What Stablecoins Are, the Various Types and Why They are Important

What Are Stablecoins? 

Stablecoins are a type of cryptocurrency whose value is tied to a more stable asset, such as fiat or government-issued currencies (like the United States dollar) and precious metals (like gold). Stablecoins offer an alternative exchange medium to volatile cryptocurrencies, such as Bitcoin (BTC) and Ether (ETH).

The key feature of stablecoins is that they are tokens that are less prone to drastic price fluctuations, making them more suitable for everyday transactions and as a store of value. Examples of some popular stablecoins include Tether USD (USDT), Dai (DAI), and USDC (formerly USD Coin).

Types of Stablecoins 

There are various types of stablecoins, each with its own underlying asset and mechanism of maintaining peg or price stability. Below are the most common types of stablecoins.

Fiat-Collateralized Stablecoins

Fiat-collateralized stablecoins are backed by reserves of government-issued currencies, like the US dollar and Euro. For these type of stablecoins, there is an equivalent or greater amount of fiat currency held in reserve for every issued stablecoin. The reserve acts as a collateral, ensuring that each stablecoin unit can always be redeemed for its equivalent value in the underlying currency. USDT, USDC, EURC (Euro Coin) are popular examples of fiat-collateralized stablecoins.

Commodity-Backed Stablecoins

Commodity-backed stablecoins are backed by reserves of physical assets like gold, silver, or oil, and the value of the stablecoin is typically pegged to the market rate of the commodity. The reserves of these stablecoins are  often held off-chain by a trusted custodian. For example, Tether Gold (XAUT) and PAX Gold (PAXG) are backed by gold, offering holders a way to invest in the commodities through cryptocurrency.

Crypto-Collateralized Stablecoins

Crypto-collateralized stablecoins are backed by reserves of other cryptocurrencies. Since the value of these cryptocurrencies can be volatile, these stablecoins are typically over-collateralized. This implies that the value of crypto held as collateral exceeds the value of the stablecoins issued, thereby providing a buffer against price fluctuations. To maintain price stability, these stablecoins are typically backed by other fiat-collateralized stablecoins as well. For instance, in addition to Bitcoin and Ethereum, DAI reserves also include USDC and USDT. Notably, DAI has since shifted to also include US treasury bills as part of its reserves, blurring the line between crypto-collateralized stablecoins and fiat-collateralized stablecoins.

Algorithmic Stablecoins

Algorithmic stablecoins take a different approach from asset-backed tokens. They are not backed by any fiat, crypto, or commodities. Instead, these stablecoins rely on algorithms and smart contracts to manage their supply in circulation, thereby keeping their market value stable. A rise or fall in price increases or decreases the number of coins in circulation based on the principles of demand and supply. These algorithmic changes in token supply then incentivises arbitrage traders to sell/buy tokens until the peg is eventually restored. . Following the collapse of the algorithmic stablecoin TerraUSD (UST), these types of stablecoins are currently regarded as generally unviable, with their ability to maintain stability under increased scrutiny.

Why are Stablecoins Important 

Stablecoins play a crucial role in the cryptocurrency ecosystem by addressing one of its biggest challenges, volatility. Crypto tokens like Bitcoin, can experience significant price swings within a short timeframe, making them risky for everyday transactions, and as a reliable store of value. 

Stablecoins offer a solution by maintaining a steady value. This stability makes them more practical for daily use, whether you're buying a cup of coffee, transferring money across borders, or receiving payments for services.

Additionally, stablecoins are important for the broader adoption of decentralized finance (DeFi). They provide a reliable medium of exchange within DeFi platforms, enabling users to trade, lend, and borrow with assurance that the value of their assets won't suddenly plummet. This consistency fosters trust and encourages more users to participate in the cryptocurrency space.

Furthermore, stablecoins can serve as a gateway for individuals looking to hold foreign currency. For instance, people living in regions with political instability can avoid government bank freezes or movement restrictions when holding stablecoins in their own non-custodial wallet.

For the current stablecoin market capitalization and other market data, check out: https://www.coingecko.com/en/categories/stablecoins