What is a stablecoin?

Cryptocurrencies known as stablecoins have a value based on the value of an external asset. Currency like the USD (as in the case of Tether (USDT)), precious metals like gold, or any other commodity are examples of these assets. Unlike other cryptocurrencies, stablecoins serve as both a store of wealth and a transactional medium, and its value is not speculative.

For instance, the value of Bitcoin, which was $16602 on November 19th, 2022, can go to $30,000 or even $10,000 in a single month. However, regardless of the month or day, stablecoins like Tether always have a value of $1. The value of Tether is always $1 USD, regardless of how much the value of the currency to which it is linked changes.

Understanding the Need for Stablecoins

Why did we need stablecoins in the first place? The answer to this question can provide the best way to start exploring more about the types of stablecoin. It is quite clear that the value of money shifts directions in various ways beyond explanation. The value of currency generally depends on the strength of the economy, thereby presenting formidable risks for everyone’s finances. Generally, people look for investment in precious metals, valuable assets, or exclusive real estate for preservation of their wealth.

The arrival of cryptocurrencies marked the introduction of completely new financial instruments. Crypto assets such as Ethereum and Bitcoin could present high levels of volatility, thereby calling for instruments to boost stability. Subsequently, the demand for stablecoins escalated in recent years with profound growth since July 2017. Stablecoins offers the most reliable solution for hedging funds in event of extremely volatile crypto prices.

Just like in the case of any emerging asset class, cryptocurrencies have also been subject to the influence of market forces. Various types of crypto projects are currently identifying methods for reducing risk and fostering participation in the wider crypto ecosystem. The different stablecoin types showed the possibilities of integrating stability directly in the crypto assets.

Why Should I Know about Stablecoin Variants?

The interest in learning about ‘what are the different types of stablecoins?’ also relates largely to the profound market downturns. The massive levels of volatility in the crypto world noted recently have been responsible for increasing the demand for stablecoins. As of now, the largest stablecoin, i.e., Tether or USDT, has a market value of almost $65 billion. The second-largest stablecoin in the crypto economy, USD Coin or USDC, holds a market value of almost $23billion. So, you can clearly anticipate the popularity levels of stablecoin and the reasons for eagerness to discover more about stablecoin categories.

What Are The Different Types Of Stablecoins?

Stablecoins have been around for some time, and now the world is getting to know them. The attention around stablecoins is not limited only to the crypto community. Traditional market investors, as well as regulators, are looking into the prospects of leveraging stablecoins. Therefore, the demand for comprehensive information regarding the different stablecoin types has been skyrocketing in recent times.

Stablecoins are just cryptocurrencies with their value pegged against some stable assets such as precious metals or fiat currencies such as the US Dollar. The different stablecoin categories are basically indicative of the assets backing them. A detailed understanding of the different types of stablecoins could help you establish promising foundation-level knowledge on stablecoins.

One thing you must know about stablecoins is that they are digital currencies on the blockchain ecosystem. It is possible to recognize stablecoins by the collateral structures backing them. You can find four different types of collateral structures for stablecoin, which establish the basis for types of stablecoin.

1. Fiat-collateralized Stablecoin

The most common type of stablecoins are those that are collateralized by fiat. They are backed by a fiat currency, such as the US dollar, the euro, or the pound sterling. The simplest stablecoin varieties with a 1:1 backing are fiat-collateralized stablecoins. According to the 1:1 ratio, one stablecoin is equivalent to one unit of currency, such as one dollar or one euro.

Due to its structural benefit, fiat-backed stablecoins are among the most straightforward stablecoin kinds. The most essential benefit for novices to better comprehend cryptocurrency is simplicity. As a result, stablecoins backed by fiat could play a significant role in promoting their widespread adoption. The economy of the nation is stable, hence there are seldom fluctuations in stablecoin’s value.

Fiat Backed Stablecoins example -1. Tether (USDT) 2. USD Coin (USDC) 3. Binance USD (BUSD) 4. True USD (TUSD)

2.Commodity-backed Stablecoins

Stablecoins that are backed by commodities, like precious metals, can be exchanged for other forms of assets. Gold is the most typical commodity used as collateral for stablecoins backed by other commodities.

In addition, there are numerous additional stablecoins that are backed by assets other than gold, such as real estate, oil, and precious metals. Owners of stablecoins with commodity collateral effectively control a physical asset with market value. In comparison to the majority of cryptocurrencies, this is a significant advantage.

Best Commodity Backed Stablecoins example -1. PAX Gold (PAXG)

3.Crypto-backed Stablecoins

Stablecoins with cryptocurrency collateral are supported by other cryptocurrencies. Such stablecoins are overcollateralized, meaning that the value of cryptocurrency kept in reserves exceeds the value of the stablecoins issued, because the reserve cryptocurrency may be subject to severe volatility as well.

To protect against a 50% drop in the price of the reserve cryptocurrency, a cryptocurrency worth $2 million might be retained as reserve in order to issue $1 million in a stablecoin backed by cryptocurrency. For instance, MakerDAO’s Dai (DAI) stablecoin is backed by Ethereum (ETH) and other cryptocurrencies worth 150% of the DAI stablecoin in circulation while still being pegged to the U.S. dollar.

Best Crypto Backed Stablecoins example -1. Dai (DAI)2. Magic Internet Money (MIM)3. Reserve Rights (RSV)

4.Algorithmic Stablecoins

Stablecoins that are algorithmic or are not collateralized would be the last category to be added. Stablecoins that are algorithmic or non-collateralized don’t have any assets or collateral to back them. Therefore, how are algorithmic stablecoins defined as stablecoins when they lack any underlying collateral?

The supply of stablecoins is regulated by an algorithm used by non-collateralized or algorithmic stablecoins. Seigniorage shares is another name for this strategy. New stablecoins will be produced to lower the price to the standard level in response to the increase in demand. When coin trade is noticeably low, coins on the market are bought up to cut down on the supply that is in circulation.

Best Algorithmic Stablecoins example -1. Neutrino USD (USDN)2. Decentralized USD (USDD)3. Frax (FRAX)4. Fei USD (FEI)

What purposes do stablecoins serve?

• Cross Border Remittance-Crypto currencies with stable prices are known as stable coins. This indicates that stable coins offer the conventional benefits of crypto currencies, such as affordable cross-border transactions, without incurring hefty costs from middlemen.
• An improved Currency– Similar to crypto currencies, stable coins operate on the block chain and are safer and simpler to use as payment than fiat money. It combines the benefits of fiat money and crypto currency. Since the transactions are less expensive, they can promote trade and offer a P2P financial system that is open to all users.
• used as a means of purchase for crypto currencies– While buying crypto currencies in India is possible without using Tether, using stable coins on Indian crypto currency exchanges results in lower transaction costs. The most often used way to purchase crypto currency
• Banking– The ability of stable coins to settle banking transactions is the most recent application to be added to the ever expanding list of stable coin’s benefits. The Office of Comptroller and Currency (OCC) of the USA legalised the use of stable coins in banking transactions on January 5, 2021. Soon, other nations are expected to do the same.The success of the crypto currency bull run is largely due to stable coins, but even inside the crypto currency community, there is a lot of disinformation. Before investing in any crypto currency, including the acquisition of stable coins, make careful to conduct in-depth research. To stay up to date on the most recent developments in the crypto currency industry, follow us on Twitter and sign up for our Telegram channel.
• Global commerce opportunity-For those living in nations with unreliable monetary systems, such as Argentina, where citizens are frequently exposed to exorbitant inflation and instability, this feature will be especially crucial. Restrictive capital control policies frequently hinder these citizens from using non-native currencies in transactions outside of the country, despite the fact that they may want to move their money to more stable stores of value. Hence, the importance of decentralised stablecoins.

Stablecoins Risks

The Problem with Centralization

This goes directly against the broad spirit of what blockchain technology is intended to be about and is likely the largest danger currently attached to stablecoins. According to the adage, blockchain was created to genuinely decentralise the information age and ensure that no one entity has total authority or domination over any area of our technological society. It was intended to bring with it a level of immutability and transparency that modern technologies, such as the internet, just cannot. This has largely been the case. On public blockchains, transactions are completely transparent and immutable. As a result, they are not within one party’s control and cannot be changed.

Sadly, this is not the case for stablecoins, as they are frequently managed and controlled by a single company through off-chain transactions and deals. Consider USDT, the most popular stablecoin on the market. In reality, a company named Tether, which acts in its own best interest as any other profit-maximizing business would, is in charge of USDT. Tether is independent of outside parties’ desires to manipulate the market supply because it controls both the supply and the rate at which USDT is distributed.

Although not technically, being a centrally backed asset clashes with the essence of blockchain technology. Anyone owning USDT faces clear dangers as a result of this lack of decentralisation since, in the event that Tether collapses for whatever reason, USDT will also collapse, potentially driving your digital USD value to zero. The majority of investment professionals would undoubtedly advise you to diversify your investments as the best defence against this. At the very least, you can safeguard yourself against a single collapse of the entity in charge of the asset by diversifying your stablecoin portfolio.

Market snapshot 

The price of the underlying asset is not totally reflected in stablecoins (s). For instance, the price of USD stablecoins can change at any time. Let’s look at some examples of fiat-backed stablecoins from Coinmarketcap as of 19-11-2022.

• Tether $0.9994
• Paxos Standard $0.9962
• Binance USD $0.9996
• TrueUSD $0.9989

Most of the time, price variations are less than 1% over or under $1.00 for the two prices mentioned above that varied by more than 1%. Some differences are explained by the laws of supply and demand in fundamental economics, but there may be many more forces at work depending on the kind of stablecoins.

It’s Difficult to Algorithmically Maintain a Perfect Peg

Also referred to as seigniorage, algorithmically backed type. These coins, whether they be a collection of digital coins like DAI or a regular fiat coin like USDT, are not backed by any kind of collateral. Instead, they rely on an algorithm (or game theory) that adjusts supply or output in response to changes in the market. Here is how it functions. Let’s say our coin’s price falls to $0.80, indicating that there is more supply than demand in the market.

The programme would determine exactly how much surplus supply is best and then acquire that much in order to return the price to $1. In theory, having an AI-powered system to constantly maintain stability in a split second seems amazing, but there are other underlying problems. First off, when there is a rapid decline in demand due to an occurrence like a black swan, this doesn’t work.

Let’s assume that a significant event occurs and that more than 80% of users withdraw their funds from this stablecoin. The algorithm would then be told to purchase enough supply to raise the price to $1, but what if the drastic occurrence causes there to be no longer be any demand for this stablecoin? Stablecoins that are algorithmically backed fundamentally depend on the future demand for their asset to increase and contract in quantity in order to remain optimal; however, if there is no such demand, the model fails. These algorithms are considerably too unstable at the moment to win the trust of the general people because they are frequently extremely sophisticated, challenging to implement, and brand-new technology.

Counter-party risk

By relying on a third party to produce money and maintain a cryptocurrency’s stability, dollars may be partially reserved rather than fully backed. In this scenario, a bank run may cause the coin’s price to drop sharply.

Conclusion

Some price variations are explained by supply and demand economics, but there are numerous more factors that might lead to more pronounced volatility.Stablecoins have experienced an exponential surge over the past 60 months, and we in no way are arguing that this is a bubble or a passing fad. Even while digital currencies are as safe as stablecoins, there are risks associated with them.This dynamic space will continue to expand, grow, and break up into new areas at the speed of light.There is no such thing as a risk-free asset. Even investing in the world’s most valuable asset, gold, has its own set of risks. Stablecoins is no different.

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