Stablecoins play an important role in the crypto ecosystem by (i) providing predictability for users who do not want the associated risk of holding volatile assets while (ii) offering access to crypto products and services.Most stablecoins are Ethereum ERC-20 tokens so in order to send those stablecoins, there would need to be some etherin the wallet to pay for the transaction fee.
Fiat-backed
The most well-known form of stablecoin is pegged to an existing fiat, or government-issued currency such as US Dollar, British Pound or Euro. They are supposed to be pegged at a 1:1 rate with cash or cash equivalents by the issuing entity, meaning the value should always be the value of the underlying asset.
Tether’s USDT and Circle’s USDC are examples of fiat-backed stablecoins.
Commodity-backed
Commodity-backed coins are a form of stablecoin whose value is collateralised by a physical asset, typically precious metals like gold or silver. They are less exposed to inflation and offer the chance for investors to invest in the underlying asset without having to source and secure the assets themselves.
Typically they are considered harder to liquidate than other stablecoins. Examples of commodity-backed stablecoins include Pax Gold (PAXG) and Tether Gold (XAUt).
In the future, it is theorised they could be anything that holds value, such as oil, a basket of shares and stocks or real estate - but examples of these are yet to reach widespread adoption.
Cryptocurrency-backed
These are a form of stablecoins pegged to another more established cryptocurrency, typically ether and bitcoin, and track the value of the underlying asset. They can be pegged to the value of the cryptocurrency itself or track the value of a fiat currency.
A stablecoin pegged to another cryptocurrency at a 1:1 ratio can be used to switch across different blockchains to use other services. Wrapped coins such as Wrapped Bitcoin (WBTC) and Wrapped Ether (WETH) are examples. They let users deposit the native coin and get a synthetic version of the same currency that can be used across different chains and DeFi protocols.
A stablecoin pegged to a fiat currency uses mechanisms to balance the collateral required and ensure price stability. They are over-collateralised to manage market fluctuations so the value of the crypto held exceeds the amount of stablecoins issued. For example, MakerDAO pools ether to create collateral for a stablecoin. Once a level of collateral is reached, it is able to issue more of the stablecoin DAI, which maintains a value of $1.
Algorithmic
Algorithmic stablecoins represent an innovative approach to maintaining price stability without relying on collateral, blending principles of traditional finance with programmable money.
Algorithmic stablecoins use algorithms to balance the supply and demand of the issued stablecoin and another cryptocurrency that backs them.
By adjusting the supply algorithmically, expanding or contracting the stablecoin supply if the value goes over or under the desired peg aims to create a stable value by creating arbitrage opportunities between the two currencies. Some offer bonds or seigniorage to bet on future expansions.
Algorithmic stablecoins are considered the highest-risk form of stablecoin and are yet to be fully battle-tested in extreme conditions. When a pegged stablecoin begins to fail, the feedback loop of selling begets more selling, and things can quickly fall apart. Most notably, the implosion of Terra’s UST stablecoin and associated cryptocurrency LUNA, which wiped out $45 billion of value in 72 hours in 2022.
