Understanding stablecoins: a guide to how they work and their different types

Stablecoins have emerged as a crucial component of the cryptocurrency market, aiming to bridge the gap between the volatility of cryptocurrencies like Bitcoin and the stability needed for everyday transactions. By pegging their value to stable assets, stablecoins offer a less volatile crypto alternative, making them more suitable for daily transactions.

What are stablecoins?

Stablecoins are a type of cryptocurrency designed to maintain a stable value. Unlike more volatile cryptocurrencies, stablecoins aim to offer a consistent medium of exchange.

●        They are designed to bridge the gap between the unpredictability of cryptocurrencies like Bitcoin and the stability required for everyday financial transactions.

●        By pegging their value to fiat currencies, commodities, or other financial instruments, stablecoins offer a crypto alternative with reduced volatility.

●        They provide a more consistent medium of exchange capable of fulfilling daily transactional needs.

Key Takeaways:

●        Stablecoins maintain a stable value by pegging to fiat currencies, commodities, or financial instruments.

●        There are four primary types of stablecoins: fiat-collateralized, commodity-backed, crypto-collateralized, and algorithmic.

●        Investors should be cautious, as stablecoins involve third-party auditors for verification of reserves, which introduces risk.

●        Regulatory scrutiny of stablecoins is increasing worldwide due to their growing market impact.

●        Tether (USDT) is the most widely used stablecoin, pegged to the U.S. dollar with a 1:1 backing.

The significance of stablecoins in the cryptocurrency market

Bitcoin’s price volatility makes it risky for everyday transactions. Investors holding cryptocurrencies for long-term appreciation don’t want to become famous for paying 10,000 Bitcoins for two pizzas. Meanwhile, most merchants don’t want to end up taking a loss if the price of a cryptocurrency plunges after they get paid in it.

Stablecoins address this problem by promising to hold the value of the cryptocurrency steady in a variety of ways.

Types of Stablecoins:

Four types of stablecoins exist, based on the assets used to stabilize their value:

1. Fiat-Collateralized
2. Commodity-Backed
3. Crypto-Collateralized
4. Algorithmic

Fiat-collateralized stablecoins

Fiat-backed stablecoins hold reserves of currencies like the U.S. dollar to secure their value. Independent custodians keep these reserves, which are regularly audited.

Tether (USDT) and TrueUSD (TUSD) are popular stablecoins backed by U.S. dollar reserves and denominated at parity to the dollar. As of late June 2024, Tether (USDT) was the third-largest cryptocurrency by market capitalization, worth more than $112 billion.

Commodity-backed stablecoins

Commodity-backed stablecoins are linked to commodities like gold or oil. They typically hold the commodity through third-party custodians or related investments.

One of the most popular commodity-backed tokens is Tether Gold (XAUt), a cryptocurrency backed by gold reserves. The gold is thought to be held by an unnamed custodian in Switzerland

Crypto-collateralized stablecoins

Crypto-collateralized stablecoins are backed by other cryptocurrencies. Because the reserve cryptocurrency may also be prone to high volatility, such stablecoins are generally overcollateralized—that is, the value of cryptocurrency held in reserves exceeds the value of the stablecoins issued.

For example, MakerDAO’s Dai (DAI) stablecoin is pegged to the U.S. dollar but is backed by Ethereum (ETH) and other cryptocurrencies worth about 155% of the DAI stablecoin in circulation.

Algorithmic stablecoins

Algorithmic stablecoins may or may not hold reserve assets. Their primary distinction is the strategy of keeping the stablecoin’s value stable by controlling its supply through an algorithm.

The price of the TerraUSD (UST) algorithmic stablecoin plunged more than 60% on 11^th of May 2022, vaporizing its peg to the U.S. dollar, as the price of the related Luna token used to peg Terra slumped more than 80% overnight.

Table summarizing the types of stablecoins

Regulatory oversight of stablecoins

Stablecoins continue to come under scrutiny by regulators, given their rapid growth and potential to affect the broader financial system. The International Organization of Securities Commissions (IOSCO) said stablecoins should be regulated as financial market infrastructure alongside payment systems and clearinghouses.

In Europe, algorithmic stablecoins are essentially banned, and all others must have assets held in custody by a third party. Reserves must be liquid and have a 1:1 ratio of assets to coins.

Key differences:

●        Stablecoins aim to provide an alternative to the high volatility of popular cryptocurrencies, which can make cryptocurrency less suitable for common transactions.

●        Stablecoins attempt to peg their market value to some external reference, usually a fiat currency.

●        Stablecoins are more useful than volatile cryptocurrencies as a medium of exchange.

Which is the best stablecoin?

The most popular and largest stablecoin by market capitalization is Tether (USDT). It is pegged to the U.S. dollar at a 1:1 ratio and backed by reserves. You can find Tether on most major crypto exchanges, including Kraken, Binance, and Coinbase.

The bottom line

Stablecoins are cryptocurrencies with a peg to other assets, such as fiat currency or commodities held in reserve. The intent behind them is to create a crypto asset with much lower price volatility, which makes them better for use in transactions.

Stablecoins have become or are becoming regulated in many jurisdictions because of the instabilities and losses that have occurred in past attempts to create stable coins.