-Types of Stablecoins and How They Work-
In theory, stablecoins are supposed to provide traders and investors a haven from the intense fluctuations and high volatility of cryptocurrencies. Still, they’ve been shrouded in controversy since they haven’t been around long enough to gain everyone’s trust. Financial analysts compare them to poker chips. Also, their system isn’t always simple, and some failed to live up to their promise of stability.
But as long as there’s demand, stablecoins are here to stay, and currently, they’re the safest investment in crypto.
So, here’s a round-up of the types of stablecoins and how they work so you can make an informed decision on what to invest.
The Four Main Types of Stablecoins
While disputable, stablecoins’ reference to poker chips isn’t exactly an overstatement. You can buy stablecoins with real money, like US dollars. Those stablecoins act as tokens you can further use to trade cryptocurrencies. When you want to cash in, you get the equivalent amount of dollars for how many stablecoins you want to redeem.
Here’s exactly how each type of stablecoin works:
As their name suggests, these stablecoins are much like fiat money, which is a government-issued currency. Fiat-collateralized stablecoins are held and reserved by a central issuer or financial institution. They’re backed by currencies like Euro, GBP, or most common of all, the US Dollar.
Fiat-collateralized stablecoins are the most common stablecoin types, allowing you to convert for the same amount of real money. This means that one stablecoin is equal to one unit of currency, like a dollar or one Euro.
Tether (USDT), TrueUSD (TUSD), Pax Dollar (USDP), and USD Coin (USDC), Euro Coin (EUROC) are popular stablecoins backed by U.S. dollar reserves and redeemable at 1:1 ratio to the currency.
Crypto-collateralized stablecoins are backed by other cryptocurrencies. Unlike fiat-backed stablecoins, these don’t rely on a central issuer and use smart contracts instead. When you buy these stablecoins, you lock your cryptocurrency into a smart contract and exchange them for tokens of their equivalent worth.
But since cryptocurrencies are volatile, these stablecoins are also over-collateralized to protect against prices that frequently go up and down. So, a higher number of cryptocurrency tokens exceeds the value of the issued stablecoins.
For example, for $1,5 million issued stablecoins, cryptocurrency tokens worth $3 million are held as reserves.
One of the most popular crypto-backed stablecoins is Dai (DAI) stablecoin from Maker Dao. It’s pegged to the U.S. dollar but backed by Ethereum (ETH) and other cryptocurrencies. DAI aims to keep a stable 1: 1 value against the US dollar. You can check its live updated value.
These stablecoins are backed by different types of interchangeable assets, like precious metals, most commonly gold. Yet, some commodity-backed stablecoins use the backing of assets such as real estate and oil.
These stablecoins’ unique element relies on the fact that investors can own a certifiable asset with a real value that’s likely to go higher over time. They can invest in gold much easier without having to source or store it.
For instance, Tether gold (XAUT) is a commodity-backed stablecoin whose currency is backed by a reserve of gold kept in a Swiss vault.
Algorithmic (Non-Collateralized) Stablecoins
Non-collateralized or algorithmic stablecoins aren’t backed by any reserves assets. In this regard, they’re similar to central banks, except banks set monetary policies based on well-known and understood economic frameworks.
Instead, non-collateralized stablecoins use an algorithm, essentially a computer program that runs a predetermined formula to keep the price stable and control its supply. They raise or reduce token production based on demand by developing a smart contract on a decentralized platform.
In fact, algorithmic stablecoins cover the highest level of decentralization and independence. At the same time, everyone can lose their money in case of a crash, and we have the Terra (UST) as the perfect example.
Other popular algorithmic stablecoins include:
- Magic Internet Money (MIM) -is provided by several crypto assets exchanges like Uniswap, PancakeSwap, and Curve Finance.
- Frax (FRAX) – the first algorithmic stablecoin system, currently implemented in Ethereum; the protocol is open-source and fully on-chain by nature, and its mechanisms allow minting, redeeming, and staking.
What are The Pros of Stablecoins
Besides giving you peace of mind as stablecoins rarely lose their value over time, here are other advantages they offer:
- a faster and easier way to invest in the crypto market
- swift payments abroad with lower fees than fiat currencies
- remove the need for any intermediaries as you can keep them in non-custodial wallets like Metamask
- offer the opportunity to earn returns from interest rates by staking them on crypto staking platforms
- provide high security and transparency since they’re built on blockchain data; investors get a clear view and information on liquidity flows
They’re Still Risky and Volatile Despite Their Stability
Stablecoins create more liquidity in the crypto market and minimize price volatility as their value is determined by supply and demand. But they’re not a one-size-fits-all solution for all the downsides in the crypto world.
Their main weaknesses are:
- they require external audits- stablecoins owners remain anonymous, so they’re regularly audited to ensure transparency
- they raise trust issues – most stablecoins are centralized by financial institutions; owners have to trust that this entity is genuinely backing up its stablecoins with a real traditional asset. For instance, Tether was accused of false claims regarding USDT being backed by 1:1 dollar reserves; after the company settled the lawsuit, it released a transparency report in 2021.
- less return on investments – stablecoins are meant to be steady, they offer low returns to traders and investors
Conclusion – Stablecoins Remain the Safer Digital Money
Many crypto experts have argued that stablecoins are far from being genuinely stable. They may not be risk-free, but unlike most cryptocurrencies, stablecoins offer investors a much higher level of reliability in terms of value.
While stablecoins can, and have crashed before, these events are less likely to happen compared to traditional cryptos.