It’s not uncommon to see a crypto coin undergo massive variations in a couple of hours. This is unheard of in traditional markets that have ways to prevent such drastic changes. However, there is one sub-concept in cryptocurrencies that offer far more stability compared to traditional ones and suitable ground for beginners: Stablecoins.
Stablecoins are cryptocurrencies that real-world assets such as commodities, gold, or fiat money support. Basically, they are an amalgamation of both traditional assets as well as crypto. Not only do they have a stable valuation, but they also provide the utility and mobility of a cryptocurrency.
Some popular examples of cryptocurrencies include USDC (Digital coin pegged to the U.S. Dollar), USDT (Tether) & DAI (DAI). However, stablecoins are of multiple types, some of which we are going to talk about today.
To keep things simple, we’ll talk about four different types of stablecoins:
- Fiat Backed Stablecoins.
- Cryptocurrency Backed Stablecoins.
- Commodities Backed Stablecoins.
- Non-collateraized Stablecoins.
As the name suggests, fiat-backed stablecoins maintain fiat currency as collateral, according to which, they issue an optimal number of crypto coins. The cost of maintaining the stability of the stablecoin is equivalent to the cost of maintaining the backing reserve. Other than that, it also includes the cost of legal compliance, maintaining licenses, auditors and the business infrastructure.
Moreover, independent custodians maintain these reserves that they have regular checkups for the necessary compliance. Popular examples of these stablecoins include Tether and TrueUSD which have a value equivalent to a 1 U.S. Dollar.
Cryptocurrency Backed Stablecoins
Quite similar to Fiat-backed Stablecoins, Cryptocurrency Backed Stablecoins involve cryptocurrencies as their collateral. However, these stablecoins have higher volatility compared to the former. A thing to note here is, these stablecoins are over-collateralized. What does this mean?
Bascially, if you use a higher amount of crypto as a reserve for your stablecoin, that particular stablecoin will experience less violent actions from the reserve. Let’s take an example. If you use $5,000 worth of BTC as a reserve and issue $500 worth of stablecoin, that stablecoin will experience 1/10th of the performance that BTC experiences.
Besides this, regular audits and monitoring can further improve the stablecoin’s stability. Popular examples of these stablecoins include DAI which is pegged against the U.S. Dollar and has the backing of Ethereum (ETH).
Commodities Backed Stablecoins
Commodities Backed stablecoins take advantage of physical assets/commodities as a reserve for issuing their stablecoins. Moreover, commodities that are generally used as reserves include precious metals such as gold, silver, etcetera. Besides this, it can also include oil and real estate.
Some of the popular stablecoins include Tether Gold and Paxos Gold, both of which are pegged to the price of gold. However, such stablecoins fluctuate more often than fiat-backed stablecoins and have the potential to lose value.
These stablecoins don’t involve any commodities or physical assets as reserves. In fact, what they derive on is a working mechanism. Basically, they use a consensus mechanism to increase/decrease the token supply on the situations and conditions present at that time.
Moreover, they also implement smart contracts on a decentralized platform, which performs in an autonomous manner. Popular examples of such stablecoins include Basecoin which while is pegged to the U.S. dollar, doesn’t rely on it as a reserve but as a marker for keeping its stability. However, the concept came under criticism majorly due to the fact of misunderstanding the value of a currency.