While cryptocurrencies operate outside traditional finance, stablecoins help tether the decentralized economy to conventional currencies. Learn how different types of stablecoin work in this blog.
Stablecoins like USDC handle billions of dollars in value each day, representing many of the largest cryptocurrencies by market cap.
They play an invaluable role in unlocking features in the DeFi landscape that would otherwise be unfeasible with traditional cryptocurrencies like Bitcoin and Ethereum.
We’re here to tell you everything you need to know about stablecoins in simple terms.
What is a stablecoin?
Stablecoins are a type of crypto token designed to maintain a relatively consistent price. This allows them to be used in ways comparable to traditional currencies like the dollar and euro.
Stablecoins play a massive role in the current crypto landscape. They are leveraged in a wide variety of use cases, including:
- Storing value.
- Sending and receiving payments.
- Interacting with smart contracts.
- Receiving salaries.
- Providing liquidity to decentralized markets.
- Staking and lending, as a means of earning passive income.
- Hedging against more volatile assets.
Stablecoins like USDC, USDT and DAI exist as a direct response to one of crypto’s most common criticisms: being ‘too volatile.’
In a landscape that has been known for its gargantuan highs and sobering lows, stablecoins allow traders to store and exchange value without having to worry about losing money as a consequence of sudden price drops.
What are the four types of stablecoins?
There are different methods that can be used to help a coin maintain a relatively consistent price.
Generally speaking, there are four types of stablecoins. Each type gets its name from how the token shields itself from significant price movements.
Fiat-backed stablecoins are backed by fiat currencies, such as the dollar, yen, and euro.
Key examples of fiat-backed stablecoins include USD Coin (USDC) and Tether (USDT). The price of these stablecoins is supposed to remain $1 USD at any given time.
These coins are designed to be worth the same price as the fiat currency they are backed by. Since fiat currencies are typically less prone to sharp price movements, fiat-backed stablecoins should hold a relatively consistent price under normal market conditions.
Many fiat-backed stablecoins claim that, for every token their users hold, an equal number of US dollars are held in a bank account. While USDC and Tether regularly issue reports and third-party audits detailing their fiat reserves, this is not the case for all fiat-backed stablecoins.
True to their name, crypto-backed stablecoins are stablecoins that are backed by reserves of other cryptocurrencies.
However, this type of stablecoin typically does not aim to hold a 1:1 price ratio with its underlying asset.
Rather, crypto-backed stablecoins work by maintaining a reserve made up of a mix of cryptocurrencies and issuing a secondary stablecoin that derives value from the reserve assets, for users to hold and trade.
Despite often being called an algorithmic stablecoin, Dai is a quintessential example of a crypto-backed stablecoin. As of the Multi-Collateral Dai upgrade, MakerDAO states that Dai tokens are backed by a portfolio of other digital assets. These reserves may vary, but currently include Ether, Wrapped Bitcoin, USDC, and Real World Assets (RWAs).
Like fiat-backed stablecoins, commodity-backed stablecoins are tied to the price of another asset. Rather than fiat currencies or crypto, this type of stablecoin is backed by commodities like oil and precious metals.
The most notorious example of a commodity-backed stablecoin is the Petro. Introduced by Venezuela’s president, these coins are supposedly redeemable for barrels of crude oil—though this claim is widely scrutinized.
Other commodity-backed stablecoins, like Paxos Gold (PAXG), are backed by gold stored in a vault.
Not all commodity-backed stablecoins claim to be redeemable for the commodity their price is tied to. Instead, they can simply mirror the price of commodities like gold as a way to maintain a relatively consistent token price.
Algorithmic stablecoins are not backed by any underlying asset. Instead, this type of stablecoin makes use of a decentralized algorithm in order to maintain a relatively stable price.
A supposed benefit of algorithmic stablecoins is that they do not rely on any asset that can be controlled by a centralized intermediary. Instead, the token supply is increased or decreased based on demand in order to keep the price stable.
In comparison, since many fiat-backed and commodity-backed stablecoins rely on currencies or commodities held in an account or vault, they may be subject to pressures from centralized institutions like banks and companies.
TerraUSD (UST) was one of the landscape’s biggest—yet most controversial—examples of an algorithmic stablecoin, which collapsed in value after a depeg incident in May 2022. Notably, many previous algorithmic stablecoins suffered the same fate.
How can you benefit from stablecoins?
With the right know-how, you can benefit from using stablecoins in a variety of ways. The most immediate way to use stablecoins is as a means of sending and receiving payments and remittances.
Outside of the crypto landscape, many common methods for sending money internationally charge a fee calculated as a percentage of your transaction's value. This means that you could lose a significant amount of money in fees, especially if you are sending or receiving a large payment.
