Broadly speaki
ng, there
are t
wo types of stablecoins. First, let’s examine collateralized stablecoins, which are crypto assets backed by reserves of different assets, such as fiat currencies, commodities or cryptocurrencies.
Fiat and commodity-backed stablecoins
Fiat-backed stablecoins operate in the same way as other digital assets, except that they aim to be pegged to real-world currencies on a 1-to-1 basis.
Stablecoins exist on multiple different blockchains, and can be bridged between chains. This enables users to seamlessly move capital around as they might with other assets.
Because of the transparency afforded by blockchain technology, every stablecoin can be easily accounted for, which in some cases has resulted in assets being frozen.
The lifecycle of fiat-backed stablecoins typically follow the same five steps:
After completing KYC, an individual or entity deposits fiat currency into the issuer's bank account.
- The company then issues the stablecoins to the entity’s supplied wallet address.
- The stablecoins then enter the digital asset ecosystem for people to use.
- Users can redeem the stablecoins back into fiat currencies at their discretion by returning them to the issuer.
- The stablecoins are then removed from circulation, returning the corresponding amount of fiat back to the holder’s bank account.
Fiat-backed stablecoins dominate overall stablecoin activity for a few reasons:
- Despite adverse media, they have performed their function reliably over a sustained period (Tether launched in 2014), which has engendered a robust sense of stability and trust.
- Fiat-backed stablecoins are incredibly liquid and widely adopted by a huge variety of decentralized and centralized platforms. This allows traders to interact with these coins knowing that there will always be sufficient liquidity to swap them for other assets.
- Unlike other variants of stablecoins, how they work and how they are backed is much more straightforward compared to their algorithmic equivalent.
- Tether and Circle are required to comply with regulation and employ independent auditors to verify that the issuers combined assets exceed their combined liabilities.
A less popular variant of collateralized stablecoins are backed by fungible commodities such as gold, silver or oil.
Rather than being pegged to a dollar or a euro, commodity-backed stablecoins represent a unit of a specific commodity, such as one Troy ounce of gold.
As with fiat-backed stablecoins, the companies issuing these coins are expected to publish regular independent audits of their physical reserves to ensure holders that they can redeem their tokens for their equivalent value of the underlying asset.
For those seeking exposure to commodities, these stablecoins enable users to do so without having to consider storage or portability. They are typically highly liquid, can be fractionalized and are issued by reputable firms.
There have been attempts to collateralize oil and agricultural commodities, but these projects have so far failed to gain any meaningful traction.
Fiat and commodity stablecoins are backed by a 1:1 reserve of real-world assets, but how they are backed can differ slightly depending on the coin. The largest and most liquid examples are:
- Tether (USDT): with $123b in circulation, USDT is backed by a mixture of USD reserves (83.89%), secured loans (5.36%) precious metals (3.95%), Bitcoin (3.81%) and other investments (2.97%), at press time.
- USD Coin (USDC): with $36.8b USDC in circulation, backed by the equivalent value of US dollar denominated assets, totalling $37b, at press time.
- Global Dollar Network (USDG): a fully cash and cash equivalent backed stablecoin with backing from Paxos, Robinhood, Anchorage and Kraken
- Tether Gold (XAUT): issued by Tether, this gold-backed coin allows holders to redeem their tokens for physical gold which Tether states it will deliver to any address in Switzerland.
- PAX Gold (PAXG): Regulated by the New York Department for Financial Services, one PAX Gold token represents one fine Troy ounce of a gold bar. PAXG has significantly more volume than its competitors.
Cryptocurrency-backed stablecoins
Cryptocurrency-backed stablecoins operate very similarly to fiat-backed stablecoins with a few key differences.
Due to the volatile nature of cryptocurrencies, these stablecoins are often over-collateralized, meaning more cryptocurrency is held in reserve or “pledged” than the stablecoin value issued.
For example, a $1 cryptocurrency-backed stablecoin might require $2 worth of cryptocurrency in reserve. This means that even if the reserve currency backing the stablecoin were to decline by as much as 50%, it should still be able to maintain its peg.
Maker DAI is an open-source platform that allows users to take out loans in the form of DAI, which is pegged to the value of 1 US dollar. DAI is collateralized by cryptocurrencies.
Here’s how DAI works:
- Users wanting to acquire DAI must first lock up their Ethereum or other assets into a smart contract. Over collateralization enables the stablecoin to hold its peg.
- Fungible DAI tokens are then generated, reflecting the amount of collateral pledged. The user is then free to deploy the DAI in any way that they see fit.
- If users want to recover their collateralized assets, they must return the DAI issued and pay a stability fee.
Automated smart contracts known as Collateralized Debt Positions (CDPs) dynamically manage supply by creating or burning DAI, and by liquidating positions where there is insufficient collateral.
If you want to learn more about DAI, this article by Kraken Learn offers a more detailed explanation.
Popular examples
In addition to DAI, here are some other popular examples of crypto-backed stablecoins:
- Synthetix USD (SUSD): Using its native SNX token as collateral, users can lock SNX tokens as collateral to mint sUSD, maintaining a collateralization ratio of 500% or higher. This high over-collateralization ratio is supposed to help absorb price fluctuations in SNX.
- Wrapped Bitcoin (WBTC): WBTC is a 1:1 representation of Bitcoin on the Ethereum blockchain. Each WBTC token is reportedly fully backed by an equivalent amount of Bitcoin held in custody.
- Decentralized USD (USD): Introduced in May 2022, USDD is an over-collateralized decentralized stablecoin pegged to 1 U.S. dollar.
Algorithmic stablecoins
Algorithmic stablecoins employ a variety of smart contract-based mechanisms to maintain a stable value by responding dynamically to supply and demand.
Unlike asset-backed stablecoins which have reserves that act as collateralization, algorithmic stablecoins typically mint and burn coins to maintain a peg and are not backed by real world assets. Additionally, these may include a secondary bond token which can be bought and redeemed for the underlying stablecoin to assist with stabilizing its price through arbitrage.
Popular examples
Perhaps due to the unprecedented failure of Terra USD (UST) and the inherent complexities of algorithmic stablecoin, there are fewer coins of this ilk with any meaningful adoption.
- Ampleforth (AMPL) is an algorithmic stablecoin that “...is a price-stable but supply volatile cryptocurrency that targets the (2019) CPI-adjusted dollar.” Via a non-dilutive process known as ‘rebasing’, supply is programmatically increased or decreased using data feeds from Chainlink (LINK). Therefore the supply is constantly expanding and contracting, with holders balances fluctuating on a daily basis. As a result, the stablecoin has repeatedly managed to return to its target price despite challenging market conditions.
For a more detailed explanation of how Ampleforth works, check out this guide by Kraken Learn.
