What is a Stablecoin? Importance and Classification of Stablecoins (2023)

What is a Stablecoin? Why is Stablecoin important in crypto? How many types of Stablecoins are there? Explore everything about Stablecoins here!

The world of cryptocurrencies has been renowned for its significant short-term and long-term volatility. While DeFi holds the promise of elevating crypto from being mere cryptocurrencies to becoming crypto assets within a new economy, they are often overlooked due to their perceived resemblance to speculative assets caused by high price volatility. Stablecoins aim to act as potential connectors between the crypto space and traditional financial markets, leveraging their 'stable' attributes.

However, when discussing Stablecoins, most people immediately think of Tether (USDT) and believe that a Stablecoin is a digital currency pegged 1:1 to the US Dollar. But the reality is quite different! The crypto market houses various types of Stablecoins, and USDT is just one among many Stablecoins available today.

In this article, FoxCryptoNews will provide readers with comprehensive insights into:

• What is a Stablecoin?
• How many types of Stablecoins exist? What are the mechanisms behind Stablecoin price stability?
• Is Stablecoin a trend worth following?

What is a Stablecoin?

A Stablecoin is a type of digital currency designed to minimize the impact of price volatility by pegging it to a more stable asset such as fiat money, commodities (gold, silver...), or even another cryptocurrency.

Leveraging blockchain attributes, Stablecoins facilitate peer-to-peer value transfer while shielding users from the high volatility seen in other cryptocurrencies.

Addressing Crypto's Challenges

Stablecoins were introduced to tackle the most significant issue in the current crypto market—volatility.

• For traders and investors, they can convert their assets into Stablecoins to avoid the volatility of cryptocurrencies without necessarily transitioning to fiat.
• For businesses, it's challenging to accept payment in a cryptocurrency with a 20 - 30% value fluctuation in a short time span. This has made widespread adoption of cryptocurrencies much more difficult.

As such, Stablecoins act as a crucial bridge between the digital and traditional financial markets. The transition from fiat to cryptocurrencies becomes considerably easier with the presence of Stablecoins.

Erik Voorhees, CEO of Shapeshift, aptly stated,

“Stablecoins are important in the same way that a bridge is important. You may not care much about the bridge, but without it, the beautiful land beyond is much harder to get to.”"

Why Stablecoins Matter in Crypto?

Most of us are uncomfortable with loss, a feeling amplified by the high volatility of cryptocurrencies, often synonymous with high risk and high returns. Tokens can experience significant price drops, sometimes by several tens of percent within a week. This can be hard to accept for many.

For instance, you make a few profitable trades and decide to convert your gains into BTC. About a week later, you convert your BTC into your local currency and realize that the amount you put in and withdrew remains relatively unchanged. How would you feel?

Stablecoins separate the high risk/high return nature of crypto from the frequent price fluctuations of crypto assets. Their 'stable' attribute makes Stablecoins more suitable for storage and value exchange.

Classifying Stablecoins

Currently, there are four main types of Stablecoins:

• Fiat-backed Stablecoin.
• Commodity-backed Stablecoin.
• Crypto-backed Stablecoin.
• Algorithmic Stablecoin.

Among them, Algorithmic Stablecoins can be further divided into three types: Rebase, Seigniorage, and Fractional.

Fiat-backed Stablecoins

Examples of these Stablecoins on the market are USDC and USDT. They are backed by the US Dollar or equivalent highly liquid assets. When 1 USDC is minted on-chain, there is a corresponding US Dollar or equivalent asset value held in reserve.

These types of Stablecoins are also referred to as Custodial or Centralized Stablecoins. Users need to trust custodians rather than on-chain smart contracts.

Despite concerns about centralization, USDC and USDT are currently the two most widely used Stablecoins in DeFi.

Commodity-backed Stablecoins

Commodity-backed Stablecoins operate similarly to Fiat-backed Stablecoins. The difference lies in their pegged value:

• Fiat-backed Stablecoins are pegged to fiat currencies, most notably the US Dollar.
• Commodity-backed Stablecoins are pegged to rare commodities, most notably gold and silver.

As of now (May 18, 2022), most Commodity-backed Stablecoins use gold as their pegged value. Tether Gold (XAUT) and PAX Gold (PAXG) are two of the largest Stablecoins in this category.

Crypto-backed Stablecoins

Crypto-backed Stablecoins use cryptocurrencies directly as collateral for their value.

DAI is the most representative Stablecoin of this type on the market. Essentially, for each DAI minted, there is approximately $1.5 - $1.6 worth of collateral in the Maker Vault.

If the collateral value falls below a minimum threshold (usually 150%), the Vault is liquidated to reduce the supply and bring the DAI price back to the pegged value.

Over-collateralization is a reasonable approach given the relatively low liquidity of the crypto market. This approach ensures DAI is backed by a larger value of collateral than the total DAI minted. However, it may have limitations in terms of scalability.

CUSD, FoxCryptoNews' stablecoin, also belongs to this category. CUSD is fully backed by BUSD and USDC, allowing users to convert or redeem it 1:1 with BUSD and USDC at any time. CUSD is crucial for supporting FoxCryptoNews' multi-chain ecosystem and facilitating seamless asset transfers across different chains.

Algorithmic Stablecoin

This type of Stablecoin is algorithmic in nature, with Basis Cash being a notable example.

