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 out. Today, we take a look at what stablecoins are, the different types and also analyse the pros and cons of each kind.

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 be kept stable and less susceptible to fluctuations in price. Stablecoins have existed in crypto as a means to transition from the volatility attached to the market without actually withdrawing funds to fiat currency.

Total Stablecoin Supply (Source: Block, Coinmetrics) 

Over the past few years, stablecoins have gained both popularity and market dominance, making them the norm nowadays for all crypto activities. Stablecoins have grown from a mere 10 million supply in 2017 to 136 billion, as of writing this article. We’ve also been seeing protocols rethinking the way pegs are held in a decentralised fashion, which we will discuss later in the article.

Types of Stablecoins

Stablecoins are primarily divided by the type of collateral which backs them. They are classified as fiat-backed stablecoins, commodity-backed stablecoins, crypto-backed stablecoins and algorithmic stablecoins.

Fiat Backed Stablecoins

Fiat backed stablecoins are the most used and well-known stablecoins in the crypto ecosystem. The idea behind fiat-backed stablecoins is that there are units of fiat for every dollar of stablecoin created. Meaning there is a 1:1 ratio of the fiat currency in reserve for the stablecoin to ensure that the stablecoin maintains its peg. Think of this as a bank account where every USD stablecoin is released for every dollar present in the account. Although USD is the most popular backed stablecoin, there exist stablecoins that peg themselves to the euro, Japanese yen and other major currencies.

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

Other fiat-backed stablecoins include USDC, BUSD, True USD and PAX

Pros: Minimal changes in peg price | Some stablecoins are regulated

Cons: Centralised | No guarantee that it is backed by physical fiat in some cases

Commodities backed stablecoins

These are stablecoins that are backed by commodities such as gold and precious metals. Commodities backed stablecoins give investors the opportunities to trade tangible assets, along with the ability to accrue some value over time. Many of these commodities are limited when it comes to transportation as well as storage, and therefore commodities backed stablecoins offer the best of physical and digital worlds. It gives investors opportunities of investing in these commodities by making them much easier and accessible. The backing is also 1:1 with these commodities, similar to the fiat-backed stablecoins.

A well-known example of commodities 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 the other mediums of attaining commodities, one of which is the simplicity of converting them to fiat or redeeming them.

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

Pros: Efficient and makes commodities easily accessible

Cons: Centralised | Needs to be audited and is reliant on trusting the third party

Overcollateralised crypto-backed stablecoins

Crypto-backed stablecoins are stablecoins backed by cryptocurrencies through smart contracts, making them decentralised. These are backed by excessive collateral and are over collateralized since cryptocurrencies are volatile and could be subject to negative price action. In the case of DAI, for every dollar of stablecoin, a value of at least 150% in cryptocurrency like ethereum is collateralised — making the ratio 1:1.50.

                                                  Example of DAI loan with the collateralization ratio of 150% 

DAI is the most popular decentralised stablecoin that was created and is facilitated through the MakerDAO smart contracts. Dai is soft pegged to the US dollar through complex systems of smart contracts. Cryptocurrencies like Ethereum are used as collateral for DAI loans that are over-collateralised 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 100 DAI ($100) loan and ETH (collateral) goes up, 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 DAI will be destroyed. This ensures the effectiveness of over-collateralisation and having DAI always collateralised. Another crypto-backed stablecoin is sUSD, a product of Synthetix protocol.

Pros: Decentralised & no counterparty risk|Can be audited by anyone since its on-chain|Censorship resistant

Cons: Not as stable as fiat-backed stablecoins

Algorithmic Stablecoins

Algo-stablecoins have been the newest iteration in the stablecoin ecosystem, aiming to bring complete decentralisation to the space without any collateralisation. This is done by making adjustments through algorithms based on different market conditions.

                                                                Illustration of rebasing when price increases or decreases 

One type of algorithmic stablecoin is rebasing, where the supply is increased when the price increases above the peg, while supply is removed when the price decreases below the peg. This results in users experiencing changes in the number of tokens in their wallets whenever a rebase occurs.

                                        Simple illustration of the complex seigniorage model of algorithmic stablecoins 

Another type of algorithmic stablecoin model is the seigniorage shares model. Seigniorage can be defined as the profits governments make by producing currency. This relates to the difference between the production cost and face value of money. Similar to the rebasing model, the stablecoin peg is held by controlling the supply of stablecoins. However, there exist two tokens for this model — one is the stablecoin itself, and the other is a share token. When the stablecoin increases above its peg, the supply increases by minting more stablecoins, which are distributed among the share token holders. The share token holders then sell these distributed stablecoins, leading to the stablecoin retracing back to the pegged value. When the stablecoin reduces below the peg and needs supply reduction, users can exchange each stablecoin for more than one coupon/bond. Once the peg is back to normal, the users can convert each of their coupons/bonds to 1 stablecoin.

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

Pros: Decentralised | Censorship resistant

Cons: Still at an experimental stage | No proven record yet | Not as stable as fiat-backed

Final Remarks

Centralised stablecoins make up by far the largest supply of coins in crypto today. They are time tested and offer the stability that stablecoins are made for — which is to move from volatility. However, these stablecoins are also the first in line when governments regulate the crypto space. Crypto backed stablecoins like DAI have been around for quite a while and are somewhat clear in terms of any censorship. It is no doubt that the stablecoin market is going to continue to increase as we progress further in the crypto space. Who knows? We could, after all, see a new type of stablecoin that is much more effective, making many of these current stablecoins obsolete.

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