to understand for anyone new to cryptocurrencies, which can allow for more widespread adoption of this new technology.

As long as the economy of the country a stablecoin is pegged to stays stable, it is guaranteed that the value of a properly collateralized coin will not fluctuate either. This means even if the entire cryptocurrency economy collapsed and the price of Bitcoin went down to $0, it would not affect a fiat-backed stablecoin at all.

Tether (USDT) The most popular Fiat-collateralized Stablecoin. Tether is currently the six-largest cryptocurrency by market capitalization and has the highest daily trading volumes of any cryptocurrency, including Bitcoin.

However, the cryptocurrency has been surrounded by plenty of controversy. Suspicions have arisen that Tether has issued more USDT than is actually backed by its USD reserves. The US Department of Justice has investigated Tether and crypto exchange Bitfinex, which share management teams, for potential market manipulation. In 2019, the New York Attorney General also launched an inquiry into an apparent misuse of Tether cash reserves. For this reason, many new fiat-collateralized stablecoins have risen up in an attempt to take Tether’s place. 

USD Coin (USDC) which is also backed by the US dollar and is managed by a consortium including crypto finance company Circle and exchange Coinbase. Each month, a report is published attesting to the actual USD reserves that back up the supply of USDC.

USDC’s reputation as a regularly audited and stable asset has helped it become a critical component in Decentralized Finance (DeFi), a broad range of decentralized financial services that rely on blockchains and smart contracts. Furthermore, in December 2020, payments giant Visa announced a partnership with USDC parent Circle to issue corporate credit cards using USDC as currency.

Two USD-backed stablecoins have been approved and regulated by the New York State Department of Financial Services — further proof this stablecoin invasion is beginning to take off. The Paxos Standard (PAX) and the Gemini Dollar (GUSD) became the world’s first regulated cryptocurrencies in September 2018.

There are numerous other fiat-collateralized stablecoins. In Singapore, payments processor Xfers recently launched the XSGD stablecoin, which is backed 1:1 by the Singapore dollar. In Europe, tokenization platform Stasis’ EURS token is collateralized by the euro. There’s even a stablecoin in Mongolia called Candy, which is backed by the Mongolian tugrik.

Commodity-collateralized stablecoins are backed by other kinds of interchangeable assets, such as precious metals. The most common commodity to be collateralized is gold. However, there are also stablecoins backed by oil, real estate, and various precious metals.

Holders of commodity-backed stablecoins essentially hold a tangible asset that has real value which is something most cryptocurrencies do not have. These commodities even have the potential to appreciate in value over time, which gives increased incentive for people to hold and use these coins.

In the case of commodity-collateralized stablecoins, anyone in the world could conceivably invest in precious metals like gold, or even real estate in Switzerland. Some of these kinds of assets have generally only been reserved for the wealthy, but stablecoins open up new possibilities of investments to average individuals globally.

Digix Gold (DGX), for example, is an ERC-20 token built on the Ethereum network backed by physical gold, where 1 DGX represents 1 gram of gold. This gold is stored in a vault in Singapore and gets audited every 3 months to ensure transparency. The creators of DGX claim they have “democratized access to gold.” DGX holders may even redeem the physical bars of gold — they just have to go to the vault in Singapore to do so.

Tiberius Coin (TCX) is backed by not one commodity, but by a combination of 7 precious metals commonly used in technology hardware. The idea is that as these metals are increasingly used to make technology such as solar panels and electric cars, TCX coins will go up in value.

SwissRealCoin (SRC) is backed by a portfolio of Swiss real estate. Token holders can even democratically vote on the investment choices.

These are stablecoins backed by other cryptocurrencies. This allows crypto-backed stablecoins to be much more decentralized than their fiat-backed counterparts, since everything is conducted on the blockchain. To reduce price volatility risks, these stablecoins are often over-collateralized so they can absorb price fluctuations in the collateral. 

For example, to get $500 worth of stablecoins, you would need to deposit $1,000 worth of Ether (ETH). In this scenario, the stablecoins are now 200% collateralized, and can withstand a price drop, let’s say, of 25%. This would still mean the $500 worth of stablecoins are collateralized by $750 worth of ETH. And if the price of the underlying cryptocurrency drops low enough, the stablecoins will automatically be liquidated.

Crypto-collateralized stablecoins are decentralized, allowing processes to be even more trustless, secure, and completely transparent. There is no single entity controlling your funds. Additionally, they are often backed by multiple cryptocurrencies in order to distribute risk. They also enjoy far more liquidity, meaning they can be quickly and cheaply converted into their underlying asset.

Crypto-backed stablecoins are the most complex form of stablecoin, which means they have not gained as much traction yet as they continue to work out their kinks. The most popular and promising example of a crypto-collateralized stablecoin is Dai. Created by MakerDAO, Dai is a stablecoin that has a face value pegged to USD, but is actually backed by ETH that is locked up in smart contracts.

Like USDC, Dai has become crucial to many DeFi applications. By nature of being decentralized, anyone can generate, buy, or sell Dai. Developers in particular can easily build decentralized apps, or dapps, on top of the Ethereum blockchain using Dai as a stable medium of exchange.

Non-collateralized stablecoins are not backed by anything, which might seem contradictory given what stablecoins are. The US dollar used to be backed by gold, but that ended decades ago, and dollars are still perfectly stable because people believe in their value. The same idea can apply to non-collateralized stablecoins.

These types of coins use an algorithmically governed approach to control the stablecoin supply. This is a model known as seigniorage shares. As demand increases, new stablecoins are created to reduce the price back to the normal level. If the coin is trading too low, then coins on the market are brought up to reduce the circulating supply. In theory, prices of these stablecoins would remain stable as they are driven by market supply and demand. This is the most decentralized and independent form of stablecoin, as it isn’t collateralized to any other asset.

However, non-collateralized stablecoins require continual growth to be successful. In the event of a crash, there is no collateral to liquidate the coin back into, and everyone’s money would be lost.

An early and popular example of a non-collateralized stablecoin was Basis, which aimed to algorithmically adjust supply in order to keep its prices stable. Even after securing over $100M in its initial coin offering (ICO), the initiative was forced to shut down in 2018 due to regulatory constraints.

Very few cryptocurrency exchanges out there currently support fiat currencies due to strict regulations. But the use of stablecoins allows exchanges to get around this problem and offer crypto-fiat trading pairs, by simply using a USD-backed stablecoin instead of actual dollars.

This will greatly help in the adoption of cryptocurrency trading as a whole, as it makes the process of joining and obtaining cryptocurrency easier for newcomers, as they can continue to think in terms of dollars or euros, instead of constantly fluctuating bitcoin values.

It will also reduce Bitcoin’s massive influence over the market, as currently most exchanges require traders to hold BTC before they can exchange it for other types of crypto.