What are the different types of stablecoins?

By Kraken Learn team
14 min
21 nov. 2024
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Key takeaways
  1. Stablecoins offer a crypto-based medium of exchange which aim to maintain a stable value and perform a range of important functions, including cross-border remittances and DeFi collateralization.

  2. While stablecoins can be backed by either fiat, commodities or crypto, the most widely adopted variants aim to be pegged 1:1 to the US Dollar and are collateralized with over $100b of real world assets.

  3. Each stablecoin variant comes with its own risks, which have to be carefully considered. These risks include, but are not limited to, counterparty risk, regulation and systemic failure.

What are stablecoins? 🔍

Stablecoins are cryptocurrencies that are created with the aim of maintaining a stable value, as opposed to assets like Bitcoin (BTC) whose prices are highly volatile

Broadly speaking, there are two main types of stablecoins:

  1. Collateralized stablecoins, backed by real world assets and crypto. 
  2. Algorithmic stablecoins, managed by algorithms and smart contracts.

Through a variety of methods, stablecoins harness the benefits of blockchain technology while allowing users to park capital in assets that attempt to hold their value.

However, achieving price stability has proved challenging for many, and not all stablecoin projects have succeeded in this endeavor, as we’ll explore below.

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Why are stablecoins important? 🚨

Stablecoins have been heralded as ‘Crypto’s Killer App’ and offer a range of functionality in and out of the crypto sphere. Here are some of the main use cases:

  • A bridge: Stablecoins offer a bridge between the world of traditional finance and DeFi, reducing the operational friction for businesses and individuals to interact with the cryptocurrency space. 
  • Trading: Stablecoins are considered by some to be the lifeblood of cryptocurrency markets, enabling investors to trade in and out of more volatile assets. Most cryptocurrencies are arguably too volatile to act as a reliable medium of exchange, but stablecoins attempt to resolve this issue. Further, in derivatives markets, futures contracts margined by a USD-pegged stablecoin now account for a sizable proportion of the overall open interest, while Bitcoin-margined futures are in decline. Stablecoins allow traders to trade a range of instruments with superior volume at exchanges where there is no option to trade in fiat currencies.
  • DeFi: Many of the largest DeFi platforms use stablecoins for collateral, lending assets or providing liquidity, and investors are attracted to using a stablecoin for these purposes. This is evidenced by the huge growth in DeFI total value locked (TVL) since 2018, which is forecasted to grow from $59b billion in 2023 to $337 billion by 2030.
  • The Unbanked: If you reside in a nation where your local fiat currency is being debased or you don’t have access to reliable financial services, stablecoins offer a lifeline. Through the use of peer-to-peer exchanges, crypto ATMs and decentralized exchanges, anyone with a smartphone and an internet connection can interact with this digital economy. Borderless, programmable with faster transaction times and lower fees, stablecoins are also used for remittances, offering a cheaper alternative to traditional remittance services

What are the different types of stablecoins? 📚

As mentioned above, broadly speaking, there are two types of stablecoins. First, let’s examine collateralized stablecoins, which are crypto assets backed by reserves of different assets, such as fiat currencies, commodities or cryptocurrencies. 

Fiat and commodity-backed stablecoins

Fiat-backed stablecoins operate in the same way as other digital assets, except that they aim to be pegged to real-world currencies on a 1-to-1 basis. 

Stablecoins exist on multiple different blockchains, and can be bridged between chains. This enables users to seamlessly move capital around as they might with other assets.

Because of the transparency afforded by blockchain technology, every stablecoin can be easily accounted for, which in some cases has resulted in assets being frozen

The lifecycle of fiat-backed stablecoins typically follow the same five steps:

After completing KYC, an individual or entity deposits fiat currency into the issuer's bank account. 

  1. The company then issues the stablecoins to the entity’s supplied wallet address. 
  2. The stablecoins then enter the digital asset ecosystem for people to use. 
  3. Users can redeem the stablecoins back into fiat currencies at their discretion by returning them to the issuer.
  4. The stablecoins are then removed from circulation, returning the corresponding amount of fiat back to the holder’s bank account.
Note that fiat-backed stablecoins are not the same as central bank digital currencies, which are issued by central banks and not companies.
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Fiat-backed stablecoins dominate overall stablecoin activity for a few reasons:

  • Despite adverse media, they have performed their function reliably over a sustained period (Tether launched in 2014), which has engendered a robust sense of stability and trust. 
  • Fiat-backed stablecoins are incredibly liquid and widely adopted by a huge variety of decentralized and centralized platforms. This allows traders to interact with these coins knowing that there will always be sufficient liquidity to swap them for other assets. 
  • Unlike other variants of stablecoins, how they work and how they are backed is much more straightforward compared to their algorithmic equivalent. 
  • Tether and Circle are required to comply with regulation and employ independent auditors to verify that the issuers combined assets exceed their combined liabilities.

