What Are the Different Types of Stablecoins?
Learn what stablecoins are and their different types.
The crypto industry is no longer a mystery to most people, especially those with access to the internet. However, even after understanding cryptocurrencies, most people still fear investing in them. Why is that? This is mostly due to the volatile nature of crypto assets such as Bitcoin.
The good news is that stablecoins have created a safer and easier way for everyone to interact with the crypto market and even invest without worrying about losing assets. So, what are these digital assets, and how do they work? This article will answer all of these questions and give you all the information you need to understand stablecoins. Let’s dive right in.
What Are Stablecoins and How Do They Work?
As aforementioned, most cryptocurrencies, such as Bitcoin, are volatile. This means you are never certain about your asset’s value due to constant price fluctuations. Therefore, if you buy and hold one bitcoin for a few years, its value might either grow or depreciate within this period. If it increases, you’ll be in profit, but if the opposite happens, you’ll be counting losses.
Stablecoins were made to solve problems with volatility by giving stability to assets that couldn't do that on their own. Stablecoins are cryptocurrencies, too; the only difference is that they function differently than volatile cryptocurrencies. These digital assets are made to keep their value stable no matter what happens on the crypto markets.
A stablecoin’s stability is usually determined by its backing asset. To keep things stable, the issuer of a stablecoin must keep reserves equal to the number of stablecoins in circulation. (We’ll discuss more on this later.)
So, a stablecoin’s price is less likely to fluctuate compared to a volatile cryptocurrency’s. Therefore, let’s say if, for instance, you could buy a house with 100,000 stablecoins today, you would still be able to do so in a few years because it would probably have the same purchasing power as right now. On the other hand, doing this with volatile crypto would be very hard to predict because its price could have gone down, making it less valuable. Of course, this is provided the house’s price remains constant.
You can buy stablecoins and store them in a hot or cold wallet. You could also sell or trade them on any legit crypto exchange in the market.
If you want to learn more about stablecoins and how they operate, read this article.
Types of Stablecoins
Stablecoins vary as they are built using different mechanisms. Stablecoins, as previously stated, are specifically designed to maintain consistent prices over time. However, that doesn’t mean they use similar methods to achieve this goal. Since each stablecoin is made by a different stablecoin issuer, the way each one stays stable is different.
These crypto assets are usually categorized depending on the method used to stabilize them. There are four main types of stablecoins you should know. They include:
Can you already tell what method is used to back these stablecoins? Don’t worry if you are still confused. The following section will shed more light on how each stablecoin works.
Fiat-backed stablecoins are the most popular stablecoins. They are the stablecoins that have gained the most traction, as the biggest stablecoins fall under this category. Additionally, fiat-collateralized stablecoins are the easiest to understand how they work, which has probably played a huge role in their popularity. So, what sets these stablecoins apart from the rest?
As the name suggests, fiat-backed stablecoins are backed at a 1:1 ratio to major fiat currencies such as the US dollar, Euro, and GBP. Most stablecoins in this category, though, are usually backed by the US dollar.
The 1:1 ratio means that for every stablecoin in circulation, a dollar is stored in the bank. To keep prices stable, the stablecoin issuer must make sure that the number of stablecoins in circulation is the same as the number of backing reserves. So, if there are 10,000,000 stablecoins in circulation, there should be $10,000,000 or more reserved somewhere.
Because stablecoin is 100% backed, this helps to maintain price stability. Proper backing also makes sure that you can easily convert your stablecoins into fiat currency whenever you need to because the stablecoin issuer has the money in the bank. When you spend your stablecoins, the company that made them takes the amount you spent out of circulation. This helps keep the 1:1 ratio.
So, these stablecoins are likely to remain stable, provided cash equivalents are available. Another factor that determines their stability is economic stability. For instance, if a stablecoin is backed by the U.S. dollar, its price won’t fluctuate, provided the US economy remains stable.
Tether (USDT) and USD Coin (USDC) are the two most popular fiat-backed stablecoins because they have stayed stable the longest and have a lot of users. Tether even releases monthly attestation reports to ensure transparency about its cash reserves.
Crypto-backed stablecoins are another popular type of stablecoins that you probably know about. These stablecoins are backed by other cryptocurrencies. This might sound like it defeats the purpose of having stablecoins in the first place, but they actually have a strategy for staying stable.
Crypto-backed stablecoins are usually over-collateralized. This means that for every stablecoin, there is double collateral stored in crypto. So, for you to buy, say, $250 worth of stablecoin, you would have to pay $500. This is called over-collateralization because you pay double the stablecoin price. This also means that the stablecoin issuer must overcollateralize the stablecoin. So, if there are 15,000,000 stablecoins in circulation, the stablecoin issuer must have at least double that amount in reserve or more. This makes the coin 200% collateralized.
Over-collateralization is crucial for crypto-collateralized stablecoins because of the volatility of the underlying cryptos. So, it uses the excess amount to help counter any volatility that might occur. Therefore, it would take lots of volatility to move the collateralization from 200% to under 100%. However, it’s important to note that if there is huge volatility and the collateralization drops beyond 100%, the stablecoin’s price will be affected. This is because the volatility would have knocked the coin’s stability off balance.
