The 4 Different Types of Crypto Stablecoins Explained

In the crypto world, stablecoins are about the only asset that has something of a predictable trajectory. But stablecoins don’t just come in one form. Different stablecoins have their own dynamics, benefits, and drawbacks depending on what category they fall into. So, let’s discuss the four main types of cryptocurrency stablecoin.

1. Fiat-Backed Stablecoins

Fiat currency isn’t backed by a physical commodity, such as a precious metal (not anymore, at least). Fiat money is issued by a government as a non-fiat (commodity-backed) currency would, though it still relies on a supply-demand balance to maintain value. The U.S. dollar, for example, is fiat currency (though it used to be non-fiat when it was backed by gold).

So, a fiat-backed stablecoin is pegged to and backed by any asset that isn’t itself backed by a physical commodity. Most fiat-backed stablecoins are backed in a 1:1 ratio. For example, USD Coin (USDC) is a stablecoin backed in a 1:1 ratio to the U.S. dollar, meaning one USDC is equivalent to one dollar. So, for every single USDC that goes into circulation, one U.S. dollar is kept in reserve.

While fiat-backed cryptocurrencies are more stable than typical cryptocurrencies, they are centralized. This is so the 1:1 ratio with their collateral can be maintained. This means that central authorities control USD Coin, which requires users to put their faith in strangers when investing in fiat-backed stablecoins.

2. Crypto-Backed Stablecoins

As the name suggests, crypto-backed stablecoins are backed by cryptocurrencies. This may seem a little oxymoronic, as traditional cryptocurrencies are so volatile that it would often be impossible to peg a stablecoin to one in a 1:1 ratio. Well, crypto-backed stablecoins do not work exactly the same as fiat-backed stablecoins, as they do not use a 1:1 peg.

Instead, crypto-backed stablecoins are often over-collateralized to compensate for the very high probability that the collateral being used will experience a price change. This is often known as a “security pledge.”

Take Dai (DAI), for example. This stablecoin can be borrowed from the MakerDAO lending platform as long as the borrower deposits some crypto collateral. At the moment, users can use Ethereum (ETH), Basic Attention Token (BAT), Compound Token (COMP), and USD Coin (USDC). Anyone wanting to borrow DAI must deposit more collateral than they’re taking out. And, if their collateral loses too much value while it’s deposited, they may have to liquidate it and return the borrowed DAI.

Wrapped Bitcoin (WBTC) is another example of a crypto-backed stablecoin. Though this coin exists on the Ethereum blockchain, it is backed by Bitcoin. In fact, the Wrapped Bitcoin project currently holds over 280,000 BTC as a reserve for WBTC, with Ethereum being used as collateral.

3. Commodity-Backed Stablecoins

Commodity-backed stablecoins are backed by physical commodities, such as gold, silver, or oil. Even real estate can be used as collateral for this kind of stablecoin. In a sense, commodity-backed stablecoins are a digital representation of a valuable real-world asset. But why would anyone need this?

Commodity-backed stablecoins are particularly useful for those who find it difficult to get their hands on literal precious materials but still want to invest in them. Investing in a commodity-backed stablecoin, say one that is backed by gold, gives an investor something that holds the same value as the collateral and can be liquidated when desired. And, because the value of these assets isn’t nearly as volatile as that of fiat or cryptocurrencies, investing in commodity-backed stablecoins can be a safer route.

Gold is generally the most popular collateral to use for commodity-backed stablecoins. Take Paxos Gold (PAXG), for example. The value of one PAXG is pegged 1:1 to the value of one fine troy ounce of a London Good Delivery gold bar. At the time of writing, this sits at around $1,800, though the price fluctuates daily.

Tether Gold (XAUt) is another example of a gold-backed stablecoin. Like Paxos Gold, one XAUt token is pegged 1:1 to the value of one fine troy ounce of gold on a London Good Delivery bar, so its value also currently sits at around $1,800.

4. Algorithmic Stablecoins

Unlike the other stablecoin types discussed here, algorithmic stablecoins aren’t backed by other assets. Rather, they are dictated by computer algorithms designed to maintain value. While an algorithmic stablecoin can be pegged to (i.e., have its price matched to) another asset, they do not have any collateral. The algorithms used by this kind of stablecoin generally control the availability of the coin, which, in turn, can control its value.

You may have seen the term “algorithmic stablecoin” in the news throughout May and June 2022 during the crash of Terra’s two cryptocurrencies, Luna and TerraUSD. The latter of these two coins, TerraUSD, was an algorithmic stablecoin pegged to (not backed by) the U.S. dollar that maintained its value through its burn-mint relationship with Luna (LUNA).

If Terra’s price exceeded one USD in value, some of it would be burned, but if it fell below the dollar, some LUNA would be burned. However, a series of events led to investors dumping their UST, which caused a huge surge in supply. And, as is often the case in the crypto industry, a coin’s price is likely to set to plummet if demand is low and supply is high. This also caused a huge crash in the price of LUNA.

The UST/LUNA catastrophe stands as a lesson on why algorithmic stablecoins are risky. Without legitimate collateral, the chance of price destabilization is considerably higher. However, algorithmic stablecoins do not require centralization, nor do they need to be controlled by a central entity, which speaks to the decentralized structure that crypto enthusiasts respect and trust.

Stablecoins Have an Exciting Future in the Crypto Industry

Unlike the majority of other cryptocurrencies, stablecoins offer investors a much higher level of reliability in terms of value. While stablecoins can, and have, crashed before, such an occurrence is much less likely for them than for traditional cryptos. So, if the volatility of the crypto market is putting you off, check out some of the big stablecoins out there to see if they could work for you.