What are the main types of stablecoins?
As stablecoins have risen in popularity, increasingly novel methods have been introduced to find the most efficient means of pegging said stablecoins to the asset classes they aim to emulate. Some of these examples are characterized by sustained success, while others have crashed and burned in spectacular fashion.
Fiat-pegged (predominantly USD)
These are stablecoins that are backed by a fiat currency like the U.S. dollar. In this category, the fiat currency that backs the stablecoin on a 1:1 basis will remain an off-chain asset—not in any way linked to another traditional cryptocurrency—backed by a reserve and issued by a centralized institution.
The symbiotic relationship between a fiat-pegged stablecoin and the currency backing it requires that the amount of the stablecoin token in circulation must be in tandem with the amount of the fiat in reserve—either in cash or cash equivalents. The biggest and most well-known stablecoins in this category are USDT and USDC.
Unlike fiat-pegged stablecoins, crypto collateral-based stablecoins are those backed by traditional cryptocurrencies, hence decentralized in all forms and open to risk distribution. To withstand fluctuations that could arise from their dependence on cryptocurrencies and their inherent volatility, crypto collateral-based stablecoins are typically over-collateralized i.e. the value of the underlying collateral must exceed the value of the corresponding stablecoin token in circulation.
This is to ensure they maintain their peg and also provides a safety net for users posting collateral, even in the face of market volatility, as it affects underlying cryptocurrencies.
A good example in this category of stablecoins is MakerDAO’s DAI which is currently backed and stable against Ether (ETH) at a minimum 150% collateralization ratio.
Pegged to—but not backed by—the value of a real-world asset, this category of stablecoins depends on on-chain algorithms to keep their prices stable. The algorithm enables the stablecoin to maintain a consistent value and usually link two coins—the stablecoin itself and a related token that backs the stablecoin.
Usually under-collateralized with no particular reserves backing their values, algorithmic stablecoins are programmed to be instructed by specialized algorithms (or smart contracts) that manage their circulating token supply in line with market demand.
Algorithmic stablecoins also come in the following varieties:
- Seigniorage model
The most prominent model utilized by algorithmic stablecoins is one that incorporates a fixed rate, generally 1:1, and relies on arbitrage to maintain its peg. If one side of the rate drops below 1, a trader can simply redeem the appreciated asset for the depreciated asset and pocket the gain.
While this model can potentially be sustainable during stages of market growth, the death spiral of UST following its de-pegging has thrown the viability of this model into question.
The algorithms adjust the number of their circulating tokens as the market price of the fiat currency they track falls below or rises above its actual price.
- Rebase/debase model
Rebase tokens (also known as elastic tokens) are a form of algorithmic stablecoins that control the supply of a coin to maintain its value.
They are usually pegged to another asset but will either mint new tokens (i.e. rebase) or burn existing tokens (i.e. debase) – according to the price movement of the stablecoin – to maintain its value when the price of the stablecoin rises above or below its actual value. Rebase tokens are highly volatile owing to price fluctuations. Their supply is not capped.
- Fractionalized model
An example of a fractionalized algorithmic stablecoin is the now-defunct Titan, as well as the open-source fractional-algorithmic stablecoin, FRAX.