Many people love crypto-backed stablecoins due to their decentralized nature. Unlike fiat-backed stablecoins that involve banks, these stablecoins don’t involve any traditional financial institutions, as everything is done on the blockchain.
Some cryptocurrencies might even be backed by several cryptoassets. This helps reduce the risk of losing stability if one cryptocurrency gets overly volatile. It also gives the stablecoin more liquidity.
Dai is one of the best crypto-collateralized stablecoins in the crypto market today. Its value is pegged to the US dollar.
The third type of stablecoin is not backed by anything and relies only on algorithms. These stablecoins are commonly referred to as "algorithmic stablecoins." Quite contradictory, right? Let’s see how this works.
Algorithmic stablecoins use algorithms that rely on market demand to determine the coin’s price. So, if there is a lot of demand for the coin on the market, the algorithm makes more stablecoins to make sure there are enough on the market. Doing so also helps prevent the market price from hiking.
However, if there is little demand, the market supply of stablecoins is reduced so that supply does not outnumber demand. Doing so helps balance the prices and keep them stable. So, algorithmic stablecoins can stay stable, provided market demand and supply always remain balanced.
Algorithmic stablecoins are also very decentralized since they don’t have a backing asset tying them to a centralized institution. This can be helpful, but since the coin has no collateral, it could also be very risky. Therefore, there is no backup in case a big crash occurs.
For these stablecoins to last on the market for a long time, they need as many uses as possible. This would help them get more adoption, thus boosting their market value. Having more value would also ensure that demand stays high, since a drop in value could make crypto investors panic and sell all of their assets.
AMPL is one of the most popular algorithmic stablecoins. This coin was made by Ampleforth and came out in 2018. Its supply is changed every day to make sure it matches demand. Another example is Terra’s UST coin.
Commodity-backed stablecoins are another growing stablecoin type in the crypto space. This type is backed by real-world assets such as oil, silver, real estate, and precious metals like gold. However, gold is the most commonly used backing asset for commodity-backed stablecoins.
If you have always wanted to invest in gold but felt intimidated by the huge capital required, then these coins might be the best option. Commodity-backed stablecoins allow you to invest in gold without worrying about how to get it or where to store it. A great example that you could consider is Tether Gold (XAUT), which is backed by gold stored in a Swiss vault. So, if you own one XAUT, that’s equal to an ounce of gold.
Another excellent example is Digix Gold (DGX). For this one, the backing gold is stored in Singapore, and the creators say it’s audited quarterly. Because of this, you can be sure that the value of your assets is backed up by real gold.
Additionally, Digix Gold (DGX) allows you to redeem your digital assets for actual gold. The only problem is that you have to go to the Singapore vault to do so. One DGX coin is equal to one gram of gold.
If you are interested in real estate, you could invest in a stablecoin backed by the same, such as SwissRealCoin (SRC). This coin is backed by Swiss real estate, and you can even vote on the real estate’s investments.
What Are the Most Popular Stablecoins Right Now?
There are around 200 stablecoins in the crypto market today. However, some are more popular and better than others. To reduce the chance of losing your money, you should stick to the most popular ones that have been stable over time. These are digital assets that are usually available on almost every crypto exchange.
Below are some of the best stablecoins to consider:
Tether (USDT), which has a market cap of $67.5 billion, is the most popular and largest stable coin right now. This coin was made by Tether Limited and came out in 2014. It is a type of stablecoin that is backed by fiat currency. When Tether first made USDT, its goal was to help crypto investors avoid market volatility and make it easier to exchange cryptocurrencies.
USD Coin (USDC)
USDC is also a fiat-backed stablecoin launched in 2018 by Circle. Although Tether is the biggest stablecoin right now, USDC is bringing plenty of competition, especially regarding transparency. The company that makes this coin sends out monthly reports on its reserves to show users that it's still stable and has all the needed reserves. This helps maintain people’s trust and even boost the coin’s adoption.
USDC Vs. USDT
Tether and USD Coin are among the biggest stablecoins on the market today. USDT currently has a market cap of $67.5 billion, while USDC follows with $51.6 billion. These two coins both peg their value to the US dollar, meaning they aim to maintain the same value as the dollar. Therefore, one USDC or USDT should always be equal to $1.
They also belong to renowned and trusted issuers with a great track record. However, Tether, USDT’s issuer, recently faced some transparency issues. There are some similarities and some differences between these assets, especially when it comes to how they can be staked, lent, and traded. Therefore, we recommend checking out our detailed comparison to learn more about them and decide which one to invest in.
Stablecoins have become an exciting haven in the crypto market since they were first introduced. Having something or somewhere to run to when volatility strikes is one of the best things to happen to crypto enthusiasts. However, not every stablecoin out there is worth investing in. This article has discussed the different types of stablecoins you are likely to come across in crypto markets. Hopefully, it has helped you understand how all the different types work and which one might be a better fit for you.