Markets, traditional or crypto, have been both strangers to “stability”. Fluctuations are seen as the only truth in markets, and we have witnessed this recently in the crypto market more than ever.
From Bitcoin to Ethereum, Coins have faced the brunt of the negative trend of 2022. While we witnessed the plummeting of major coins in red, there was a unique kind of behavior portrayed by some stable coins despite the plunging market.
Stablecoins are cryptocurrencies whose value is tied to a stable asset like precious metals or fiat currencies like the US dollar. The multiple stablecoin categories are based on the assets that back them up. Stablecoins’ value is less susceptible to price movements because of their backing by other assets, hence the name.
During transactions, they provide quick processing, security, and privacy of cryptocurrencies such as Bitcoin and Ethereum. In addition, they have stable prices and are not as volatile as other cryptocurrencies, hence, providing a win-win situation for the investor.
Let us look at the types of stablecoins in the market.
Types of Stablecoins
Fiat-collateralized stablecoins are backed by a fiat currency such as the Euro, the British Pound, or the US Dollar. Fiat-collateralized stablecoins hold a fiat currency reserve as collateral for producing a sufficient amount of cryptocurrency coins.
Major examples of Fiat-Collateralised Stablecoins are USD Tether (USDT) and USD Coin (USDC).
Commodity Collateralised Stablecoins
Tangible assets such as precious metals, oil, and real estate are used to back commodity-backed stablecoins. Gold is the most commonly utilized commodity as collateral for commodity-backed stablecoins. Owners of commodity-collateralized stablecoins are effectively exercising ownership over a commodity. Commodities, in general, have the potential to appreciate in value over time. Hence, these kinds of stablecoins offer the possibility of higher incentives.
Gold Security Currency (GSX), Tether Gold (XAUT), and Paxos Gold (PAXG) are some of the most popular gold-backed stablecoins.
Stablecoins that are crypto-collateralized are backed by other cryptocurrencies. Because the reserve cryptocurrency may be volatile, such stablecoins are over-collateralized, meaning that the value of the cryptocurrency held in reserves exceeds the value of the stablecoins produced. Decentralization is the most important characteristic of Crypto-Collateralised Stablecoin.
Stablecoins supported by crypto could help processes become more trustless by improving security and transparency. The benefit of decentralization is that a single body does not control your finances. Furthermore, some crypto-backed stablecoins have many cryptocurrencies backing them to ensure efficient risk distribution.
An example of Crypto-Collateralised Stablecoins is DAI. Dai was backed by Ether when it was introduced.
The prices of algorithmic (non-collateralized) stablecoins are maintained using a method similar to that of a central bank but without the need for reserves. Such operations are similar to central bank printing banknotes to maintain the value of a fiat currency. This can be done by launching a decentralized network with a self-contained smart contract.
In essence, algorithmic stablecoins could provide stability based on market supply and demand. It’s also worth noting that algorithmic stablecoins have the greatest degree of decentralization and independence.
The difference is that a central bank transparently determines monetary policy based on well-defined parameters, and its standing as a legal tender issuer adds to the credibility of that policy.
In a crisis, algorithmic stablecoin issuers cannot rely on such advantages. For instance, on May 11, 2022, the price of the TerraUSD (UST) algorithmic stablecoin plummeted by more than 60%, destroying its peg to the US dollar, while the price of the sister Luna token used to peg Terra plummeted by more than 80%.
Stablecoins are backed by either collateral or by the demand-supply algorithm. They are a lesser volatile alternative to investing in the highly volatile crypto market – yet are not foolproof. Hence, investors should do their own research before investing in the market.
Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn’t represent any investment advice or WazirX’s official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.