Stable coins are a new type of cryptocurrency that are backed by a reserve asset like fiat currency, a commodity, or another cryptocurrency in order to keep their prices stable. Stable coins are becoming more popular because they try to combine the best features of both cryptocurrencies and traditional currencies, like instant transactions, security, privacy, and a value that doesn’t change much.
There are three main types of stable coins, based on the mechanism used to stabilise their value:
- Fiat-backed stable coins: These are stable coins that are backed by a fixed amount of fiat currency, such as the US dollar or the euro, held in a bank account or a trust. The most common examples of fiat-backed stable coins are Tether (USDT), USD Coin (USDC), and Binance USD (BUSD). These stable coins claim to keep a 1:1 ratio with their respective fiat currencies, but they may have problems like being able to be audited, complying with regulations, and dealing with other people.
- Crypto-backed stable coins: These are stable coins that are backed by a basket of other cryptocurrencies, like Bitcoin or Ethereum, that are overcollateralized to account for price changes. The most common example of a crypto-backed stable coin is Dai (DAI), which is backed by Ethereum and governed by a decentralised autonomous organisation (DAO). These stable coins claim to be more transparent, decentralised, and resilient than fiat-backed stable coins, but they may face issues such as scalability, complexity, and volatility risk.
- Algorithmic stable coins: These are stable coins that are not backed by any asset but instead rely on an algorithm that adjusts the supply of the stable coin according to demand and market conditions. The most common example of an algorithmically stable coin is TerraUSD (UST), which is backed by a native token called Luna that is burned or minted to maintain the peg. These stable coins say they are more innovative, flexible, and scalable than stable coins backed by fiat or crypto, but they may have problems with governance, security, and stability.
Stable coins are an important development in the world of cryptocurrencies because they make it possible for digital assets to be used for more things, like payments, remittances, lending, trading, and DeFi. But stable coins also have to deal with a lot of problems and trade-offs when it comes to design, regulation, adoption, and competition. Before investing in or using stable coins, investors and users need to know what the different types are and what their pros and cons are.