Stablecoins are one of the essential components of the cryptoverse. They aren’t nearly as volatile as other cryptocurrencies because they are usually pegged at a 1:1 ratio with fiat currencies like USD, other real-world assets, and sometimes even cryptocurrencies.
Top 5 stablecoins
While stablecoins were initially developed as a possible solution to overcome the price volatility experienced by other cryptocurrencies, they have since become a vital component of the ever-expanding decentralized finance (DeFi) sector.
Per a recent research report compiled by crypto Exchange AAX, in as little as three years, the combined market capitalization of fiat-pegged stablecoins has crossed past $181 billion – experiencing nearly 5,400% growth between Jan 2019 and April 2022. At the same time, the total volume of adjusted on-chain stablecoin has skyrocketed from $8.81 billion to $464 billion, registering an increase of almost 5,150%.
Several different types of stablecoins are classified into two broad categories: centralized and decentralized. Each of these categories comes with its own advantages and drawbacks. To help you better understand the difference between centralized and decentralized stablecoins, let us first take a closer look at how stablecoins work in the crypto space.
Stablecoins: Centralized And Decentralized
Stablecoins are designed so that they can be pegged with multiple sources, including fiat currencies, other cryptocurrencies, precious metals, and even algorithmic functions. Since the core aim of stablecoins is to offer traders access to more stability than other cryptocurrencies, the most prominent stablecoins are generally pegged at a 1:1 ratio with the US Dollar.
The reason is that a stablecoin backed by a fiat currency will become more “stable” as it will be linked to centralized financial institutions (central banks and such) that can easily step in and control prices when the market valuations are volatile. In this context, stablecoins that aren’t backed by fiat but with a cryptocurrency, like Bitcoin (BTC), may experience extreme volatility because there is no regulatory body to step in and control the prices.
As we mentioned above, stablecoins can be classified into two categories:
Centralized (Custodial) Stablecoins
Simply put, centralized stablecoins are usually fiat-backed and connected with a third-party custodian like a non-bank financial company, banks, and other organizations. Reserves that match stablecoin issuance are usually invested in highly liquid assets like US Treasuries, money market instruments, commercial paper, and cash. All centralized stablecoins achieve “stability” via a 1:1 peg with fiat currencies like USD, EUR, AUD, and others.
Some of the most-commonly used centralized stablecoins include Tether (USDT), USD Coin (USDC), Binance USD (BUSD), Gemini Dollar (GUSD), TrueUSD (TUSD), and PAX Dollar (USDP).
That said, fiat-backed stablecoins are essentially tokenized IOUs deployed on a blockchain network (Ethereum, for instance). Through minting and redemption mechanisms, centralized stablecoins balance supply and demand.
Unlike other cryptocurrencies with wildly fluctuating values, fiat-backed stablecoins experience fewer fluctuations. Additionally, users may mint stablecoins by depositing equivalent fiat with a custodian and then redeeming or burning the tokenized versions to receive their fiat in return.
The popularity of fiat-backed stablecoins is higher than other stablecoins, primarily because they were the first stablecoins to enter the crypto market and are easy to understand (and use). However, the major drawbacks of centralized stablecoins include the over-dependence on a single entity and lack of transparency.
While fiat-backed stablecoins are indeed less volatile, their centralized operating processes increase counterparty risks while at the same time going against the core principles of blockchain technology (transparency and decentralization).
Decentralized (Non-custodial) Stablecoins
Decentralized stablecoins can be further subdivided into two categories:
Crypto-backed stablecoins: These stablecoins are backed by other crypto assets. Since the underlying asset is itself highly volatile, crypto-backed stablecoins are generally overcollateralized to ensure stability. For instance, a crypto-backed stablecoin worth $1 might be backed by a crypto asset worth $2. This is done to ensure that the stablecoin has built-in protection and can maintain its value even if the linked asset loses value. DAI is one of the most popular crypto-backed stablecoin. It is backed by the US Dollar and runs on the Ethereum blockchain.
Algorithmic stablecoins: Algorithmic stablecoins aren’t backed by any asset. Instead, these stablecoins rely on a computer algorithm to maintain their value. For instance, when the value of an algorithmic stablecoin crosses the preset price ($1, for example), the underlying algorithm automatically mints new tokens to lower the price. Likewise, if the value falls below $1, the algorithm automatically cuts the supply to drive the price higher. An example of an algorithmic stablecoin is TerraUSD (UST).
Each of the aforementioned categories of stablecoins carries its respective benefits and drawbacks. For example, crypto-backed stablecoins, though a promising decentralized alternative to centralized fiat-backed stablecoins, comes at the cost of over-collateralization. This, in turn, drives out significant liquidity from the broader crypto market.
Finally, algorithmic-backed stablecoins don’t include the safety net offered by fiat-backed stablecoins or overcollateralized crypto-backed stablecoins. Since the entirety of their tokenomics relies upon balancing demand and supply with market conditions to maintain a peg, it leaves room for unpredictable price fluctuations, even at times rendering the pegged stablecoin useless.