Most stablecoins charge the same to send a transaction, regardless of how much is being sent. As a result, they can be an ideal solution for larger payments, and since this fee can be very low on certain crypto networks, stablecoins have become a popular method for settling any international transaction.
You can also use stablecoins in decentralized applications to trade or in order to earn yield, receive coins in airdrops, and access decentralized lending.
Finally, a common way to use stablecoins is to shield your digital assets during times of market volatility. Rather than cash out of crypto completely, you can simply trade for stablecoins using token swaps.
What are the downsides of stablecoins?
Despite their significant utility, stablecoins have also caused significant controversy in the crypto landscape.
The biggest controversy in recent years was the crash of the TerraUSD algorithmic stablecoin, which wiped out billions of value and resulted in a global manhunt for its creator, Do Kwon. It is suspected that Kwon was also behind the launch of a previous algorithmic stablecoin that failed to receive regulatory approval.
It is important to be mindful that not all stablecoins are created equal; some tokens lose their value as a result of bad code and exploits. Other risks include that the assets backing the coin simply do not exist, or that the issuer has privileged access allowing them to drain the smart contract that locks up the collateral which gives the coin value.
Lack of transparency
A longstanding issue facing both fiat-backed and commodity-backed stablecoins has been a lack of transparency regarding their supposed reserves.
USDT, the largest stablecoin by market cap, faced significant scrutiny over its long refusal to undergo third-party audits, and was at one point fined $42M for undercollateralizing its reserves between 2016 and 2018.
Nowadays, both USDT and USDC report on their reserves and both tokens maintain at least 100% of reserves in dollars or dollar-equivalent assets. However, this may not be the case with other stablecoins.
Other stablecoins that claim to be backed by a physical commodity or currency, may not actually allow you to redeem your coins for the asset they are ‘backed’ by, and may fail to provide sufficient evidence that they even hold a 1:1 ratio of the commodity itself. When this is not sufficiently disclosed ahead of time, traders can end up being shortchanged.
Importantly, cryptocurrencies were designed to birth a movement of financial decentralization. Many stablecoins, however, are far less decentralized than they might seem.
USDC, for instance, is one of the largest stablecoins in the market, but it is fully controlled by Circle. This makes it a permissioned system, and funds can be frozen if needed. In 2022, for example, Circle froze $75,000 USD worth of funds tied to accounts that had used a crypto mixer known as Tornado Cash.
What happens when a stablecoin depegs?
The relationship between a stablecoin and its underlying asset is commonly referred to as a ‘peg’. As long as its peg is maintained, the price of the token is expected to remain stable.
Over the past few years, the crypto landscape has been drastically impacted by stablecoins depegging. Often, this is due to factors like holders panicking (simulating a bank run), coding flaws, and/or targeted exploits.
When TerraUSD (UST) depegged from the $1 USD valuation it was designed to algorithmically maintain, it set off a chain reaction that quickly saw its sister token (LUNA) plummet to virtually nothing. This resulted in billions in lost value, and contributed to volatility across the crypto landscape at large. While TerraUSD still exists today, it is worth only fractions of a dollar and can no longer be considered a stablecoin.
Every type of stablecoin can depeg, it is not a risk unique to algorithmic stablecoins like TerraUSD. Other stablecoins, including USDC, have also seen incidents where the price fell, most notably during the collapse of Silicon Valley Bank, which caused huge losses for holders. This also had a runoff effect on Dai, which holds a significant volume of USDC in its reserves.
Official vs. unofficial stablecoins
An important distinction to make when it comes to stablecoins is whether the token you are holding has been officially issued by the protocol or is an unofficial copy.
In order to give stablecoins access to multiple blockchains rather than just the network they were built on, many stablecoins have been ported across several networks.
This can either be done officially, by the same issuer of the original native token, or unofficially by a third party.
Importantly, if you are holding an unofficial bridged version of a stablecoin, it could prevent you from redeeming the tokens you hold at the price you expect. In addition, unofficially bridged stablecoins could also be at increased risk of depegging for various reasons.
You can swap your bridged USDC for native USDC on Matcha, or use a cross chain swap to trade across networks if needed. Make sure to read our guide to the difference between bridged tokens and native tokens to learn more.
Trading stablecoins on Matcha
Matcha lets you easily trade virtually all popular stablecoins, with support for over 5 million tokens. As a decentralized exchange aggregator, Matcha also helps you get the best prices on your trades by sourcing liquidity from over 100 decentralized exchanges at once.
Start trading with Matcha today to enjoy cross chain swaps, limit orders, and even MEV protection, with quick access to both stablecoins and traditional cryptocurrencies across 9 different networks, at the best price available.