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Stablecoin are no less than a phenomenon with the potential of uniting financial systems across the world using technology. They are cryptocurrencies that imitate the value of a fiat currency while still retaining all the characteristic traits of regular cryptos, offering users an almost non-volatile option to store their funds. With the right application, stablecoin can be the core element of tomorrow’s financial architecture.
This is why the adoption of stablecoin is skyrocketing with the market cap of stablecoin closing in on $129 billion, growing by over 545% since last October. Apart from crypto enthusiasts, stablecoin has also touched the other end of the spectrum with traditional users preferring them to conventional bank deposits.
At this time, stablecoin are broadly classified into four types based on their underlying collateral structure. So, let’s take a look.
Types of Stablecoin
Fiat-Backed Stablecoin
These coins are pegged in a 1:1 ratio by a reserve of fiat currencies such as the U.S. Dollar or Euro. To add context, for every USD placed in the reserve of the issuer, one Euro Stablecoin (EURST) is made available for circulation.
Fiat-backed stablecoin are also called off-chain coins because they follow the traditional method of collateralization, where a fiat currency is stored in a reserve with a central authority or financial institution. The reserve is maintained proportionately with the issued tokens to attain stability in the coin’s price.
USDT is the most popular stablecoin but it has always had its fair share of controversy due to lack of transparency and not disclosing regular audit reports with the public. In recent times, one fiat-backed stablecoin that’s making inroads into the crypto space is the Ethereum-based Euro Stablecoin (EURST), which is backed by the dollar but represents the value of the euro. Other examples are USDCoin, TrueUSD, and PAXOS STANDARD, all of which are backed by the U.S. dollar.
Crypto-Backed stablecoin
Crypto-backed stablecoin are those stablecoin that are backed by cryptocurrencies. Since crypto is a volatile market and stability is a far-fetched dream, these crypto-backed stablecoin are often over-collateralized to compensate for the volatility in the value of the underlying cryptocurrency. The working of these stablecoin is a complex process involving the use of smart contracts to maintain their value.
Since crypto-backed stablecoin are based on smart contracts, they are called on-chain tokens. The key advantage of these stablecoin is decentralization as every transaction is recorded on the blockchain. Some examples of crypto-backed stablecoin are DAI and Wrapped Bitcoin (WBTC).
Commodity-Backed stablecoin
Drawing reference from the narrative of ‘Bitcoin is Digital Gold’, commodity-backed stablecoin derive their value from commodities like gold, silver, oil, or real estate. Since commodities are open to fluctuation in price, these stablecoin are also susceptible to price changes.
On the flip side, commodities are limited by supply unlike fiat money, hence, their value is unlikely to fall drastically. Therefore, commodity-backed stablecoin are being used as hedges against the volatility of other financial markets.
With NFTs maturing as a market and tokenization being adopted in markets like real estate, commodity-backed stablecoin can be utilized as their native tokens. The most prominent examples of commodity-based stablecoin are Tether Gold (XAUT) and Pax Gold (PAXG). Each PAXG is pegged to a 1 troy ounce of physical gold and can be bought and sold across borders. However, the underlying gold remains in the Brinks vaults in London.
Algorithmic stablecoin
Algorithmic stablecoin, as opposed to other types of stablecoin, are not backed by assets but are maintained using complex algorithms. These stablecoin achieve price stability using smart contracts that alter the volume of supply of these tokens. The elasticity of demand and supply is the fulcrum for these stablecoin to revolve around.
If the stablecoin increases in value, smart contracts are generated to supply tokens into circulation. Conversely, if the stablecoin decreases in value, smart contracts sell these tokens which decreases them in circulation. Since they are independent of collateral, the success of algorithmic stablecoin are directly related to their continuous demand.
The need for continuous demand is a bottleneck that limits the growth potential of algorithmic stablecoin. But with innovative mechanisms being developed briskly, there is a possibility for these stablecoin to be stable and scalable with enough incentives for users to leverage them as a medium of exchange.
Ampleforth and Frax Finance are two reliable examples of algorithmic stablecoin.
Conclusion
Today, there are no flawless stablecoin but their inherent qualities provide them a huge window of opportunity for growth and evolution. While lawmakers can see the potential of stablecoin, many have raised concerns over its actual stability. The Biden administration shared that when regulated, stablecoin could “support faster, more efficient, and more inclusive payments options”. Many lawmakers highlight that not all stablecoin are created equally, and despite the general name, one can be riskier than the other. This is what differentiates EURST as a 100% fiat-backed stablecoin that is audited in real time – it offers a strong backing in a very transparent way. The need for stability in the crypto market is not only a bonus for market participants but is a credible antithesis for the narrative of the crypto market being a speculator’s heaven.
The paradox of stablecoin is yet to be solved, after which, it remains to be seen if they replace, complement, or coexist with fiat and central currencies.
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