What Is Stablecoin?
Cryptocurrencies are known for their highly volatile nature, which can lead to fluctuations in their market value. For example, in 2013, one Bitcoin was worth over $1,000, but then it dropped to $200. However, in 2017, it surged 20 times (to around $20,000) within 12 months before dropping again in 2018 and 2019. Stablecoins were created to solve the problem of rapid market swings.
Stablecoins are a type of cryptocurrency designed to provide price stability, regardless of market direction. Their value is pegged to the value of an underlying asset that maintains a consistent value, such as a fiat currency, or a commodity like gold.
Most stablecoins are backed by fiat currencies like the USD at a 1:1 ratio, ensuring that the value of the two assets remains the same. For example, a stablecoin pegged to the USD maintains a stable value of $1, where each token represents $1. This means that users can sell their stablecoins for USD at any time without significant price fluctuations.
Stablecoins allow users to store value safely in a volatile market while protecting themselves against market movements.
What Kinds of Stablecoins Are There?
Each stablecoin has a different approach to maintaining price stability. Thus, they can be categorized into four types: fiat-collateralized, commodity-backed, crypto-collateralized, and algorithmic stablecoins.
Fiat collateralized stablecoins are digital tokens that derive their value from being backed by a reserve of traditional currency, such as the US dollar. These stablecoins aim to provide stability and minimize price volatility by maintaining a 1:1 ratio with the underlying fiat currency.
These stablecoins are backed by a tangible asset, such as silver or gold. For example, the value of Paxos Gold (PAXG)is fixed at a 1:1 ratio to the value of a fine troy ounce (a metric for weighing precious metals) of a London Good Delivery gold bar.
Crypto-backed stablecoins are collateralized by other crypto assets. They are often overcollateralized to maintain their peg and account for market volatility. This means that the value of the crypto required to create or issue the stablecoin is higher than the value of the stablecoin itself. For example, DAI uses BAT for collateral. If DAI wanted to mint $500 worth of DAI stablecoins, they would need $1,000 worth of BAT as collateral. The 200% over-collateralization helps ensure that the value of DAI remains stable so that even when BAT dips by 20%, DAI is still backed by $800 worth of crypto.
Algorithmic stablecoins are also known as algostables or non-collateralized stablecoins since they are not backed by any assets. Instead, they use complex algorithms to control the supply of stablecoins in circulation in order to maintain price stability. Consider an algorithmic stablecoin fixed at $1 in value. If the demand increases, the algorithm automatically mints more stablecoins to maintain the value at $1. However, if the demand declines, the price is likely to go below $1. Hence, the algorithm removes some stablecoin from supply to increase the price back to $1 through a process called “crypto burning.”
While the theoretical concept of stablecoins is to offer price stability by maintaining a 1:1 ratio to an asset with consistent value, they have failed to practically do so on several occasions. A notable example is the de-pegging of TerraUSD (UST).