A Complete Guide to Stablecoins
It's not just Tether now.
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From 2018 onwards, new stablecoins have been pouring onto the markets. Although many are straightforward fiat-collateralized variants on the original stablecoin, Tether, many other projects are also innovating on the stablecoin concept. Therefore, this guide categorizes and explains the different types of stablecoins on the market today.
The Rising Popularity of Stablecoins
One reason that stablecoins have become so prevalent over the last couple of years is, quite simply, that there’s a demand for them. A Binance report published in November 2019 indicated that around 96 percent of institutions surveyed were using stablecoins, predominantly fiat-backed.
Although the report didn’t elaborate on how the stablecoins are used, it seems most likely that they represent a fast and inexpensive alternative to fiat deposits and withdrawals and a means of avoiding Bitcoin’s volatility. This is also how they became popular among retail exchange users, particularly on exchanges that don’t offer the opportunity to purchase crypto with fiat.
Currently, few stablecoins have any kind of regulated status. Those that do, such as Gemini Dollar and TrueUSD, have obtained it on a voluntary basis. However, the regulatory status of stablecoins could soon change, based on recent statements from agencies such as FinCEN that stablecoins represent a form of money transmission. If this happens, users of stablecoins may find themselves subject to know-your-customer and anti-money-laundering checks.
Types of Stablecoins
By definition, a stablecoin is a token designed with stability in mind. How that stability is achieved is where stablecoins vary. Although there are now dozens of different types of them in circulation, they all fall into one of three broad categories: collateralized stablecoins, non-collateralized stablecoins and hybrid coins.
Collateralized Stablecoins can be split into four sub-categories.
Fiat-backed stablecoins are simply tokens whose value is pegged to and backed by, reserves of fiat currency. Tether (USDT) was the first stablecoin and introduced the overall concept of a fiat-backed digital currency pegged to the value of the US dollar and backed by reserves representing the total market capitalization.
However, over the years since it launched in 2014, Tether was criticized for its failure to produce any audit documentation that could prove it was fully collateralized by the equivalent US Dollar value. This came to a head in April 2019 after the New York Attorney General issued a court order against Tether’s parent company iFinex. It alleged that Bitfinex used Tether reserves to remain solvent. Technically,Tether is likely to be fully collateralized — though part of it is in the form of debt owed from within the iFinex group.
The incident didn’t topple Tether from its position as the reigning stablecoin of choice, ranking fourth on CoinMarketCap at the time of writing. Nevertheless, if Tether were to sink tomorrow, there’s no guarantee that the company could make good on the total value of its obligations to token holders.
There are plenty of alternatives to choose from that offer a greater degree of transparency. True USD has published its audit documentation confirming reserves. Paxos Standard and Gemini Dollar are both regulated in the state of New York. USD Coin is backed by reserves held in financial institutions.
Although many fiat-backed stablecoins are pegged to a single fiat currency, it doesn’t necessarily have to be so. The plan for Facebook’s Libra cryptocurrency was that it would be pegged to a basket of national currencies, similar to the IMF’s Special Drawing Right.
A more recent development in the fiat-backed stablecoin space, and one that will perhaps prove to trump all its predecessors, is the concept of Central Bank Digital Currency. Both the European Central Bank and the People’s Republic of China have been exploring their own versions of a CBDC. Although the idea has its critics, the IMF has recently given cautious approval.
Critics of fiat-backed stablecoins point to the fact that they derive their value from centralized banking systems. Even further, that they undermine the economic principles of cryptocurrencies. From these arguments emerged crypto-backed stablecoins.
Crypto-backed stablecoins are backed by cryptocurrency but use protocols to ensure that the value doesn’t fluctuate with the price of the token backing the stablecoin. Dai is the biggest and best example. The DAI token is pegged to the value of the US dollar and is backed by Ether. DAI holds its price via the Maker smart contract, which creates and destroys MKR tokens in response to fluctuations in the price of ETH.
Maker recently launched multi-collateral Dai tokens, enabling users to stake Basic Attention Token to back DAI.
Crypto-backed stablecoins are less popular than their fiat-backed counterparts. Nevertheless, there are still a few others of note. Synthetix uses a similar methodology to Dai and is also based on Ethereum, although it isn’t as popular. Currently, there is more ETH staked in Maker than any other DeFi project.
Recently, Money on Chain launched the first bitcoin-backed stablecoin, running on the Bitcoin-based RSK smart contract platform. Like DAI, Money on Chain also uses a two-token system, with the Dollar on Chain (DOC) token pegged to the US dollar, and a second token called BitPRO assuming the volatility risk of DOC being backed by BTC.
Crypto-backed stablecoins with Maker, in particular, have proven to be very popular among fans of decentralization and can be a way of earning passive income for anyone wanting to stake the underlying tokens. However, one concern is that if there is suddenly a massive drop in the markets, the coins could end up under-collateralized.
Asset-backed stablecoins are underpinned by reserves of assets other than fiat or cryptocurrencies. Although this category is still relatively new, it has the potential to become very broad. These tokens aren’t necessarily pegged to the price of a fiat currency but to the value of their underlying asset.
For example, Venezuela’s famous crypto failure Petro was linked to the price of oil. Digix is backed by and pegged to the price of gold. Similarly, Paxos, the issuer of the Paxos Standard, also offers a gold-backed token called Paxos Gold.
Asset-backed stablecoins are less used as a medium of exchange and more as a way of investing or trading in the underlying asset, without actually having to take physical custody. Furthermore, because asset-backed tokens represent a title of ownership, there may be legal or regulatory implications depending on the jurisdiction.
Also known as algorithmic stablecoins, or seigniorage supply coins, these coins don’t have any underlying asset. They’re somewhat comparable to fiat currencies issued by central banks in that their value is increased or decreased according to supply and demand, as a means of dampening volatility. The difference is that central banks determine the supply for fiat currencies, whereas with a non-collateralized stablecoin, this is performed by an algorithm or a decentralized model of governance based on holder votes.
This type of stablecoin is currently less well-known than the others described above. Bitbay is one example, which combines algorithmic control with voter-based governance.
One reason why these coins have proven less popular than other types of stablecoins is perhaps that they aren’t particularly effective at achieving stability. For example, NuBits, which was a DAO-governed non-collateralized stablecoin, failed after its USD peg broke several times. The lack of reserve means that there is nothing to hedge against a sudden drop in demand.
Hybrid stablecoins allege to combine the best of all stablecoin features, by offering a mix of reserve backing for a token that also uses algorithms or voting to offset volatility. However, they are often structured in quite a complex way.
Boreal, the stablecoin issued by Auroradao (now rebranded under IDEX), is one example of a hybrid stablecoin. It’s backed by a combination of ETH reserves and loans, with the price managed by Decentralized Capital, the decentralized bank of IDEX ecosystem.
Another example, more centralized and more recently launched, is Saga. It’s an ambitious project, tipped as a rival to Facebook’s Libra, and with an advisory team that includes Nobel Laureate in Economics Myron Scholes. The ERC-20 Saga token is pegged to the IMF SDR and will initially be backed by reserves. However, the project foresees that over time, the value of the token will be determined solely by the underlying smart contract.
The stablecoin space is evolving fast. However, it seems unlikely that the market can sustain the sheer number of new tokens that have appeared over the last two years, particularly in the fiat-backed category. Perhaps regulation may cause some to drop away, or perhaps market forces may come into play and squeeze out the lesser-used coins. Either way, it seems there is plenty of appetite for stablecoins as an asset class, meaning the successful tokens stand a good chance of lasting well into the future.