Types of Stablecoins and How Do They Work
For a trader, volatile cryptos are good as they can allow larger profit margins. For an investor looking for a currency to store value, this is a significant disadvantage. In addition to the high transaction fees, this is also one of the main reasons why many companies do not accept currencies such as Bitcoin as a means of payment. When a currency fluctuates within a few hours, it is difficult to use it as a means of payment.
Stablecoins aim to offer a solution to this problem. These are cryptocurrencies that are less susceptible to price fluctuations. The idea of a price-stable cryptocurrency was already discussed in 2014. However, the first projects of this kind only started in 2017 with Basecoin, Carbon, or MakerDAO. From these ideas, a stablecoin was born.
So, what is a stablecoin? A stablecoin is a digital currency connected to a “stable” reserve asset such as the US dollar or gold. Stablecoins come in various forms: fiat-backed, crypto-backed, commodity-backed, and algorithmic.
How do Stablecoins work?
The stablecoins segment has developed significantly over the past year. Decentralized stablecoins, for example, are more transparent and also more stable than conventional stablecoins because their value is automatically stabilized. As decentralized stablecoins become larger, they can provide more stability and transparency within the traditional financial system.
To put it simply, a stablecoin is an asset-based on the blockchain. This asset is tied to a specific price, usually one US dollar.
Here are the advantages of stablecoin that attract many investors:
· Due to this price-fixing, holders of stablecoins are independent of the fluctuations of the crypto market.
· Stablecoins offer a secure and stable investment solution.
· Assets invested in stablecoins remain in the crypto space and can be invested more quickly in the growing DeFi sector.
To ensure their legitimacy as a means of payment, stablecoins must be backed by fiat currency, other cryptocurrencies, or on-chain tokens.
Types of Stablecoins
Each stablecoin project has developed its own mechanism, but they generally boil down to four basic models. Find more information in this article below.
1. Fiat-Collateralized Stablecoins
This model is used by Tether, for example. Fiat currency like the US dollar can back the crypto’s value. With this mechanism, a centralized company or financial institution holds assets and issues tokens in return. This gives the digital token value because it represents a claim on another asset with a certain value.
However, the problem with this approach is that it is controlled by a centralized company. As this model involves fiat currency, the issuing party must have a particular basic trust that they actually have the appropriate assets to pay out the tokens. Fiat currencies introduce serious counterparty risk for token holders. The example of Tether shows this difficulty because the solvency and legitimacy of the company were publicly questioned several times in the past.
2. Commodity-Collateralized Stablecoins
Commodity-backed stablecoins are backed by the value of commodities, such as gold, oil, diamonds, silver, and other precious metals. The most popular commodity to be collateralized as a backing asset is gold; Tether Gold (XAUT) and Paxos Gold (PAXG) are the most common examples here.
Commodity-backed stablecoins are backed by rare gems, gold, oil, and real estate. Of these types, stablecoins backed by precious metals are the most commonly seen. While commodity-backed stablecoins are less prone to inflation than fiat-backed ones, they are also less liquid and harder to redeem.
3. Crypto-Collateralized Stablecoins
This approach aims to create stablecoins backed by other trusted assets on the blockchain. This model was initially developed by BitShares but is also used by other stablecoins. Here security is backed by another decentralized cryptocurrency. This approach has the advantage of being decentralized. The collateral is stored confidentially in a smart contract, so users do not rely on third parties.
However, the problem with this approach is that the collateral intended to back the stablecoins is itself a volatile cryptocurrency. If the value of this cryptocurrency falls too quickly, the issued stablecoins may no longer be adequately secured. The solution would be overinsurance. However, this would result in inefficient use of capital, and larger amounts of money would have to be frozen as collateral compared to the first model.
4. Non-Collateralized Stablecoins
Uncollateralized stablecoins are price-stable cryptocurrencies that are not backed by collateral. Most implementations currently use an algorithm. Depending on the current price of the coin, more algorithmic stablecoins will be issued or bought from the open market. This is intended to be a counter-regulation to keep the course as stable as possible.
The advantage of this type of algorithmic stablecoins is that it is independent of other currencies. In addition, the system is decentralized as it is not under the control of a third party but is solely controlled by the algorithm.
However, the most severe disadvantage is that there is no pledged security in the event of a crash since the value of the stablecoin is not tied to any other asset in that case.
What Can You Do with a Stablecoin?
Now that we’ve explained what stablecoins are let’s move on to what we can do with them. Lend them to generate profits. Lending stablecoins has a significant benefit as it takes market volatility out of the equation.
Through the lending CeFi and DeFi platforms, investors can earn above-average interest rates, which are higher than the usual interest rates in traditional finance. Most banks offer annual interest rates that do not exceed 1%, while interest rates for stablecoins range from 4% to 12% per year. Many lending platforms even offer daily interest payouts, allowing investors to earn on compound interest.
