The crypto market is famous for its extreme volatility, which seems to scare away many investors from engaging with this relatively new asset class. Fortunately, there are special types of cryptocurrencies that almost completely eliminate price changes and withstand even the wildest ups and downs: stablecoins. Read on to find out all you need to know about these unique digital assets.
What is a stablecoin?
The answer is quite simple: a special type of cryptocurrency that has its value pegged to a fiat currency, for instance the USD, EUR, or CHF. As a result, one stablecoin is basically always worth as much as the fiat currency it’s connected to.
As an example, let’s take Tether (USDT), the most popular stablecoin with the biggest market cap. This crypto is pegged to the United States dollar which means 1 USDT always equals 1USD. It’s important to mention that there is often a tiny difference between the values of the two, but for the most part, it’s negligible.
The major subcategories of stablecoins
Stablecoins, while having many similar characteristics, can differ from each other when it comes to fundamentals. Based on how they operate and how they’re built, we can distinguish between centralized, collateralized, uncollateralized, and undercollateralized stablecoins. In the following sections, all of these will be explained and presented using practical examples.
While many crypto tokens are decentralized, there are some that are issued and managed by a central issuer. Tether (USDT), USD Coin (USDC), and STASIS EURO (EURS) are perfect examples of the latter category, as they are both centralized in terms of management and control. Tether is the most popular stablecoin and the 4th biggest cryptocurrency overall, with a market cap of more than $76B.
Centralized cryptocurrencies are a controversial topic within the space. The community’s opinion is polarized: some endorse the idea of combining the benefits of having a central authority, such as quick decision making and efficient management with the innovative features of cryptocurrencies. On the other hand, many argue that the whole point of this asset class is to offer a fully trustless, decentralized way of dealing with money and finance in general to prevent biased behavior and establish directly community controlled networks.
As the name suggests, coins belonging to this category are backed by a certain other asset, in most cases by fiat, or other cryptocurrencies. Projects that issue collateral backed tokens typically should have access to the – at least – equivalent amount of the backing asset.
An example would be if one organization pegged its stablecoin to the US dollar and issued 100,000 of its token, the company would need to hold at least $150,000, or more as a collateral for the tokens issued, thereby guaranteeing their value.
Examples of the above category are Dai (DAI), and Liquidity USD (LUSD), both holding more than what they issued in the collateral asset.
Contrary to their collateralized version, uncollateralized stablecoins are issued without any asset backing them, making them lack an intrinsic value. What could serve as the base of the valuation is the issuing organization, the tokens’ utilities, speculation, or a combination of all the above. In stablecoin’s special case, maintaining a stable valuation is mostly achieved by algorithmic balancing, where the issuer acts a sort of central bank who actively reduces or provides excess supply to increase, or decrease the value of the asset. A perfect example of the above mechanism would be Ampleforth (AMPL).
It could come as a surprise to some that fiat currencies have been, in fact, also uncollateralized since the second half of the 20th century, when the gold standard was removed from US legislation.
To relate back to the characteristics of uncollateralized stablecoins, the value of fiat currencies also derives from the fact that they are backed and accepted by governments and legislative authorities, combined with universal acceptance within a nation or community.
Undercollateralized stablecoins are in between their uncollateralized and collateralized counterparts. Essentially, they are directly backed by a certain asset, however, the issuer holds less of that asset than the issued tokens’ value. Creating an alternative, a sort of hedging of the two other types, some investors prefer this type, while others argue that any uncollateralized asset should not have been issued in the first place, as it can increase the serious risk of wrongdoing, and decrease investments’ security.
Undercollateralized systems often work as a combination of algorithmic balancing and underlying collateral. For instance, Frax (FRAX), an undercollateralized stablecoin utilizes an algorithm that increases, or decreases the collateral backing FRAX depending on market conditions to ensure a stable value throughout.