Two Main Types of Stablecoins Explained Simply

Stablecoins are a type of cryptocurrency designed to maintain a stable value relative to a specific asset, such as the US dollar.

One of the main benefits of stablecoins is that they can be used as a safe-haven asset during market volatility, similar to how people often turn to gold or cash.

There are two main types of stablecoins: fiat-collateralized and cryptocurrency-collateralized.

Fiat-collateralized stablecoins are backed by a reserve of traditional currencies, such as the US dollar, which helps maintain their value.

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There are two main types of stablecoins: fiat-collateralized and crypto-collateralized. Fiat-collateralized stablecoins are backed by sovereign currency, such as the US dollar, and require the issuer to maintain reserves worth the same amount as the tokens issued. This type of stablecoin is seen in TrueUSD and Tether (USDT).

Crypto-collateralized stablecoins, on the other hand, are backed by other cryptocurrencies, which can be prone to high volatility. To mitigate this risk, these stablecoins are often overcollateralized, with the value of the reserve cryptocurrency exceeding the value of the stablecoins issued. MakerDAO's Dai (DAI) is an example of a crypto-collateralized stablecoin.

Here are some examples of stablecoins by type:

Fiat-collateralized stablecoins are backed by a reserve of a fiat currency, such as the U.S. dollar, to maintain the stablecoin's value. This ensures that the stablecoin's value remains stable and pegged to the fiat currency.

Tether (USDT) and TrueUSD (TUSD) are popular stablecoins backed by U.S. dollar reserves and denominated at parity to the dollar. As of late June 2024, Tether (USDT) was the third-largest cryptocurrency by market capitalization, worth more than $112 billion.

Fiat-collateralized stablecoins maintain a reserve of a fiat currency, such as the U.S. dollar, as collateral, assuring the stablecoin's value. The reserves are maintained by independent custodians and are regularly audited.

The reserves can be in the form of the asset the token represents in the first place, bank deposits, or other cash equivalents. For example, Tether (USDT) and USD Coin (USDC) are both pegged to the U.S. Dollar.

Examples of fiat-collateralized stablecoins include Tether (USDT), TrueUSD (TUSD), USD Coin (USDC), and First Digital USD (FDUSD). Here is a list of some notable fiat-collateralized stablecoins:

Fiat-collateralized stablecoins can be invested in on some of the best crypto exchanges and apps like Kraken and Coinbase. They offer a reliable and secure way to store and transfer value, with a value that is pegged to a fiat currency.

Crypto-collateralized stablecoins are backed by other cryptocurrencies, which can be prone to high volatility. This means they're often overcollateralized, with the value of the reserve cryptocurrency exceeding the value of the stablecoins issued.

To give you an idea of this, MakerDAO's Dai (DAI) stablecoin is backed by Ethereum (ETH) and other cryptocurrencies worth about 155% of the DAI stablecoin in circulation.

This overcollateralization is a deliberate strategy to ensure the stability of the stablecoin. By holding a larger amount of reserve cryptocurrency, issuers can absorb potential losses and maintain the peg to the underlying asset.

The value of crypto-collateralized stablecoins is pegged to that of other cryptocurrencies, making them not conventionally safe. This is because the underlying asset can also be highly volatile.

Here are some key characteristics of crypto-collateralized stablecoins:

This type of stablecoin is often preferred by crypto natives who prioritize censorship resistance and stability, as seen with the growing adoption of Liquity USD (LUSD).

Commodity-Backed Assets are a type of stablecoin that uses commodities like gold, silver, or oil as collateral to provide stability.

Some commodity-backed stablecoins hold the commodity using third-party custodians, like Tether Gold (XAUt), which is thought to be held by an unnamed custodian in Switzerland.

Commodities like gold are the most popular choice for collateral in commodity-backed stablecoins, offering a way to participate in the gold market without the challenges of physically owning gold bars.

Tether Gold (XAUt) and Paxos Gold (PAXG) are two examples of commodity-backed stablecoins that allow holders to benefit from the stability of gold while still having the utility of a cryptocurrency.

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Algorithmic stablecoins are a type of stablecoin that uses algorithms to control the supply of the coin and maintain its value. This is done through smart contracts and complex formulas that adjust the coin's supply based on market demand.

