Fiat currencies are the currencies you and I use every day to buy groceries and services such as the U.S. dollar, the British pound or the Euro (depending on where you are in the world). Fiat currencies offer a stable and largely predictable amount of value, making them suitable for both short and long term financial transactions. Stablecoins attempt to bridge the gap between these stable options and cryptocurrencies, which have shown volatility but offer greater utility benefits.
Utility benefits of crypto include fast financial transfers between two accounts, international transfers that are a lot cheaper than using banks and a wider access to financial services.
4 Types of Stablecoins
- Fiat-Backed Stablecoins: Stablecoins backed by real-world currencies in a one-to-one ratio.
- Commodity-Backed Stablecoins: Stablecoins that use commodities like gold, real estate or metals to provide their stability.
- Crypto-Backed Stablecoins: Stablecoins that use one or more cryptocurrencies as collateral.
- Algorithmic Stablecoins: Stablecoins that use algorithms to control their supply and achieve stability in the marketplace.
How Do Stablecoins Work?
There are four main types of stablecoins in circulation: fiat-backed, commodity-backed, crypto-backed and algorithmic.
1. Fiat-Backed Stablecoins
Fiat-backed stablecoins are the cryptocurrencies most closely related to fiat (or traditional) currencies because they are backed by real-world currencies. Each fiat-backed stablecoin is tied to a specific fiat currency in a one-to-one ratio. The most common fiat currency to use is the U.S. dollar.
The stablecoin issuer ensures stability of their cryptocurrency by keeping fiat currency as collateral with a financial institution. The stablecoin always has a set amount of fiat currency in reserve that’s proportionate to the stablecoins it has issued. For example, if a stablecoin issuer has one million U.S. dollars in reserve, it might only offer one million stablecoins, each worth one U.S. dollar.
2. Commodity-Backed Stablecoins
Commodity-backed stablecoins are cryptocurrencies that use commodities such as gold, real estate or metals as collateral to provide their stability. Of these, gold is generally the most popular commodity used as collateral for commodity-backed stablecoins.
Examples here include Paxos Gold (PAXG) or Tether Gold (xAUT). These specific Stablecoins allow holders to participate in the gold market and have the utility benefits of a cryptocurrency without the challenges of physically owning gold bars.
3. Crypto-Backed Stablecoins
Crypto-backed stablecoins are cryptocurrencies that use one or more cryptocurrencies as collateral to provide their stability. These stablecoins use a mix of smart contracts on the blockchain to lock in cryptocurrency reserves instead of relying on a central financial institution to hold reserves like fiat-backed cryptocurrencies.
The process works like this: The buyer locks up their original cryptocurrency (e.g. Ethereum) in a smart contract in return for an equivalent amount in stablecoins. One of the more popular stablecoins to use this approach is the DAI stablecoin.
4. Algorithmic Stablecoins
Algorithmic stablecoins are the outlier in that they do not use any form of collateral to achieve their stability. Instead, these stablecoins achieve their price stability by using algorithms to control the supply and circulation of their tokens on the marketplace. These stablecoins will issue new tokens when the price of stablecoins goes above the target price or above the fiat currency it is tracking. This will reduce its price by increasing supply. Conversely, these stablecoins will stop issuing tokens if the price goes below the target, which will raise the price by limiting supply.
Why Are Stablecoins Important to Cryptocurrency?
Stablecoins have become an important part of the cryptocurrency ecosystem because they provide a cryptocurrency option wherein stability is a key requirement of the financial transaction.
Stablecoins offer a way for consumers to use cryptocurrencies to buy financial products that require more stability such as mortgages and some insurances, thus opening up new markets and financial options for cryptocurrencies that were traditionally restricted to fiat currencies.
Cryptocurrencies are typically much more volatile than traditional assets such as stocks, commodities or currencies. For example, in May 2017, Bitcoin reached a price of $2,000 but then skyrocketed to an eye-popping $19,000 by December 2017. In 2020 as the world entered Covid lockdowns, Bitcoin’s price was around $7,000 but then skyrocketed again to over $19,000 by November 2020.
This volatility means it’s hard to predict and rely on the value of a cryptocurrency over the medium or long term. Without the ability to rely on the value of these coins, cryptocurrencies are less suitable for financial transactions that require a stable value over a longer period of time, such as real estate transactions.
Stablecoins were invented to fill this need and provide an important addition to the cryptocurrency marketplace. Stablecoins were created to provide stability, long-term purchasing power and the predictability of a fiat currency alongside the utility benefits of cryptocurrencies. These utility benefits may include fast and straightforward international money transfers without the expensive fees charged by banks.
The Future of Stablecoins
Stablecoins have become a popular option for consumers wanting to own cryptocurrencies but who also desire the stability and predictability of fiat currencies. As of writing this article, the stablecoin market is worth nearly 140 billion U.S. dollars. The stablecoin with the highest market capitalization value is Tether, which is pegged to the U.S. dollar as its fiat-backed currency. Tether has a total market value of just over 66 billion U.S. dollars.
That said, some have called for more regulation around stablecoins given their rapid and popular growth. Stablecoins have significant potential to disrupt traditional payment systems and financial infrastructure while also being the clearest cryptocurrency competition to fiat currencies, which are carefully regulated by governmental bodies and central banks. This may mean stablecoin providers come under scrutiny as their cryptocurrencies displace traditional fiat currencies while providing new forms of financial products and platforms.