A less popular variant of collateralized stablecoins are backed by fungible commodities such as gold, silver or oil. 

Rather than being pegged to a dollar or a euro, commodity-backed stablecoins represent a unit of a specific commodity, such as one Troy ounce of gold. 

As with fiat-backed stablecoins, the companies issuing these coins are expected to publish regular independent audits of their physical reserves to ensure holders that they can redeem their tokens for their equivalent value of the underlying asset. 

For those seeking exposure to commodities, these stablecoins enable users to do so without having to consider storage or portability. They are typically highly liquid, can be fractionalized and are issued by reputable firms.

There have been attempts to collateralize oil and agricultural commodities, but these projects have so far failed to gain any meaningful traction.

Popular examples

Fiat and commodity stablecoins are backed by a 1:1 reserve of real-world assets, but how they are backed can differ slightly depending on the coin. The largest and most liquid examples are:

  1. Tether (USDT): with $123b in circulation, USDT is backed by a mixture of USD reserves (83.89%), secured loans (5.36%) precious metals (3.95%), Bitcoin (3.81%) and other investments (2.97%), at press time.
  2. USD Coin (USDC): with $36.8b USDC in circulation, backed by the equivalent value of US dollar denominated assets, totalling $37b, at press time.
  3. Tether Gold (XAUT): issued by Tether, this gold-backed coin allows holders to redeem their tokens for physical gold which Tether states it will deliver to any address in Switzerland.
  4. PAX Gold (PAXG): Regulated by the New York Department for Financial Services, one PAX Gold token represents one fine Troy ounce of a gold bar. PAXG has significantly more volume than its competitors. 

Some other noteworthy examples are: 

Associated risks

In December 2023, S&P Global published its ‘Stablecoin Stability Assessment’, where it rated several prominent stablecoins, examining factors such as quality risks, collateralization, legal and regulatory framework, and redeemability to name a few. 

The findings of the report made the following stability assessments of the major stablecoins, from strongest to weakest::

  1. USD Coin: 2 (strong)
  2. Gemini Dollar: 2 (strong)
  3. Pax Dollar: 2 (strong)
  4. Dai: 4 (constrained)
  5. First Digital USD: 4 (constrained)
  6. Tether: 4 (constrained)
  7. Frax: 5 (weak)
  8. TrueUSD: 5 (weak)

Looking into the report, there are a few common risk factors that are assessed:

Systemic Failure: A depegging event occurs when a stablecoin’s value deviates from its underlying real-world asset. 

This has happened many times over the industry’s history, with perhaps the most recent major event being in March 2023, when USDC depegged in part due to its exposure to Silicon Valley Bank. As with many similar events, the situation was partially rectified by arbitrage traders who quickly bought up the distressed asset at a discount. 

Regulation: Fiat-backed stablecoins have come under considerable scrutiny over the years, and the degree to which punitive regulation can damage trust and stability is an ever-present concern.

Counterparty Risk: Something that has dogged Tether for many years is the alleged lack of transparency with regards to their reserves. In 2022, Tether was ordered by a U.S. judge to produce financial records relating to the backing of USDT. One of the great risks inherent to all stablecoins is that users may someday find themselves unable to redeem their crypto stablecoins for the fiat collateral.

Centralization: Many of the major stablecoins are issued by centralized companies, which users have to trust to maintain sufficient reserves and act appropriately. Stablecoin transactions are not necessarily permissionless - companies have cooperated with law enforcement to freeze assets on occasion.

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Cryptocurrency-backed stablecoins

Cryptocurrency-backed stablecoins operate very similarly to fiat-backed stablecoins with a few key differences. 

Due to the volatile nature of cryptocurrencies, these stablecoins are often over-collateralized, meaning more cryptocurrency is held in reserve or “pledged” than the stablecoin value issued. 

For example, a $1 cryptocurrency-backed stablecoin might require $2 worth of cryptocurrency in reserve. This means that even if the reserve currency backing the stablecoin were to decline by as much as 50%, it should still be able to maintain its peg. 

Maker DAI is an open-source platform that allows users to take out loans in the form of DAI, which is pegged to the value of 1 US dollar. DAI is collateralized by cryptocurrencies. 

Here’s how DAI works:

  1. Users wanting to acquire DAI must first lock up their Ethereum or other assets into a smart contract. Over collateralization enables the stablecoin to hold its peg. 
  2. Fungible DAI tokens are then generated, reflecting the amount of collateral pledged. The user is then free to deploy the DAI in any way that they see fit. 
  3. If users want to recover their collateralized assets, they must return the DAI issued and pay a stability fee. 

