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What Is a Stablecoin?

There Are Three Types of Stablecoins. What Makes Them Different?

Aug 29, 2022

Stablecoins recently garnered worldwide headlines due to an experimental stablecoin known as TerraUSD, or UST, which collapsed and resulted in billions of dollars lost. The lesson? Not all stablecoins are created equal. While stablecoins were initially designed to store value in between crypto asset trades, today they serve a variety of purposes. Below is a review of the different types of stablecoins and how they operate. 

A stablecoin is a digital currency recorded on a blockchain whose value is “pegged,” or tied, to a stable reserve such as a currency or commodity. Because stablecoin value is tied to other assets, it is possible to avoid the fluctuations inherent in other cryptocurrencies. Stablecoins ease domestic and international transactions by providing fast, secure, and low-fee transfers that operate worldwide and settle instantly on a peer-to-peer basis. 

There are three main types of stablecoins: asset-backed with traditional collateral, asset-backed with crypto collateral, and algorithmic stablecoins. 

1) Asset-backed with traditional collateral

Trust is fundamental for traditional, asset-backed stablecoins. Using conventional collateral, assets are principally separated into commodities and fiat money. For full reserve stablecoins like USD Coin (USDC), trust is garnered through only partnering with blue chip banks, custodians, and auditors like BlackRock, Bank of New York Mellon, and Grant Thornton, and providing transparent records of USDC reserves to anyone with an internet connection, including monthly attestations. While USDC is fully collateralized using cash and cash equivalents like U.S. Treasuries, there are other stablecoins such as Tether (USDT) that use a mix of currencies and commodities to give the stablecoin value. 

Generally, collateral can operate in one of two ways: 

  • Fiat-backed stablecoins are pegged to a specific fiat currency like USD or Euros. This peg uses automated stability mechanisms to achieve a 1:1 ratio between the number of stablecoins in circulation and the amount of fiat currency in reserve. For instance, JPMorgan has issued the first bank-backed digital token called “JPM Coin” for instantly settling transactions between clients in their wholesale banking business. 
  • Commodity-and-fiat-backed stablecoins are pegged to a hybrid of commodities and a specific fiat currency like USD. This is similar to using a basket of goods to establish price stability. 

2) Asset-backed with crypto asset collateral

There are also asset-backed stablecoins that use crypto asset collateral to create price stability. Since the collateral supporting these stablecoins is held on-chain, these types of stablecoins typically claim to rely less on third parties. 

To verify that reserves are fully collateralized, people can inspect the open source code as well as the condition of the reserves, which creates a high level of transparency. Using this model, regular audits become more open and economical. Therefore, on-chain designs enjoy a greater degree of transparency by using fewer trusted parties than off-chain designs. In addition, stablecoins collateralized using crypto assets can reduce banking requirements. Stablecoins collateralized by crypto assets rely on fewer traditional assets like cash and cash equivalents and, therefore, run into fewer potential liquidity concerns, or other potential holding complications.

Compared to full reserve asset-backed stablecoins, crypto-collateralized stablecoins like MakerDAO, also known as DAI, face stability issues. In particular, it becomes more difficult for the market to trust that the peg can be maintained when crypto assets fluctuate so sharply. The crypto-collateralized mechanism may require additional tokens such as DAI, which may increase the degree of complexity.

3) Algorithmic stablecoins

Algorithmic stablecoins use algorithms to mimic central banks’ monetary policies to prevent inflation by keeping track of market supply and demand. When the number of stablecoins in the market is too large, the price of algorithmically supported stablecoins decreases. To prevent such depreciation, smart contracts automatically reduce the amount of stablecoins in the market by employing certain monetary strategies that function like the Federal Reserve selling U.S. Treasuries to tighten monetary policy. Similarly, stablecoins used to buy debt are destroyed, decreasing money supply, and increasing stablecoin price. Algorithmic stablecoins are more complicated than asset-backed stablecoins and have presented many challenges in maintaining their 1:1 peg to the reference currency. As Securitize Capital’s Chief Investment Officer, Adil Abdulali, recently told Barron's regarding the Terra LUNA system, "Algorithmic incentives for stablecoin pegs remain an unsolved problem. Old-fashioned, reserve-backed stablecoins such as USDC continue to be the only viable digital dollars we work with."

Terra-LUNA’s $60 billion collapse in May 2022 underscores why people have had concerns with experimental algorithmic stablecoins. There remain liquidity, regulatory, and market risks involved in investing in stablecoin products because each stablecoin functions differently. Therefore, choosing the right stablecoin such as an asset-backed stablecoin with traditional collateral is paramount to success.

To learn more about how stablecoin yield products can complement your investment strategy, get in touch with Adil Abdulali

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