Stablecoins are digital currencies whose value is pegged to the value of a specific currency, commodity, or financial instrument. The extreme volatility of the most widely used cryptocurrencies, such as Bitcoin (BTC), has made investing in cryptocurrencies less acceptable for everyday transactions. Stablecoins seek to address this issue.
Based on the method used to maintain its value, there are three different kinds of stablecoins.
- Fiat-Collateralized Stablecoins
- Crypto-Collateralized Stablecoins
- Algorithmic Stablecoins
Stablecoins that are “fiat-collateralized” keep a reserve of a fiat currency (or currencies), such as the dollar, as security for the stablecoin’s value. Other types of collateral can be commodities like crude oil or precious metals like gold or silver, however, the majority of fiat-collateralized stablecoins have U.S. dollar reserves.
These reserves are kept up-to-date and frequently audited by independent custodians. Popular stablecoins like USDT, USDC, and BUSD are backed by U.S. dollar reserves and pegged to the dollar.
Stablecoins with cryptocurrency collateral are supported by other cryptocurrencies. Such stablecoins are overcollateralized, meaning that the value of cryptocurrency kept in reserves exceeds the value of the stablecoins issued, because the reserve cryptocurrency may be subject to severe volatility as well.
In order to issue $1 million in a stablecoin backed by cryptocurrency, a reserve cryptocurrency worth $2 million can be kept as insurance against a 50% drop in the value of the reserve cryptocurrency. For instance, MakerDAO’s Dai (DAI) stablecoin is pegged to the US dollar but is backed by Ethereum (ETH) and other cryptocurrencies worth 150% of the DAI stablecoin in circulation.
Stablecoins that use algorithms might or might not have reserves. Their main difference is how a stablecoin maintains its value by using an algorithm to restrict its supply, which is effectively a computer program that follows a predetermined formula.
In a crisis, algorithmic stablecoin issuers are unable to rely on these benefits. On May 11, 2022, the price of the associated Luna token used to peg Terra fell more than 80% overnight, causing the price of the algorithmic stablecoin TerraUSD (UST) to plummet more than 60% and lose its peg to the US dollar.