Stablecoins: Fiat-backed vs Crypto Collateralized vs Algorithmic

What are stablecoins? Stablecoins are a category of cryptocurrency whose value is pegged to another asset, most typically a fiat currency, to maintain a stable value in the ultra-volatile world of crypto.[1] Stablecoins are typically designed to maintain a set ratio to an underlying fiat currency to which they are pegged. The most common peg is the United States Dollar (“USD”).

There are three key characteristics that define a stablecoin: stability, capital efficiency, and decentralization.[2] As of today, any given stablecoin falls on a spectrum of meeting these three characteristics. Typically, only two characteristics are met. The market has not seen a stablecoin successfully integrate all three characteristics simultaneously. This is known as the stablecoin trilemma.[3]

There are many varieties of stablecoins on the market, but the three most common types are fiat-backed, crypto collateralized and algorithmic.

First, the most well-known and widely adopted stablecoin in the market is the fiat-backed stablecoin. Fiat-backed stablecoins are digital assets that maintain financial reserves in fiat currency held by a regulated institution such as a bank. This type of stablecoin holds its reserves in a bank vault or with a trusted financial custodian. Fiat-backed stablecoin reserves are a weighted mix of cash and cash equivalents such as commercial paper. For example, a $10 billion fiat-backed stablecoin may hold $4.0 billion in physical cash and the remaining $6.0 billion in cash equivalents. The centralized entities operating this type of stablecoin must generate revenue and do so through the yield on their cash equivalents. The two largest stablecoins by market capitalization, Tether & USD Coin (USDC), fall in this category. As previously mentioned, these stablecoins are not decentralized; however, they are stable and capital efficient, thus allowing for significant scaling. Their stability is reliant upon the entity maintaining significant reserves coupled with compliance with both auditors and regulators to prove transparency of these reserves.

Second, crypto collateralized stablecoins are a popular variety that reside exclusively on the blockchain. This type of stablecoin collateralizes crypto assets via an electronic vault system. The collateralized vault triggers a smart contract to mint brand new stablecoins. Due to crypto’s inherent volatility, assets are often overcollateralized with ratios routinely reaching 200%. As a result, this type of stablecoin is highly decentralized yet capital inefficient. A crypto collateralized stablecoin gives up capital efficiency to maintain decentralization. As the crypto market matures and volatility decreases it is likely the collateralization ratios will fall. The overcollaterization structure is a form of stability protection designed to keep the stablecoin from depegging (losing their desired 1:1 ratio). Over time, the market capitalization of these decentralized stablecoins should continue a slow, but methodical growth.

Third, algorithmic stablecoins are a newer category that also reside exclusively on the blockchain. This type of stablecoin relies upon an algorithm that pegs itself to a physical currency. They are not fully backed by collateral and rely upon an algorithm to maintain their 1:1 price peg. The laws of supply and demand are integral to the mechanics of this variety of stablecoin. When demand for the stablecoin increases and its price subsequently appreciates over $1.00, the protocol issues a new supply of stablecoins to drop the price back to its pegged $1.00 price. Alternatively, when the price of the stablecoin falls below $1.00, stablecoins are removed from circulation through a process known as burning[4]. Due to its location on the blockchain as well as its undercollateralized nature, this stablecoin is both decentralized and capital efficient. The weakness of these stablecoins is a lack of stability. Stability is a highly desired feature of stablecoins, and it has proven an elusive goal for all algorithmic stablecoins to date. Earlier this year the algorithmic stablecoin TerraUSD (UST), lost its peg. This depegging caused a quick collapse that severely impacted the entire crypto market.

It is not clear today which stablecoin model or models will prevail. As innovation continues to drive forward the crypto landscape, we expect to see continued efforts to solve the stablecoin trilemma and solidify the position of stablecoins as an integral pillar of the crypto economy.

Investing in cryptocurrencies comes with risk that may not be suitable for all investors, and as such, it is vital that potential investors conduct their own due diligence before buying or selling any cryptocurrency.

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The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.

^[1] https://www.coindesk.com/learn/fiat-backed-stablecoins-what-you-need-to-know-about-tether-usd-coin-and-others/

^[2] https://a16zcrypto.com/wp-content/uploads/2022/05/state-of-crypto-2022_a16z-crypto.pdf

^[3] https://blog.kaiko.com/the-stablecoin-trilemma-5c9149a8c9d5

^[4] https://defieducation.substack.com/p/stablecoins-reinventing-dollars