In this system, BAC is the Stablecoin pegged to $1 and subject to daily stability mechanisms.

Ví dụ về cách hoạt động của Basis Cash:

Basis cash có 3 Token là BAC, BAS, BAB:

BAC là Stablecoin - nó được Peg vào 1$ và có cơ chế ổn định hàng ngày.

When BAC trades above $1:

• BAS holders can stake BAS to earn inflation (in BAC) following this formula:
• (Your BAS/Circulating Supply BAS) * Total Supply BAC * (TWAP BAC Price - 1).
• BAS holders earn free BAC, which they theoretically sell to the market for profit, pushing down the BAC price toward $1.

When BAC trades below $1:

• BAC holders can use BAC to buy BAB at a rate of BAB = (BAC Price)^2.
• BAB is non-expiring and can be redeemed when BAC exceeds $1.
• For example, if a user is holding 10 BAC and the price per BAC is $0.8, they can use 10 BAC to purchase 15.625 BAB.
• Assuming the BAC price rises to $1 three days later, the user can exchange 15.625 BAB for 15.625 BAC and sell them on a DEX, making a nearly 50% profit from their initial 10 BAC.

In this model, buying pressure pushes the BAC price up to $1.

Besides Basis Cash, the market features various other algorithmic Stablecoins with innovative operational models. In general, there are three main price-keeping models:

• Rebase: This adjusts the circulating token supply to maintain the token's price. If the token price exceeds $1, the holder's wallet will automatically expand its holdings and vice versa. Examples include AMPL and BASE.
• Seigniorage: This approach utilizes multiple tokens to stabilize the value of the original Stablecoin. Traders engage in arbitrage based on the price difference between them, aligning the Stablecoin price with the peg. Notable examples are UST, BAS, and FEI.
• Fractional: A combination of Fiat-backed Stablecoin and Seigniorage Stablecoin. Notable token: FXS.

Investing in Stablecoins: Will Stablecoins Become a Trend?

Before discussing the trend of Stablecoins, let's take a brief look at the evolution of the Stablecoin ecosystem from its inception in 2013 to the present.

Additionally, Stablecoins are poised to continue their robust growth with participation from major players such as JPM Coin from J.P. Morgan bank and Facebook's Libra.

Moreover, Stablecoins enable us to generate passive income securely, much like depositing funds in a bank. Below are a few ways to earn profits with Stablecoins.

Yield Farming

Yield Farming involves using a token pair to provide liquidity and earn rewards from the platform. This token pair can be Stablecoin-Stablecoin or Stablecoin-Altcoin. The second option offers higher profits but comes with higher risk due to potential Impermanent Loss.

Some platforms that support Stablecoin farming include:

• Curve Finance: 3 - 35% APY.
• Convex Finance: 2 - 28% APY.
• Saber Finance: 3 - 20% APY.
• Ellipsis Finance: 4 - 70% APY.

Tham khảo thêm: Yield Farming hoạt động như thế nào?

Staking

Staking is a safer way to generate income compared to Yield Farming, as it only requires providing one type of token instead of two. Of course, the returns will be lower.

Some platforms that allow Stablecoin staking are:

• Binance: 3 - 13% APY.
• Yearn Finance: 2 - 22% APY.
• Stargate Finance: 4 - 6% APY.

Tham khảo thêm: Bí kíp tối ưu lợi nhuận khi Staking Coin

Lending

Lending involves lending out Stablecoins. Essentially, providing Stablecoin lending is similar to staking.

Some platforms that allow lending Stablecoins are:

• Aave: 2 - 7% APY.
• Compound: 1 - 2% APY.

Where to Buy Stablecoins?

Through CEX exchanges: All CEX platforms support buying and selling Stablecoins using various methods, such as using crypto assets or using funds from your bank card.

Through DEX exchanges: There are DEX platforms created specifically to support low-slippage Stablecoin exchanges, such as Curve Finance, Ellipsis, or Mobius.

Direct minting: Instead of buying Stablecoins, you can also mint them directly by using collateral. Projects that support this include MakerDAO (DAI), Abracadabra Money (MIM), etc.

Closing Thoughts

To summarize some key points from this article:

The most important characteristic of Stablecoins is their ability to separate the high risk/high return nature of crypto from the frequent volatility of other crypto assets, making them a more suitable cryptocurrency for storage and value exchange.

There are four types of Stablecoins with different characteristics:

• Fiat-backed Stablecoin: USDC and USDT are the most widely used Stablecoins in DeFi.
• Commodity-backed Stablecoin: Operates similarly to Fiat-backed Stablecoins, pegged to rare commodities like gold or silver.
• Crypto-backed Stablecoin: DAI is a prominent example. DAI is always backed by a collateral value greater than the total minted DAI. However, this type of stablecoin's scalability is limited.
• Algorithmic Stablecoin: These are algorithmic Stablecoins, with price stability based on three main mechanisms: Rebase, Seigniorage, and Fractional.

These are the basic pieces of information for those who are new to Stablecoins and are starting to explore the concept.

FoxCryptoNews has more in-depth analysis of Stablecoins within different ecosystems, detailing characteristics, classifications, development stages, and data analysis. This can help project future trends and investment opportunities in Stablecoins. Learn more here.

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Aug 14, 2023