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Stablecoins – What are the types and does it matter which one you use?


We interact with stablecoins all the time in the crypto space, whether we are buying cryptocurrencies, selling them, or even cashing in. Today we take a look at what are Stable Coins, the different types, and also analyze the pros and cons of each type.

What are Stablecoins?

Stablecoins are a type of cryptocurrency that has a peg attached to an external asset like the US dollar. These currencies are intended to remain stable and less sensitive to price fluctuations. Stablecoins have existed in crypto as a way to move from market-attached volatility without actually withdrawing funds into fiat money.

Total stable coin supply (Source: Block, Coinmetrics)

Over the past few years, stablecoins have gained both popularity and market dominance, making them the standard these days for all crypto activity. Stablecoins have gone from a mere supply of 10 million in 2017 to 136 billion, at the time of writing. We’ve also seen protocols rethink how pegs are maintained in a decentralized fashion, which we’ll discuss later in the article.

Types of stable coins

Stablecoins are mainly divided by the type of collateral backing them. They are categorized into trust fund backed stablecoins, commodity backed stablecoins, cryptocurrency backed stablecoins, and algorithmic stablecoins.

Fiat backed stablecoins

Fiat-backed stablecoins are the most widely used and well-known stablecoins in the crypto ecosystem. The idea behind fiat-backed stablecoins is that there are units of fiat currency for every dollar of stablecoins created. This means that there is a 1: 1 ratio of fiat money in reserve for the stablecoin to ensure that the stablecoin retains its peg. Think of it as a bank account where every USD stablecoin is released for every dollar in the account. Although the USD is the most popular backed stablecoin, there are stablecoins that peg against the Euro, Japanese Yen, and other major currencies.

The very first stablecoin was Tether, which was established in 2014 and continues to be the highest capitalization in terms of stablecoins, ranking 4th among all cryptocurrencies. However, Tether has also been the focal point of regulatory scrutiny due to its undisclosed bitfinex affiliation and non-transparent 1: 1 reserve fiat support.

Other trust fund backed stablecoins include USDC, BUSD, True USD and PAX

Advantages: Minimal changes in the price of the ankle | Some stablecoins are regulated

The inconvenients: Centralized | No guarantee that it is backed by a physical fiat in some cases

Commodity backed stablecoins

They are stable coins backed by commodities such as gold and precious metals. Commodity-backed stablecoins provide investors with the ability to trade tangible assets, as well as the opportunity to accumulate value over time. Many of these products are limited in terms of transportation and storage, and as a result, commodity-backed stablecoins offer the best of both physical and digital worlds. It gives investors the opportunity to invest in these commodities by making them much easier and accessible. Support is also 1: 1 with these products, similar to fiduciary-backed stablecoins.

A well-known example of commodity-backed stablecoins would be PAX Gold, which is a digital asset. Each PAX token is backed by one troy ounce (t oz) of a 400 oz gold bar. These have many advantages over other means of obtaining goods, one of which is the simplicity of converting them to fiat or redeeming them.

Comparison of PAX GOLD with other conventional methods (Source: PAXOS)

Advantages: Efficient and makes products easily accessible

The inconvenients: Centralized | Must be audited and depends on the trust of the third party

Oversized Encrypted Stablecoins

Cryptocurrency-backed stablecoins are stablecoins backed by cryptocurrencies through smart contracts, which makes them decentralized. These are backed by excessive collateral and are oversized as cryptocurrencies are volatile and could be subject to negative price action. In the case of DAI, for every dollar of stablecoin, at least 150% value in cryptocurrency like Ethereum is guaranteed, making the ratio 1: 1.50.

Example of a DAI loan with a collateralization rate of 150%

DAI is the most popular decentralized stablecoin that has been created and is facilitated by MakerDAO smart contracts. Dai is weakly pegged to the US dollar thanks to complex smart contract systems. Cryptocurrencies like Ethereum are used as collateral for DAI loans which are oversized at the ratio mentioned above. This means that for $ 200 of ETH, 150 DAI ($ 150) would be the liquidation price. Suppose the user takes a loan of 100 DAI ($ 100) and the ETH (collateral) increases, an additional DAI can be borrowed. If the $ 200 ETH drops to $ 149, the smart contract immediately liquidates the loan. Once the loan is repaid, the collateral can be withdrawn and the DAI will be destroyed. This ensures the efficiency of oversizing and the fact that DAI is always guaranteed. Another encrypted stablecoin is sUSD, a product of the Synthetix protocol.

Advantages: Decentralized and counterparty risk free | Can be audited by anyone as their channel | Censorship resistant

The inconvenients: Not as stable as fiat backed stablecoins

Algorithmic stablecoins

Algo-stablecoins were the latest iteration of the stablecoin ecosystem, aiming to bring complete decentralization to the space without any guarantees. This is done by making adjustments through algorithms based on different market conditions.

Illustration of rebasing when the price goes up or down

One type of algorithmic stablecoin is relining, where the supply increases when the price increases above the peg, while the supply is removed when the price decreases below the peg. As a result, users experience changes in the number of tokens in their wallets every time a rebase occurs.

Simple illustration of complex seigniorage model of algorithmic stablecoins

Another type of algorithmic model of stablecoin is the seigneury shares model. Seigniorage can be defined as the profits that governments make by producing money. This is the difference between the cost of production and the face value of money. Similar to the rebase model, the stablecoin peg is maintained by controlling the supply of stablecoins. However, there are two tokens for this model – one is the stablecoin itself and the other is a share token. As the stablecoin rises above its peg, the supply increases by hitting more stablecoins, which are split among the holders of the action tokens. The stock token holders then sell these distributed stablecoins, which brings the stablecoin back to the indexed value. When the stablecoin goes below the peg and requires a reduction in supply, users can exchange each stablecoin for more than one coupon / bond. Once the peg has returned to normal, users can convert each of their coupons / bonds into 1 stablecoin.

Another interesting type of algorithmic stablecoin is algorithmic fractional stablecoins. These are partially collateralised and use these algorithms to their advantage. Frax is the first type of fractional, algorithmic stablecoin and maintains its foothold by algorithmically using USDC and its native FXS share token.

Advantages: Decentralized | Censorship resistant

The inconvenients: Still at the experimental stage | No history yet | Not as stable as the fiat-back

Final remarks

Centralized stablecoins are by far the largest offering of crypto coins today. They are time tested and provide the stability that stablecoins are designed to move away from volatility. However, these stablecoins are also the first to come online when governments regulate the crypto space. Crypto-backed stablecoins like DAI have been around for quite some time and are pretty clear in terms of censorship. There is no doubt that the stablecoins market will continue to rise as we move forward in the crypto space. Who knows? After all, we might see a new type of stablecoin that is much more efficient, rendering many of these current stablecoins obsolete.

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