Types Of Stablecoins

Digital assets are evolving at a rapid pace, and it can be hard to keep up with them — whether it’s the adoption of cryptocurrencies with updated utility or AI tokens. Stablecoins are direct proof of how each coin is improving by leaps and bounds. In this guide, we’ll dive into their history and examine different types from various perspectives.

What Is A Stablecoin?

If you’ve encountered the digital market, you’re likely already familiar with this term.

Stablecoins are tokens that hold a value directly pegged to a currency, commodity, or financial instrument of equivalent worth. However, each virtual coin uses different methods to maintain stability. It’s important to note that tokens are tied to an underlying asset as a source of value, as it helps diversify the overall risk associated with many cryptocurrencies. This is a key step in combating general volatility and specifically in addressing sharp fluctuations in their overall value.

Developers typically choose the US dollar as the most popular peg. This happens for obvious reasons, as there is no more significant currency in the global economy. Its status as the world’s reserve peg has given it an excellent reputation and a reliable method for determining value. The most popular stablecoins in the crypto market are the USD-pegged USDT and USDC.

In fact, stablecoins are, to some extent, revolutionaries in the world of cryptocurrency. Many discussions around digital assets focus on negative views about fast price fluctuations, leading to the misconception that virtual funds are unsafe for investment. The coins aim to solve this long-standing issue and operate in another, more stable mode. Overall, stablecoins include categories such as collateralized, fiat-backed, crypto-backed, algorithmic, and decentralized. Further, we’ll explore each of them in more detail.

Collateralized And Non-Collateralized Stablecoins

Let's start with the stablecoins that are collateralized. Essentially, they maintain their value by backing it with reserves of other assets. Collateralized stablecoins are backed by assets such as fiat currency, commodities, or cryptocurrencies to maintain their value. This type is considered to be more stable.

Non-collateralized coins rely on algorithms and market mechanisms to maintain their value instead of being backed by reserves. Their alternative name is algorithmic. If the price of a stablecoin falls below a set level, algorithms reduce supply by buying back coins from the market to restore the value. If the price rises higher, supply increases, which stabilizes the value.

Fiat-Backed Stablecoins

Fiat-backed stablecoins are one example of collateralized coins, whose value is supported by reserves of fiat currency, such as the U.S. dollar or the euro.

For example, USDT maintains a 1:1 peg to the US dollar. It’s important to mention that as of September 2024, USDT ranks third in market capitalization. Moreover, USDT is the most liquid cryptocurrency on the market, with the highest trading volume, often double that of Bitcoin. This asset undergoes frequent audits by independent accounting firms since this type of coin relies on custodians and regular audits.

Fiat-backed types serve purposes like trading, money transfers, and borrowing in the decentralized finance sector. Their drawbacks include centralization and the risk from a lack of independent third-party audits. Nevertheless, the fame and practicality of fiat-backed stablecoins highlight their importance in the crypto space.

Crypto-Backed Stablecoins

Crypto-backed stablecoins are digital assets that are collateralized by other cryptocurrencies. Instead of relying on fiat reserves, these stablecoins use a basket of cryptocurrencies as collateral. Due to asset price fluctuations, users typically need to over-collateralize. For example, with a stability ratio of 150%, a customer must deposit $150 worth of cryptocurrency to receive $100 in stablecoins. A key case is DAI, the largest crypto-backed coin by market capitalization at the time of writing.

The main advantage of this type lies in their decentralization, avoiding reliance on fiat reserves or traditional banking systems. Although this fund may be more volatile than its fiat counterparts, it benefits from full integration into the crypto ecosystem. However, they also face the risk of volatility, which requires over-collateralization to reduce potential risks.

Commodity-Backed Stablecoins

Commodity-backed stablecoins are tied to the value of physical assets, such as gold or silver. Their advantage lies in being backed by tangible funds, which provides an additional level of security and stability.

Organizations that store physical goods in reserves issue these stablecoins. For instance, each unit of the coin may be backed by a specific amount of gold held in certified vaults. Similar to fiat-backed, holders of these coins can, in some cases, request the exchange of tokens for the corresponding physical goods.

A bright example is Paxos Gold (PAXG), where each token is equivalent to one troy ounce of gold. So, this type of investment serves as an excellent hedge against inflation. However, stringent regulation from authorities poses a downside, particularly concerning precious metals or commodity markets.

Algorithmic Stablecoins

Algorithmic stablecoins use algorithms to regulate the supply of stablecoins and maintain their value. While this type is more challenging to implement, it represents an innovative approach to achieving stability in the cryptocurrency world.

This means that a computer operates based on a formula designed to protect the value of the asset. These types employ algorithmic and incentive mechanisms to maintain price stability. Unlike fiat-backed, which rely on collateral, algorithmic stablecoins operate without it. This independence from asset reserves is a significant advantage.

The stability of algorithmic stablecoins largely depends on market demand. If demand drops below a critical level, the entire system can collapse. This is what happened to TerraUSD, which fell below its $1 peg, causing a massive sell-off and a sharp decline in the price of Luna. TerraUSD's market cap plummeted from $18 billion to $100 million, and in May 2022, the Terra-Luna crash wiped out over $40 billion in investor wealth.

Despite these potential risks, the transparency and decentralization can be appealing to some users, as algorithmic operations are entirely governed by verifiable code.

Centralized And Decentralized Stablecoins

Centralized and decentralized stablecoins differ in how they are governed within the crypto ecosystem. Centralized stables are supported and issued by a central organization, typically a private company, which issues and manages them. They maintain reserves in fiat currency or other assets to keep the coin's value pegged to something like the US dollar. A prominent example is Tether (USDT). The central organization controls the issuance of funds and can block transactions as needed to comply with regulatory requirements.

The main advantages of a centralized type include a high level of reliability in maintaining a stable value due to their reserves and compliance with legal regulations. However, risks exist, such as dependence on the central organization and vulnerability to interventions from regulatory authorities.

Decentralized stablecoins operate under decentralized networks or algorithms. It represents a category of cryptocurrencies. Their value typically relies on a system of over-collateralization with cryptocurrencies or on smart contracts. The main advantage is the lack of dependence on a central authority, aligning with the ideology of total decentralization in crypto space. However, the lack of central authority can be considered as a disadvantage. For example, as was the case with TerraUSD, which shows the unreliability of such coins.

Well, the market offers such a variety of stablecoins that provide users with a range of options. It allows them to choose the best coin that suits their needs. The key is to select a reliable platform for buying and selling cryptocurrencies. For instance, Cryptomus P2P exchange could be an excellent choice. It offers numerous stablecoin types to work with, and low fees can be a nice bonus.

Which type of stablecoin appeals to you the most? Write it in the comments.