What Are The Different Types of Stablecoins & How do They Work?

Paigambar Mohan Raj
Source: Coinbase

Stablecoins are crypto tokens that are pegged to a certain fiat currency, or to precious or rare metal. Fiat currencies are usually global currencies such as the US Dollar or the Euro. Stablecoins offer a bridge between fiat currencies and cryptocurrencies. Launched in 2014, BitUSD was the first ever stablecoin.

Now although stablecoins are crypto tokens pegged to the price of another asset, there are different types of stablecoins based on their collateral structure. Let us take a look.

Different types of stablecoins

Based on the collateral structure, there are four main types of stablecoins.

Fiat-backed: As the name suggests, this type of coin is backed by real fiat currency reserves. They usually have a 1:1 ratio to their underlying backing. One coin would be equivalent to one unit of currency, such as one dollar or one euro, according to the 1:1 ratio. As a result, every stablecoin backed by fiat has actual fiat money in a bank account to support it. The stablecoin’s administrator will transfer the appropriate amount of fiat money from its reserve to the user’s bank account when a user redeems their coins. At the same time, an equivalent number of coins are destroyed or removed from circulation.

Because of their structural benefit, fiat-backed coins are among the simplest of stablecoins.

Examples of such coins are USD Coin (USDC) and Tether (USDT). Tether is the largest stablecoin issuer by market cap. However, many have raised issues with Tether’s lack of a proper audit. Some believe that the firm does not have the necessary reserves in backing.

Crypto-backed: These coins are backed by cryptocurrencies. Since traditional cryptocurrencies are so volatile, it may seem a little paradoxical to link a stablecoin to one in a 1:1 ratio. However, crypto-backed coins don’t use a 1:1 peg, and hence don’t function exactly the same as fiat-backed stablecoins. Instead, these assets are over-collateralized. This is to make up for the extremely high chance that the collateral would see a price fluctuation. It is often referred to as a “security pledge.”

Examples of such coins are DAI and Wrapped BTC.

Apart from fiat and crypto

Commodity-backed: These tokens are backed by physical commodities, such as gold, silver, or oil. In a sense, commodify-backed tokens are a digital representation of a real-world asset. Commodity-backed stablecoins are very helpful to people who desire to invest in precious materials but find it difficult to obtain actual precious materials. When an investor purchases a token backed by a commodity, they receive a currency that is liquid and has the same value as the collateral. Gold is the most popular commodity for such coins.

Examples of commodity-backed coins include Paxos Gold (PAXG) and Tether Gold (XAUt). Both these tokens are pegged 1:1 to the value of one fine troy ounce of a London Good Delivery gold bar.

Algorithmic: Algorithmic stablecoins aren’t backed by any other assets, in contrast to the other stablecoins. Instead, they are governed by computer code. Although an algorithmic coin can be anchored to another asset, they lack any form of security. These stablecoins usually use algorithms to regulate the coin’s supply, which in turn can regulate its value.

Terra’s UST was probably the most popular algorithmic stablecoin as it was at the heart of the crypto market crash of 2022. The value of TerraUSD was preserved via its burn-mint connection to Luna (LUNA). Some Terra would be burned if the price was more than one USD, whereas some LUNA would be burned if the price was lower. However, a series of events caused investors to dump their UST, leading to a surge in supply. This led to a massive spiral which caused the crash of both tokens.