Exploring Different Types of Stablecoins: Fiat-backed, Crypto-backed, and Algorithmic
Date: 2024-02-05 Author: Dima Zakharov Categories: BLOCKCHAIN
Stablecoins, Fiat-backed:
Fiat-backed stablecoins are created to mirror the value of traditional currencies like the US dollar and euro, making them the most popular category. Their issuers claim to maintain reserves of liquid assets to support the stablecoin in the blockchain. Ideally, they hold their reserves in cash or equivalents, such as treasury bonds, which should match or exceed the amount of stablecoins in circulation. Notable examples of fiat-backed stablecoins are USDT Tether and USDC Circle.
These stablecoins are commonly used for trading, money transfers, as well as lending and borrowing in the decentralized finance sector. However, they are centralized, and their reserves may include volatile and risky assets. The absence of independent third-party audits adds an additional layer of risk. Nevertheless, the popularity, liquidity, and resistance to price manipulation of fiat-backed stablecoins underscore their importance in the cryptocurrency space.
Stablecoins, Crypto-backed:
As the name suggests, crypto-backed stablecoins are backed by cryptocurrencies used as collateral. Due to the volatile nature of cryptocurrencies, crypto-backed stablecoins usually require overcollateralization to ensure stability. For instance, a 150% collateralization requirement means a user needs to deposit cryptocurrency worth $150 to mint a stablecoin worth $100. The most prominent example of a crypto-backed stablecoin is DAI by MakerDAO, currently the largest crypto-backed stablecoin by market capitalization.
Crypto-backed stablecoins are decentralized but not without risks. Fluctuations in the collateral supporting these stablecoins can disrupt their peg, and a drop in prices can trigger automatic liquidation of the underlying collateral.
Algorithmic Stablecoins:
Algorithmic stablecoins employ algorithmic and incentive mechanisms to maintain price stability. Unlike fiat-backed stablecoins with collateral or crypto-backed stablecoins with overcollateralization, algorithmic stablecoins often operate with insufficient backing. This means they do not rely on asset reserves matching their value.
The stability of algorithmic stablecoins heavily depends on market demand. If demand falls below a certain threshold, the entire system can fail. An example of such a failure occurred when TerraUSD, an algorithmic stablecoin, experienced a significant unpegging event, causing a mass sell-off and a subsequent plunge in the price of Luna, Terra's governance token, in May 2022.
Despite these potential drawbacks, the transparency and decentralization offered by algorithmic stablecoins can be appealing to some users since their operations are entirely governed by auditable code.
Finally, there are stablecoins backed by physical assets, such as Paxos Gold and Tether Gold, which claim to be backed by physical reserves of precious metals, providing stability through tangible assets.
