The Holy Grail Of Stablecoins: What Are Different Types Of Stablecoins?

2021/08/06 11:09:47

The current bear cycle in the crypto market has driven considerable volatility among stablecoins. If you’ve been actively following the latest developments in the market, you’re already aware of the limelight on LUNA and the UST stablecoin. As a crypto investor, it is nearly impossible to escape discussions about stablecoins within this context. But if you’d like to learn more about these digital assets and their importance in the overall market, here’s something that can help.

Introduction: What are Stablecoins?

Stablecoins are one of the core primitives of the DeFi space. They entail all the benefits of being a cryptocurrency, such as transparency, security, and privacy, without the volatility and price fluctuations that are prevalent in other cryptocurrencies like Bitcoin and Ethereum. Stablecoins are not managed by a central bank like fiat currencies but by private organizations, DAOs and even consortia.

Fiat currencies and certain physical assets (gold, silver, etc.) are more stable than Bitcoin, Ethereum, and other crypto assets. Stablecoins are the type of cryptocurrencies that are pegged to other assets such as gold or the US dollar. As a result, stablecoins do not suffer from extreme price volatility and provide a safe gateway for traders and businesses, similar to fiat currency.

USDT Has Lion’s Share of Stablecoin Market | Source: TheBlockCrypto

Stablecoins growth has been phenomenal this year. To give a perspective, $30 billion in stablecoins were available in January 2021. Today, the total supply of stablecoins has surpassed $138 billion, all thanks to their low volatility. Among all the stablecoins, USDT is still responsible for over 45% of the total stablecoins market cap.

Stablecoins are chain agnostic, which means that they are available across many different public blockchains. USDT, the largest stablecoin by market cap, is available on Tron, Ethereum, Bitcoin (Omni), Solana, EOS, Algorand, Liquid, and SLP. Due to high transaction fees on Bitcoin and Ethereum, users have the option to use other blockchains that have much lower transaction fees. However, USDT (or any other stablecoin) from one blockchain can't be transferred to an address of another blockchain.

Types of Stablecoins

There are four primary types of stablecoins based on the underlying collateral: fiat-backed, crypto-backed, algorithm-backed, and commodity-backed. Let's discuss each one of these types to understand how they are different from each other.

Fiat-backed Stablecoins

These stablecoins are backed 1:1 by an underlying fiat currency asset as collateral, such as the US Dollar, Euro, or Canadian Dollar. All the underlying collateral is off-chain with an issuer or a financial institution. USDT, TUSD, GUSD, and PAX are some of the common fiat-backed stablecoins.

Crypto-backed Stablecoins

Unlike the fiat collateral, these stablecoins are backed by on-chain crypto collateral. Because of the volatility of the underlying crypto assets, these stablecoins are over-collateralized, which means more collateral is needed to mint these stablecoins. The best example of crypto-backed stablecoins is DAI, with a collateralized ratio of 200% (To mint $1,000 worth of DAI, you need to deposit $2,000 worth of ETH as collateral).

Algorithm-backed Stablecoins

These stablecoins are backed by specialized algorithms and smart contracts that govern and manage the price by increasing or decreasing the total supply of tokens in circulation. These stablecoins maintain a $1 market value but are not pegged to any physical underlying fiat or crypto asset.

Commodity-backed Stablecoins

These stablecoins are backed by physical assets like precious metals (gold, silver), oil, and real estate. Gold and silver are the most popular commodity, and they are kept as the underlying collateral. The stable value of these commodity-backed stablecoins is pegged to the equivalent dollar value of the underlying commodities. Popular examples of these stablecoins include Tether Gold (XAUT) and Paxos Gold (PAXG).

Most Popular Stablecoins by Market Cap and Usage

Let’s explore the most trending stablecoins in the market based on market cap and liquidity. Here’s everything you need to know to get started with stablecoins:

Tether (USDT)

The world’s leading stablecoin in terms of market cap, market share, and liquidity, Tether’s USDT is the most popularly used digital asset in this category. Owing to its high liquidity, it is the most popular base currency for trading digital assets on leading crypto exchanges, including KuCoin.

As the most widely accepted among stablecoins, USDT makes it possible for businesses and individuals to send and receive payments in crypto instantly. Digital transactions with USDT enjoy low transaction costs, instant settlements, high security, and the added benefit of price stability.

Tether, the company behind the USDT stablecoin, maintains its peg to the US dollar through fiat-backed reserves. The reserves are spread across Treasury bills, reverse repo notes, cash and bank deposits, commercial paper and certificates of deposit as well as money market funds.

After coming under some criticism for the opaque nature of its reserves a few years ago, Tether made this information public and brought on board independent accountants to audit their USD reserves. This has helped increase users’ trust in the USDT and supported its continued lead in the stablecoin market.

Enjoying a first mover advantage, Tether (USDT) is available for use across multiple blockchain ecosystems, including Ethereum, TRON, EOS, Algorand, Avalanche, and Solana.

USD Coin (USDC)

USD Coin (USDC) is a stablecoin created and managed by the Centre Consortium, a member-based group founded by Circle and Coinbase in 2018. The fiat-backed stablecoin USDC is pegged to the value of the US dollar via investment in dollar-denominated reserves to maintain this peg.

It is the second most widely used stablecoin and enjoys the second largest market cap in this category after USDC. On account of its high liquidity, leading crypto exchanges worldwide offer crypto trading pairs with USDC as the base currency for trading on their platforms.