In an algorithmic stablecoin, the price of the coin is controlled by issuing or buying back tokens when the price rises or falls. For instance, if the price of the coin rises above its peg, the algorithm issues more tokens to increase the supply and bring the price back down.

Algorithmic stablecoins don't rely on centralized entities or collateral to achieve stability, which lowers the risk of regulatory control and mismanagement. They are mostly decentralized and trustless, supporting the goal of creating a financial system that is less vulnerable to censorship and external control.

Algorithmic stablecoins offer a unique set of advantages that set them apart from traditional stablecoins.

One of the main advantages is that they don't depend on centralized entities, which lowers the risk of regulatory control and mismanagement. This makes them a more decentralized and trustless option.

Algorithmic stablecoins are designed to be more resistant to censorship and external control, which is a major benefit in today's financial landscape.

By using algorithms to control the supply and circulation of their tokens, algorithmic stablecoins can issue new tokens when the price goes above the target price, reducing its value by increasing supply. Conversely, they stop issuing tokens if the price goes below the target, raising the price by limiting supply.

Let's take a look at some examples of stablecoins. PayPal USD (PYUSD) is a stablecoin that was issued by Paxos Trust and launched in August 2023. It's fully backed by U.S. Dollar deposits and short-term U.S. Treasuries.

PYUSD is listed on the Ethereum blockchain as an ERC-20 token. TrueUSD (TUSD) is another stablecoin that was launched in mid-2018 by TrustToken, now operating as Archblock. It's also listed on the Ethereum blockchain.

Here are some key facts about these two stablecoins:

Tether (USDT) is a fiat-collateralized stablecoin, meaning its value is pegged to a traditional currency. It's issued by Tether Limited, a company owned by iFinex.

Tether has a long history, originally launched as RealCoin in July 2014 and rebranded to Tether in November 2014. This was a strategic move to differentiate itself in the market.

The USDT stablecoin has become the largest in the cryptocurrency market, with a market capitalization of over $112 billion. This is a testament to its widespread adoption and trust in the digital currency space.

Tether is supported on multiple blockchains, including Bitcoin (Omni and Liquid protocols), Ethereum, Avalanche, Kava, Polkadot, TRON, EOS, Algorand, and Solana. This broad support allows users to easily integrate USDT into their existing workflows.

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USD Coin (USDC) is a fiat-collateralized stablecoin that is pegged to the U.S. Dollar. It was first released on September 26, 2018, as a result of a collaboration between Circle and Coinbase.

USDC is designed to tokenize U.S. Dollars and allow them to be used on public blockchains and the internet. It has a market cap of $32 Billion and is supported on multiple blockchains including Ethereum, Avalanche, Solana, Algorand, TRON, and Stellar.

Here's a breakdown of USDC's supported blockchains:

USDC is a fiat-collateralized stablecoin, meaning its value is pegged to the U.S. Dollar through a reserve of U.S. Dollars held by its issuer, Circle.

Stablecoins can be categorized based on their working mechanisms, which is a key aspect to understand when exploring this type of cryptocurrency.

There are three main types of stablecoins: crypto-collateralized, algorithmic, and fiat-collateralized stablecoins.

Fiat-backed stablecoins have their downsides, and one major disadvantage is their centralized nature. This reintroduces third-party risk and regulation, going against crypto's trustless and censorship-resistant goals.

A central organization is needed to manage fiat-backed stablecoins, making them vulnerable to regulatory pressure, mismanagement, or corruption. If reserves or distribution are mishandled, the coin could lose its peg.

Counterparty risk is a significant risk for fiat-backed stablecoins, relying on reserves stored in a bank. If the bank fails, the reserves go along with it, leaving the issuer with no liquidity and the stablecoin to depeg.

Fiat-backed stablecoins must follow local regulations, which means they're subject to inflationary government currencies and changing laws. If laws change suddenly, issuers may be forced to stop operations, causing the coin to lose its value.

Stablecoins derive their market value from an external reference, making them a unique breed of cryptocurrency.

There are three main categories of stablecoins: crypto-collateralized, algorithmic, and fiat-collateralized stablecoins. Each of these categories has its own working mechanism, which affects how they maintain their value.

The key to stablecoins is their ability to stabilize their value, which is achieved through their respective mechanisms. For example, crypto-collateralized stablecoins use other cryptocurrencies as collateral to maintain their value.

Here are the three main categories of stablecoins and their working mechanisms: