Understanding stablecoins and their purpose
Stablecoins are digital assets designed to maintain a consistent value, often by pegging their price to a fiat currency like the U.S. dollar. By reducing the volatility typically associated with digital assets, stablecoins offer a bridge between traditional finance and cryptocurrency.
There are three primary types of stablecoins, each with its own structure and risk considerations:
- Fiat-backed (collateralized)
These are the most common type of stablecoin. Each token is backed 1:1 by fiat currency or short-term government debt, with reserves typically held in regulated financial institutions. Transparency and regular audits are key components of trust in this model.
Examples: USDC, USDT (Tether), TrueUSD
Key traits:
- Simple to understand and widely used
- Considered lower risk, though reliant on issuer compliance and reserve verification
- Crypto-backed
Backed by other cryptocurrencies such as ETH, these stablecoins are often over-collateralized to account for the price volatility of the underlying assets. Collateral is held in smart contracts rather than traditional banks.
Examples: DAI, sUSD
Key traits:
- Decentralized structure
- Increased complexity and risk due to market volatility and smart contract exposure
- Algorithmic (non-collateralized)
These stablecoins use code, not reserves, to maintain price stability. Algorithms automatically expand or contract token supply based on market conditions. While the goal is price stability, this model remains largely experimental.
Examples: Frax (partially algorithmic), TerraUSD (defunct)
Key traits:
- Offer decentralization
- High risk and prone to failure during periods of stress
Other models to be aware of:
- Commodity-backed: Pegged to assets like gold (e.g., Pax Gold)
- Hybrid models: Combine multiple elements from the categories above to balance stability and decentralization
Understanding these categories can help financial institutions assess which stablecoins, if any, align with their risk tolerance, regulatory obligations, and long-term strategy.