Automated smart contracts known as Collateralized Debt Positions (CDPs) dynamically manage supply by creating or burning DAI, and by liquidating positions where there is insufficient collateral. 

If you want to learn more about DAI, this article by Kraken Learn offers a more detailed explanation. 

Popular examples

In addition to DAI, here are some other popular examples of crypto-backed stablecoins:

  1. Synthetix USD (SUSD): Using its native SNX token as collateral, users can lock SNX tokens as collateral to mint sUSD, maintaining a collateralization ratio of 500% or higher. This high over-collateralization ratio is supposed to help absorb price fluctuations in SNX.
  2. Wrapped Bitcoin (WBTC): WBTC is a 1:1 representation of Bitcoin on the Ethereum blockchain. Each WBTC token is reportedly fully backed by an equivalent amount of Bitcoin held in custody.
  3. Decentralized USD (USD): Introduced in May 2022, USDD is an over-collateralized decentralized stablecoin pegged to 1 U.S. dollar.

Associated risks

Systemic risks: There have been many instances where stablecoins have run into trouble from systemic failures, resulting from some form of exploit. 

Stablecoins depend on smart contracts, oracles and blockchain networks to work efficiently. A failure, bug, exploit or other issue with these smart contracts may lead to a failure in their ability to allow tokens to be redeemed for any underlying collateral, which could cause the stablecoin to de-peg. In March 2020, ‘Network congestion and high gas prices’ led to the theft of $8M in MakerDAO collateral. The destabilization of other stablecoins can have a knock-on effect; when USDC depegged in 2023, it also resulted in the depegging of DAI

Depegging can sometimes be resolved by smart contract-driven corrective measures which manage the supply, but this is not always the case. 

Regulation: The lack of a regulatory regime for decentralized applications, of which there is no centralized custodian, presents its own unique challenges and risks. It is unclear exactly how DeFi platforms will be regulated in future, and there is a great deal of uncertainty as to how punitive or restrictive any policies might be.

Collateralization: Because crypto-backed stablecoins use collateral that is highly volatile, there is always the possibility that a very sharp move down in price could cause liquidation—particularly when a single asset represents a significant portion of the overall pool of collateral. For example, USDC represents a significant portion of DAI’s collateral. If USDC de-pegs, or the issuer of USDC freezes USDC, this could cause DAI to de-peg. This is much less likely due to mandatory over-collateralization, but the risk always remains. 

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Algorithmic stablecoins

Algorithmic stablecoins employ a variety of smart contract-based mechanisms to maintain a stable value by responding dynamically to supply and demand. 

Unlike asset-backed stablecoins which have reserves that act as collateralization, algorithmic stablecoins typically mint and burn coins to maintain a peg and are not backed by real world assets. Additionally, these may include a secondary bond token which can be bought and redeemed for the underlying stablecoin to assist with stabilizing its price through arbitrage.

Note that while DAI uses smart contracts to manage the supply and adjust the stability fee, it is not an algorithmic stablecoin because it is fully collateralized. Algorithmic stablecoins are fully dependent on algorithms to manage the peg. If demand for the token increases and exceeds $1, the supply is increased. Conversely, if demand falls, supply decreases.

Popular examples

Perhaps due to the unprecedented failure of Terra USD (UST) and the inherent complexities of algorithmic stablecoin, there are fewer coins of this ilk with any meaningful adoption. 

  • Ampleforth (AMPL) is an algorithmic stablecoin that “...is a price-stable but supply volatile cryptocurrency that targets the (2019) CPI-adjusted dollar.” Via a non-dilutive process known as ‘rebasing’, supply is programmatically increased or decreased using data feeds from Chainlink (LINK). Therefore the supply is constantly expanding and contracting, with holders balances fluctuating on a daily basis. As a result, the stablecoin has repeatedly managed to return to its target price despite challenging market conditions

For a more detailed explanation of how Ampleforth works, check out this guide by Kraken Learn. 

Associated risks

Systemic Failure: The greatest risk of using algorithmic stablecoins is that the rebasing system is unable to maintain the peg or completely fails. In May 2022, the $18b algorithmic stablecoin TerraUSD (UST) had a catastrophic meltdown. In what appeared to be a targeted attack that preceded a miraculous series of events, the UST stablecoin fatally depegged and the native LUNA token lost 96% of its value in a single day, erasing $28b from the Terra ecosystem. 

In summary, it is hard to overstate the significance of the role that stablecoins play in the cryptocurrency ecosystem. Stablecoins act as a bridge for traditional finance, facilitate cross-border payments and offer a fully collateralized, crypto-based medium of exchange with a stable value. The several variations of stablecoins are the lifeblood of decentralized finance, but investors should carefully consider how they work and the attached risks before deploying capital into them. 

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