Stable coins are cryptocurrencies with a low price-volatility. Stable coin creators peg them to a stable asset such as a fiat currency. And this relative stability makes them suitable for everyday transactions as a medium of exchange as well as a store of value. So, stable coins play an important role in decentralized finance applications and also serve as Central Bank Digital Currencies.
Price volatility is a common feature of most cryptocurrencies. Unsurprisingly, constant swings of prices make it difficult for us to use cryptocurrencies for everyday transactions, as a medium of exchange. This problem of volatility is what stable coins are attempting to solve. To achieve stability, creators of stable coins peg them to relatively stable fiat currencies such as US dollars. And stable coins are quite popular because investors like the idea of having the best of both worlds- the advantages of cryptocurrencies and lower price fluctuations. For some investors, stable coins are ‘US dollars on a blockchain’! Some of the well-known stable coins are USDT, Tether and Gemini Dollar. Given their relative stability, several decentralized finance (DeFi) protocols use stable coins.
Types of stable coins
We can classify stable coins based on how they relate to other stable assets or in other words, how we collateralize them. And the major types of stable coins include, fiat-collateralized, gold-collateralized, crypto-collateralized and non-collateralized or algorithmic, stable coins. Let’s look at each of these types.
- Fiat-collateralized stable coins
These are cryptocurrencies backed by a reserve of a real currency and stored in a real-world location (i.e., off chain), often controlled by a third party. Usually, the collateralization ratio is one-to-one. And these currencies are also audited to make sure that they are, in fact, collateralized. Examples of these types of stable coins are Tether (USDT), Gemini Dollar and PAXOS Dollar. Another variant of this is Petro, an oil-reserves backed stable coin which the government of Venezuela created. - Gold-collateralized stable coins
As the name implies, these stable coins have investment-grade gold backing them. Examples of this type of stable coins are Cache Gold (CGT), Tether Gold (XAUt) and PAX Gold (PAXG). - Crypto-collateralized stable coins
Yes, you read that right! How can cryptocurrencies provide stability to other cryptocurrencies? The way to solve this issue is to over-collateralize. And several decentralized protocols (DeFi) use this type of stable coins. Obviously, the drawback of this type is that, in highly volatile markets, there is a risk of liquidation. For example, MakerDAO, a popular DeFi protocol, uses this type of stable coin named DAI for transactions. - Non-collateralized or Algorithmic stable coins
Unlike the above two categories, these coins are not collateralized at all. Here, software algorithms maintain the prices of stable coins. As you might have guessed, this is very much like how central banks maintain the price stability of regular currencies by controlling money supply. Probably, this is the ideal type of stable coin that marries the advantages of decentralization (with all the virtues of a blockchain) with a good price stability. Obviously, the major disadvantage of this type is that there is no collateral whatsoever and if the technology malfunctions, investors will have nothing to fall back on. Prominent examples include Terra (LUNA) and Ampleforth (AMPL).
Disadvantages of stable coins
The major drawbacks of stable coins are two-fold. One, these coins do not have absolute stability. They are only relatively stable when compared to cryptocurrencies in general. Second, investors often do not have enough proof that the collaterals are faithfully maintained.
The future of stable coins
Given the price stability of these coins, investors seem to veer towards holding stable coins. And the volume of stable coins is growing steadily. Also, regulators in most countries seem to favor the growth of stable coins and this augurs well for this category of cryptocurrencies. Central Bank Digital Currencies (CBDCs) that several central banks are currently experimenting with, are going to be stable coins.