Stablecoins are meant to exude value stability in a volatile environment by being tied to a stable asset such as precious metals or fiat currencies.
Investors can use tokens to store crypto assets at a stable value. They are also essential for trading on exchanges, since most of the trading pairs on cryptocurrency exchanges such as Binance or Coinbase are traded against stablecoins.
But there are significant differences between the various stablecoins, for example in the way the currency is protected or in the risk assessment. Therefore, below is a brief overview of the different types of tokens.
stablecoins backed by Fiat
The most common variant are fiat-backed stablecoins. As the name suggests, these are cryptocurrencies that are physically backed by fiat currencies (such as US dollars or euros) and are therefore considered relatively safe. In most cases, projects accumulate physical reserves of fiat currency at a ratio of 1: 1 to the outstanding amount.
The best known representatives of this category are sometimes Tether (USDT) and USD Coin (USDC). With a market capitalization of US $ 78.8 and $ 50 billion, they are the top dogs of the stablecoin industry and at the same time an important part of the crypto economy. But the centralization of these projects always offers room for discussion.
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stablecoins backed by raw materials
Commodity-backed stablecoins are also physically supported. However, security here is not provided by national currencies, but by commodities such as precious metals, real estate, or even oil. The most popular asset is gold. Due to the physical security, this type of stablecoin is also considered to be relatively safe.
Digix Gold (DGX) provides a practical example of this. Commodity stablecoin is based on the price of gold. 1 DGX corresponds to the price of one gram of gold. According to the Foundation, the physical reserves are stored in Singapore. The project is currently seeking a license in the Asian financial stronghold.
stablecoins supported by cryptocurrencies
The third category is cryptocurrency-hedged stablecoins, which are also based on the performance of fiat currencies. However, at least one cryptocurrency such as Bitcoin or Ether (ETH) is deposited as collateral. The degree of protection within this category can vary. Typically, cryptocurrency-backed stablecoins are over-secured to provide a financial buffer against falling prices. One example is DAI.
The stablecoin is pegged to the US dollar and backed by ether. The following example illustrates how the system works:
Let’s say $ 200 in ETH equals $ 100 in DAI. This gives you 200% protection. For example, if the ETH rate drops by 25%, the $ 100 in DAI is still covered by $ 150 in ether.
The advantage of cryptocurrency-backed stablecoins lies in their decentralization, because unlike fiat or commodity-related stablecoins, collateral is not managed by an entity that investors need to trust. The downside is once again associated with higher risk, as higher price fluctuations are possible.
Finally, there are unsecured algorithmic stablecoins that attempt to track the price of a fiat currency (usually USD). This type of stable-value cryptocurrency is mainly characterized by the fact that there is no protection from a virtual or physical asset. Rather, an algorithm regulates the amount of circulation.
In practice, this is how it works: in case of high demand, the algorithm creates new coins in order to keep the price of the stablecoin as constant as possible, for example at 1 USD. On the other hand, if the demand decreases, the algorithm buys back the excess supply until the price has approached the USD 1 threshold again. In most cases, the stablecoins are then “destroyed”.
In general, algorithmic stablecoins are valued for their high degree of decentralization. However, this is offset by an equally high level of risk, as the most recent example of Terra impressively demonstrates.
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