What is Stable Coin ?
Stablecoins are designed to have a more stable value compared to traditional cryptocurrencies by being pegged to fiat currencies like the US dollar or other assets like gold. The goal is to allow stablecoins to benefit from the advantages of being a cryptocurrency without the extreme volatility. If traditional cryptocurrencies are likened to investing in a high-risk stock, stablecoins are akin to withdrawing cash from an ATM.
There are four main types of stablecoins in the crypto world, and we will delve into them later in the article: fiat-backed, crypto-backed, commodity-backed, and algorithmic.
The recent events with UST and LUNA have been strongly felt throughout the majority of the market. At the end of this article, I believe you will have some insight into which stablecoin to trust more and when to prefer one over the other. But before that, let's take a look at how stablecoins work.
How Stablecoins Work
A. Fiat-Backed Stablecoins
This is the most common type of stablecoin, backed or collateralized by a fiat currency. What does this mean?
Fiat-backed stablecoins are backed 1:1, meaning each stablecoin is backed by an equivalent amount of fiat currency. For example, for every stablecoin in existence, there is real fiat currency held in a bank account as collateral, off-chain. When we redeem the stablecoin on the blockchain for fiat at our bank, the stablecoins left behind are burned, ensuring the balance of supply and fiat currency.
However, in reality, this may not always be the case. Tether (USDT), for instance, was proven not to be 1:1 until 2019, revealing that only 10% of its reserves were backed. So, while the theory is sound, the practice might differ. Examples of fiat-backed stablecoins include BUSD, USDC, and USDT.
B. Crypto-Backed Stablecoins
Crypto-backed stablecoins are supported by other cryptocurrencies. In this case, there's no need for real fiat currency as collateral; everything is on-chain, creating a theoretically decentralized structure.
For example, to acquire a stablecoin worth $500, you would need to deposit $1000 worth of Bitcoin (or any other cryptocurrency). In this scenario, stablecoins are now 200% collateralized, and even in the event of a 25% price drop, the $500 stablecoins are collateralized with $750 worth of BTC. However, if the price of the collateralized cryptocurrency drops, the stablecoin will be automatically destroyed, ensuring stability. These types of stablecoins often use multiple cryptocurrencies as collateral to diversify risk. The most popular example of a crypto-backed stablecoin is Dai.
C. Commodity-Backed Stablecoins
Commodity-backed stablecoins are supported by other interchangeable valuable assets. The most common collateral is gold, but stablecoins backed by other commodities like real estate, oil, and various precious metals also exist.
An example is Digix Gold (DGX), where 1 DGX represents 1 gram of gold, backed by the Ethereum network. The gold is stored in a vault in Singapore and undergoes audits every three months. Another example is PAX Gold (PAXG).
D. Algorithmic Stablecoins
Algorithmic stablecoins do not use fiat or cryptocurrencies as collateral. Instead, they rely on specialized algorithms and smart contracts to manage token supply and maintain price stability. Examples of these stablecoins include UST, AMPL, BAC, and UXD. In an algorithmic stablecoin system, when the market price falls below the fiat currency it tracks, the circulating token supply is reduced. Conversely, if the token price surpasses the tracked fiat currency's price, new tokens are minted to adjust the stablecoin's value downward.
While algorithmic stablecoins seem theoretically perfect, none have consistently achieved stability. The recent collapse of UST has raised doubts about the future of some algorithmic stablecoins, despite their seemingly decentralized nature.
In conclusion, each type of stablecoin has its own advantages and disadvantages. The choice between them depends on the specific use case and individual preferences. For instance, fiat-backed stablecoins may offer a more direct link to traditional currencies but involve centralization risks. On the other hand, algorithmic stablecoins aim for decentralization but face challenges in maintaining stability. It's essential to carefully evaluate the features and mechanisms of each stablecoin before choosing one for your needs.
