March 6, 2023

What Are Different Types of Stablecoins?

Stablecoins are alternative crypto assets that have gained prominence in the recent times. Our blogpost walks you through the different types of stablecoins and their applications as well as use cases.

What Are Different Types of Stablecoins?

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Until a few years ago, when people heard about cryptocurrencies, Bitcoin was the first thing they thought about. Then came other crypto assets such as altcoins and stablecoins.

The explosion in the crypto community caused these assets to gain immense traction. However, even now, traditional market investors and regulators have shown interest in altcoins and stablecoins.

The main reason for the such growing popularity is the potential embedded in these stablecoins. It reduces the volatile nature of cryptocurrencies by maintaining a fixed value over time.

In this article, we will talk about stablecoins and the different types available.

What are Stablecoins?

Just as the name implies, stablecoins are a class of cryptocurrencies with price stability and are usually pegged to a real currency such as the U.S dollar or gold. They are digital assets designed to maintain a fixed value over time where one unit of a stablecoin support equals one unit of corresponding fiat currency.

Stablecoins, like every other cryptocurrency, is built on the blockchain system. However, they are backed by fiat currencies that are pegged to them to achieve stability. These stablecoins track the underlying asset, such as the U.S dollar, and reflect its value. It's a process that ensures its value is stable or matches fiat currencies.

The issuing organization of any stablecoin sets up a reserve with the financial institution that owns the real currency or assets. For example, the issuing organization could set up a reserve of 1 billion dollars with the financial institution and issue 1 billion coins with a fixed value of $1 per coin.

These stablecoins differ from coins such as Bitcoin, Ethereum, and other altcoins whose price is based on the market forces from investors trading for profits.

Why Are They Important?

One major challenge with cryptocurrencies is the drastic price fluctuations, which sometimes make it difficult to use them for regular transactions. So basicallym for, pricing, things can be extremely difficult.

On the other hand, stablecoins are pegged and possess the characteristics of other coins because they are open to everyone. Therefore, these stablecoins are used as functional currency within a crypto brokerage.

For instance, traders can convert Bitcoin and other altcoins to stablecoins such as Tether, USDC, and BUSD, and not into fiat currencies.

Fiat currencies are issued by the bank and aren't available 24/7. Stablecoins, however, are available almost always.

In addition, stablecoins are built on the blockchain system and can be used with smart contracts.

Types of Stablecoins with examples

Commodity-backed stablecoins

Commodity-backed stablecoins are coins backed by physical assets such as precious metals, oil, and real estate. One of the most popular precious metals for commodity backing is gold, and the owners of these commodity-backed stablecoins exercise their ownership rights over tangible assets with actual value.

But it is essential to understand that even these commodities can either lose or gain value as their prices still fluctuate. Traditionally, items such as gold, oil, and other precious metals are scarce – restricted to the high class of society. But these stablecoins are paving opportunities for average individuals to invest in these precious metals irrespective of their geographical locations.

An example of a commodity-backed stablecoin is Digix Gold (DGX). DGX is an ERC-20 token built on the Ethereum network and backed by a physical gold reserve.

One DGX is pegged to one gram of gold, and users can redeem physical gold bars from the reserve. Other examples of this type of stablecoin are the Tiberius Coin, shortened as TCX, and the SwissRealCoin which shrank as SRC.

Crypto Collateral Stablecoins

Cryptocurrencies can also be stablecoins, and this may seem a bit out of place because of their volatility. However, these stablecoins are backed by other cryptocurrencies that serve as collateral.

The crypto-backed stablecoins occur on-chain and employ intelligent contracts while independent of a central issuer. An example of a crypto-backed stablecoin is the Wrapped Bitcoin (WBTC), which is backed by Bitcoin and built on the Ethereum blockchain.

The reserve cryptocurrencies are susceptible to high volatilities, so they are over-collateralized (i.e. the value of cryptocurrencies held in reserve exceeds the unit of stablecoins issued) to ensure the pegs are intact during times of high volatility in the crypto market. For instance, $5 million worth of cryptocurrencies can be held in reserve for issuing$2.5 million worth of stablecoins.

One outstanding benefit of crypto-backed stablecoins is that they offer better decentralization when compared to fiat-backed stablecoins. These crypto-backed stablecoins allow processes to be more trustless and secure while not having to rely on any single entity controlling your funds.

Some of these stablecoins have the backing of several cryptocurrencies, which helps spread the risk more efficiently. Furthermore, crypto-backed stablecoins have adequate liquidity.

Fiat-backed Stablecoins

This type of stablecoin is a digital representation of fiat currencies held by a regulated institution such as traditional banks. Compared to other stablecoins, fiat-backed coins are backed by fiat currencies.

These stablecoins rely heavily on the value of underlying assets and must remain directly proportional to the number of coins in the market. An example of this stablecoin is the Tether (USDT), where 1 USDT equals 1 USD.

Some other examples of this stablecoin are the USD Coin (USDC) and the Binance USD (BUSD), which Binance and Paxos founded.

You can use these stablecoins to make payments because they are reliable. But when investors want to purchase fiat-backed stablecoins, they have to exchange their fiat currencies or some other cryptocurrencies for them.

The same goes for when they need to sell their fiat-backed cryptocurrencies. Investors either convert them to fiat currencies or exchange them for other cryptocurrencies.

Fiat-backed cryptocurrencies are not built on blockchain technology, nor do they need miners. Instead, they employ centralized servers and rely on third parties to manage their transactions.

Seigniorage-Style Stablecoins

It is also known as an algorithmic stablecoin. These stablecoins are pretty different from the others mentioned above. For example, seigniorage-backed does not have any reserve in smart contracts because they are self-collateralized, and no collateral is used to mint these stablecoins.

They employ complex algorithms to control the assets' supply. And by doing so, they can keep their value stable.

They operate similarly to central banks since they don't depend on some reserve assets to maintain the stability of the currency they issue.

The difference, however, is that central banks set policies based on specific parameters, and their position as currency issuers strengthens the policy's credibility.

Final Thoughts

Stablecoins are digital assets that bring the stability of fiat currencies into blockchain technology. As such, they can be used for different transactions. For example, the peace these coins bring to the ecosystem makes them useful for trading cryptocurrencies and staking.

Furthermore, stablecoins are a vital component in cryptocurrency adoption in the credit and loan markets.

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