Stable Coins Explained
Stablecoin is a type of cryptocurrency that has its value backed into something. The value of this form of cryptocurrency can be pegged to fiat money, commodity, or other assets. Stablecoins (as the name suggests) aim to be stable, and, with that, to act like a medium of exchange or a reserve of value in a volatile environment, the Crypto Market.
With this stability, stablecoins can act as the medium of exchange in the Crypto Market scenario, but not all of it is stable as the name suggests. This occur based on what the stablecoin is backed by.
There are, mainly, four types of stablecoins: fiat-backed, crypto-backed, commodity-backed, and algorithmic.
Fiat-backed: stablecoin with its value underlied by cash, cash equivalents, or other assets, commonly more liquid assets. So, it can be backed by US Dollars and US Treasuries. Examples of fiat-backed stablecoin: Tether (USDT) and USD Coin (USDC).
Crypto-backed: stablecoin backed by other cryptocurrencies. Due to the volatility of the other cryptocurrencies, this type uses frequently over-collateralization to maintain its value. In other words, it has more underlying components than the price that it aims to have. For example, if the aimed price is USD 1, it will have more than the proportion 1 to 1 in backed assets. Bitcoin (BTC) and ether (ETH) are used commonly in this kind of stablecoin. Example of crypto-backed stablecoin: DAI (DAI).
Commodity-backed: stablecoin backed by commodity (ies). The principle is the same, although now with its value underlied by a commodity. Commodities have less volatility than a stock or a cryptocurrency, but it is still volatile. Example of commodity-backed stablecoin: Paxos Gold (PAXG) — stablecoin of gold.
Algorithmic: stablecoin that its peg relies on algorithms to change its own supply of tokens or the asset underlying its value. This type of stablecoin can have the total supply burned (diminished) or increased to maintain the peg, the same occurring with the balancer asset (it can be another cryptocurrency); all of this functioning only with an algorithm behind. Example of algorithmic stablecoin: terraUSD with its balancer token Luna.
One important consideration is that the price of stablecoins is not supposed to be USD 1 (proportion 1:1), this is only supposed to happen when a specific stablecoin aims to be pegged to US Dollar. Another one is that stablecoins do not have their own blockchains; so, they use blockchains (Layer 1) such as Ethereum, Solana, and Avalanche.
Another common mistake is confusing Central Bank Digital Currency (CBDC) with Stablecoin. Simplifying:
• CBDC — issued by central banks, domestic use with possibly cross-border uses, and total control by the central bank issuer;
• Stablecoin — issued by banks or other finance agents, global use accordingly to the blockchain used, and controlled by single or multiple issuers with the possibility to be supervised by economics agents.
The Stablecoins are important not only for the Crypto Market as a medium of exchange or reserve of value, but also as a DeFi (Decentralized Finance) facilitator who includes more people in the monetarized world, improving their lives.