Every unit of USDC in circulation is backed by a dollar held in reserves by Circle. The Centre consortium holds dollar reserves in a combination of cash and short-term US Treasury bonds to maintain the value of the USDC against the USD.

What makes the USDC extremely popular is that it is backed and issued by regulated financial institutions. The high acceptance of this stablecoin among regulatory authorities gives it an edge over several of its competitors in the low volatility stablecoin market.

USD Coin can be used across Ethereum, Avalanche, TRON, Stellar, Solana, Algorand, Flow, and Hedera blockchains.

Binance USD (BUSD)

Binance USD (BUSD) is also one of the most trusted and regulated stablecoins available in the crypto market at present. Created by leading crypto exchange Binance and issued in partnership with Paxos, BUSD enjoys the approval of the New York State Department of Financial Services (NYDFS).

Binance’s own version of the digital dollar is available for purchase or redemption on their platform as well as on Paxos at zero fees. It is available for trading on leading cryptocurrency exchanges around the world, KuCoin included.

BUSD’s dollar-backed reserves are stored in the form of cash, cash equivalents, and US Treasury Bills. The collateral maintaining BUSD’s peg to the USD is audited and reported on a monthly basis by Withum.

The BUSD cryptocurrency is supported as an ERC-20 token on the Ethereum blockchain and as a BEP-2 token on the Binance Chain.

TerraUSD (UST)

The leading algorithm-backed stablecoin, TerraUSD (UST) functions very differently from the other leading stablecoins as its peg to the US dollar is maintained by smart contracts running on the Terra blockchain. These smart contracts monitor the total supply and demand of UST tokens in the market and automatically burn or mint LUNA tokens - the native cryptocurrency of Terra, to maintain the price stability of the UST.

USDT/UST Price Chart on KuCoin TradingView | Source: KuCoin

Earlier this year, the Luna Foundation Guard (LFG) committed to buying up Bitcoin as reserves for the UST stablecoin. This move will further help with the price stability mechanism of the UST and drive up investor confidence and its use in the market.

As of May 2022, LFG’s total reserves stand at around $2.91 billion. Its BTC reserves make up for more than 90% of this share. The recent market volatility has forced LFG to deploy these reserves to help prop up the value of the UST, which has slipped below its pegged value of the US dollar.

LFG is expected to receive a loan of 750 million UST from Terraform Labs while it is also set to loan out $750 million worth of BTC from its reserves to stabilize the volatility in the UST. These moves should help rebalance the demand for TerraUSD stablecoin and rebound its value towards the USD.

The TerraUSD is supported on several leading blockchains, including Terra, Ethereum, Solana, Harmony, Binance Smart Chain, Cosmos, Avalanche, Fantom, and Polygon.

Dai (DAI)

The second algorithm-backed stablecoin in the list, the credit for DAI’s creation and management goes to MakerDAO, one of the most established DAOs in the crypto market. The decentralized stablecoin runs on the Ethereum blockchain and its price stability mechanism is managed by the Maker Protocol and its native token MKR using the power of smart contracts.

Having been around for several years, the crypto-backed stablecoin Dai enjoys widespread adoption, being integrated into more than 400 applications and services. DAI is supported by Leading DeFi protocols, crypto wallets, blockchain-based games, NFT marketplaces, and more.

Dai is backed by collateral consisting of a combination of multiple cryptocurrencies. Whenever the demand for DAI rises, more of such collateral gets deposited via smart contracts to back the stablecoin and maintain its peg to the USD.

The multi-collateral version of the DAI which exists at present was launched in November 2019. Dai is especially popular among crypto investors as it is one of the most transparently managed stablecoins operated by a decentralized autonomous organization instead of a central bank or centralized financial institution.

DAI is an ERC-20 token that can be used on the Ethereum blockchain.

Stablecoins: A Better Medium of Exchange

Stablecoins are known for a better medium of exchange compared to other mainstream cryptocurrencies like Bitcoin and Ethereum due to less volatility and wild price fluctuations. They tend to bridge the gap between fiat currencies and cryptocurrencies, and provide a safe gateway for businesses and investors who want less volatility and associated risks.

Stablecoins are also a primary vehicle and a primitive for the world of DeFi. The recent growth in stablecoins mainly came from the surge in demand for various DeFi products. Stablecoins are widely used to serve as collateral in many DeFi lending protocols and in the process of liquidity mining across various decentralized exchanges (DEX).

Due to the less volatile nature of stablecoins, many traders use them to hedge against volatility and secure their holdings in other assets. If the price of Bitcoin is falling down, investors and traders can instantly sell them for stablecoins to avoid further losses. We have seen during the bear markets that the on-chain volume of stablecoins increases, as we last saw in March 2021.

Adjusted On-chain Volume of Stablecoins | Source: TheBlockCrypto

Wrapping Up

Stablecoins are an integral part of the cryptocurrency and DeFi ecosystem. The low volatility of stablecoins makes them a perfect medium of exchange, especially for small businesses planning to accept crypto payments but cannot absorb the volatility of mainstream cryptocurrencies. Due to an uprising demand for stablecoins, they became one of the top interest-bearing assets, overtaking several other cryptocurrencies like Bitcoin and Ethereum, across many DeF lending protocols, earning the highest APY.