Golden Encyclopedia | What are the different types of stablecoins?

Author: Yogita Khatri, Theblock Translation: Shan Oppa, Golden Finance

Stablecoin is a cryptocurrency designed to maintain a stable value. However, not all stablecoins take the same approach to achieving this goal. They can be broadly divided into three broad categories: fiat stablecoins, cryptocurrency-backed and algorithmic stablecoins.

Fiat-backed stablecoins

Fiat-backed stablecoins are designed to mirror the U.S. dollar and the value of traditional currencies, such as the euro, is by far the most popular category. Their issuers claim they maintain a reserve of liquid assets to back stablecoins on the blockchain. Ideally, they hold reserves in cash or cash equivalents (such as Treasury bonds) that equal or exceed the circulating supply of their stablecoin. Tether’s USDT and Circle’s USDC are typical examples of fiat-backed stablecoins.

Stablecoins backed by fiat currencies are often used for transactions, remittances and lending activities in the field of decentralized finance. However, these stablecoins are centralized, their reserves may include volatile and risky assets, and the lack of independent third-party audits creates additional risks. Nonetheless, the popularity, liquidity, and resistance to price manipulation of fiat-backed stablecoins underscore their importance in the cryptocurrency space.

Cryptocurrency-backed stablecoins

As the name suggests, cryptocurrency-backed stablecoins are Cryptocurrency-backed as collateral. However, due to the volatility of cryptocurrencies, cryptocurrency-backed stablecoins often require overcollateralization to a specific ratio to ensure stability. For example, the collateralization requirement is 150%, meaning a user would need to deposit $150 worth of cryptocurrency in order to mint $100 of stablecoins. The best example of a cryptocurrency-backed stablecoin is MakerDAO’s DAI, which is currently the largest cryptocurrency-backed stablecoin by market capitalization.

Cryptocurrency-backed stablecoins are decentralized and trustless, but they are not without risks. Volatility in the collateral backing these stablecoins has the potential to disrupt their pegs, potentially automatically liquidating the underlying collateral if prices collapse.

Algorithmic stablecoins

Algorithmic stablecoins use algorithms and incentive mechanisms to maintain their price stability . Unlike collateralized fiat-backed stablecoins or over-collateralized cryptocurrency-backed stablecoins, algorithmic stablecoins typically operate undercollateralized. This means they do not rely on asset reserves to realize their value.

The stability of algorithmic stablecoins depends largely on market demand. If demand drops below a certain threshold, the entire system collapses. This is exactly what happened last year, when the TerraUSD stablecoin experienced a major decoupling event that saw its price fall below $1, causing a massive sell-off and causing the price of Luna, the governance token of the Terra blockchain system, to drop. In May 2022, the collapse of Terra -Luna wiped more than $40 billion from investor wealth in just a few days.

Despite these potential drawbacks, the transparency and decentralization offered by algorithmic stablecoins may be attractive to some users as to how they operate Fully controlled by auditable code.

Finally, there are asset-backed stablecoins, such as Paxos Gold and Tether Gold, which claim to be backed by physical reserves of precious metals, providing stability through tangible assets.