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Stablecoins, a subset of cryptocurrencies designed for value stability, employ diverse strategies to achieve their goal, falling into three primary categories: fiat-backed, crypto-backed, and algorithmic stablecoins.
Fiat-Backed Stablecoins:
Undoubtedly the most prevalent, fiat-backed stablecoins seek to emulate traditional currencies like dollars and euros. Examples include Tether's USDT and Circle's USDC. These stablecoins purport to hold liquid reserves equal to or surpassing their circulating supply, typically in cash or cash equivalents. Despite their popularity and utility for trading and decentralized finance (DeFi) activities, concerns linger due to centralization, the inclusion of volatile assets in reserves, and the absence of independent audits.
Crypto-Backed Stablecoins:
Represented by MakerDAO's DAI, crypto-backed stablecoins derive collateral from cryptocurrencies. Given the inherent volatility of crypto assets, over-collateralization is a common requirement for stability. For instance, a 150% collateralization ratio mandates depositing $150 worth of crypto to mint $100 of stablecoin. While these stablecoins offer decentralization and trustlessness, risks persist, such as potential disruptions in peg due to collateral fluctuations and automatic liquidations during price crashes.
Algorithmic Stablecoins:
Operating in an under-collateralized manner, algorithmic stablecoins rely on algorithmic and incentive mechanisms to uphold price stability. Unlike collateralized or over-collateralized counterparts, they do not depend on asset reserves for value. However, their stability hinges heavily on market demand, making them vulnerable to faltering if demand drops below a critical threshold. The de-pegging event of the TerraUSD stablecoin in May 2022 and the subsequent sell-off exemplify this vulnerability. Despite offering transparency and decentralization, algorithmic stablecoins come with inherent downsides that users must consider.
In addition to these categories, there are asset-backed stablecoins like Paxos Gold and Tether Gold, claiming backing from physical reserves of precious metals, providing stability through tangible assets. Each stablecoin category presents unique advantages and risks, catering to diverse preferences within the crypto space. Understanding these nuances is crucial for users navigating the multifaceted landscape of stablecoins.
