The growing need for stablecoins

With the ongoing digitization of the financial sector, digital currencies have become central. However, volatility remains a major issue for these currencies. This is where stablecoins enter the scene. 

As of June 1, 2024, the total cryptocurrency market cap reached $2.6T, with stablecoins representing 6.0% (about $0.2T). Tether ($USDT) and USDC ($USDC) are 3 and 7 by market cap among all cryptocurrencies. 

Ethereum leads the stablecoin market with a 49.9% share, followed by Tron at 35.6%, and other networks at less than 3.5%. 

What are stablecoins, and why are they so important? Let's explore this topic further.

Essence of stablecoins

Stablecoins are digital currencies whose value is anchored to another asset, such as a commodity or fiat currency, to stabilize their price. 

They have gained significant popularity in recent years by offering the benefits of both digital and traditional currencies. By maintaining a 1:1 peg to a reserve asset or algorithm, they bridge the gap between these worlds. 

Stablecoins provide an alternative to the high volatility of popular cryptocurrencies like Bitcoin ($BTC), making them more suitable for everyday transactions. Additionally, they serve as a safe haven during bear markets, as seen when their dominance peaked at 17.8% after the collapse of the Terra ecosystem and the FTX exchange.

The main types of stablecoins

There are four different types of stablecoins, including commodity-backed stablecoins, fiat-backed stablecoins, crypto-backed stablecoins, and algorithmic stablecoins.

Fiat-collateralized stablecoins 

Fiat-backed stablecoins are a type of cryptocurrency whose value is maintained at the level of traditional currencies (e.g., USD, EUR, CNY) through reserves of these currencies or equivalent assets. 

The mechanism of fiat-backed stablecoins relies on reserves held by an independent custodian and regularly audited to verify their existence and match the issued stablecoins. Each unit of a stablecoin is supported by an equivalent amount of reserve assets, which can be in the form of:

• Fiat currency. Primary backing with currencies like USD, EUR, or others held in bank accounts.
• Cash equivalents. Highly liquid and reliable assets, like treasury bonds, are quickly convertible to cash.

Notable examples of fiat-backed stablecoins include Tether ($USDT) and USDC ($USDC).

Commodity-collateralized stablecoins

Commodity-backed stablecoins are a type of cryptocurrency whose value is pegged to traditional currencies, maintained through reserves of physical assets such as precious metals or other tangible assets. 

The mechanism of commodity-backed stablecoins relies on storing these physical commodities as collateral to secure the value of the stablecoin. These commodities can include precious metals like gold or silver or other valuable assets that possess stable value and high liquidity. 

Notable examples of commodity-backed stablecoins include Paxos Gold ($PAXG), and Tether Gold ($XAUT).

Crypto-collateralized stablecoins 

Cryptocurrency-backed stablecoins are a type of cryptocurrency whose value is maintained at the level of fiat currency by reserving other cryptocurrencies as collateral.

The mechanism of cryptocurrency-backed stablecoins relies on using smart-contracts to manage reserves and maintain price stability. Given the volatility of cryptocurrencies, these stablecoins are typically over-collateralized, meaning the value of the reserves exceeds the value of the issued stablecoins.

The process of collateral management and liquidation is governed by decentralized protocols on the blockchain. If the value of the collateralized cryptocurrency falls below a certain threshold, smart contracts automatically liquidate a portion of the reserves to redeem some stablecoins and restore the necessary collateral ratio.

Stablecoins can be backed by a single type of cryptocurrency (such as Ethereum ($ETH), Bitcoin ($BTC), or other altcoins) or by a basket of different coins weighted according to specific parameters.

The most notable example of cryptocurrency-backed stablecoins is DAI ($DAI).

Algorithmic stablecoins

Algorithmic stablecoins are a type of cryptocurrency whose value is maintained at the level of fiat currency through algorithmic mechanisms that control market supply and demand, rather than through asset reserves.

The mechanism of algorithmic stablecoins relies on smart contracts and algorithms to automatically adjust the supply of stablecoins in response to changes in demand. This is achieved through various methods, such as minting and burning tokens linked to the stablecoin.

The price of algorithmic stablecoins is maintained at 1 USD through the following mechanisms:

• Supply regulation. Algorithms automatically increase or decrease the number of stablecoins in circulation based on their current market price. If the stablecoin price exceeds 1 USD, new tokens are issued to increase supply and lower the price. If the price falls below 1 USD, tokens are bought back or burned to decrease supply and raise the price.
• Participant incentivization. Market participants can be incentivized to engage with the system through bonuses or rewards for actions that help maintain the peg. For instance, they may receive bonuses for purchasing stablecoins during periods of shortage.
• Linked tokens. Some algorithmic stablecoins use linked tokens to help stabilize the price. These tokens can be used to redeem or issue new stablecoins based on market needs.

A notable example of algorithmic stablecoins is Frax ($FRAX).

New concepts

Do not think that the world of stablecoins is rigid. Today, we are witnessing the emergence of new types of stablecoins, expanding the utility of these digital assets. These innovations aim to enhance stability and liquidity, making stablecoins more attractive for various financial applications and users:

Collateralized debt position stablecoins

CDP stablecoins are credit agreements based on smart contracts where users deposit assets, such as $ETH, as collateral to receive loans in stablecoins. This system allows users to unlock liquidity in their crypto holdings without selling them. Notable CDP stablecoins launched in 2023 include Curve's $crvUSD and Aave's $GHO.

LST-backed stablecoins

The transition of Ethereum to Proof-of-Stake (PoS) and the introduction of staked ETH withdrawals have significantly fueled the growth of Liquid Staking Tokens (LSTs) like $stETH, $rETH, and $WBETH. In 2023, there has been an increase in LST-backed stablecoins, such as $eUSD by Lybra and $mkUSD by Prisma. These stablecoins are overcollateralized with LSTs, offering holders the dual benefits of earning yields while maintaining the essential properties of stablecoins. The growth of ETH staking supports the expansion of this stablecoin market.

Centralized stablecoins

The notable successes of leading incumbent centralized stablecoins, particularly from a financial standpoint, have paved the way for new entrants. First Digital's $FDUSD and PayPal's $PYUSD stand out as centralized solutions that have gained significant market share quickly. Remarkably, despite launching later than other emerging decentralized models, both stablecoins have outstripped them in market cap. This underscores the prevailing trend of centralized stablecoin dominance and highlights the benefits of integrating with centralized liquidity sources.

Bottom line

The stablecoin market is rapidly evolving, offering stability in the volatile world of cryptocurrencies and gaining increasing popularity for everyday transactions. A significant trend is the entry of major traditional financial players, like First Digital with $FDUSD and PayPal with $PYUSD, which are quickly capturing market share. This highlights the dominance of centralized stablecoins and the advantages of integrating with centralized liquidity sources.

These developments show the growing recognition and adoption of stablecoins by traditional financial institutions, enhancing their growth and application. Moreover, new stablecoins bridge the Web2 and Web3 sectors, combining the reliability of traditional finance with blockchain innovation. This convergence strengthens the market position of stablecoins and expands their financial applications.