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FN 231 - Stablecoins
Stablecoins are a specific type of token that have brought a lot of utility to the DeFi ecosystem. This course will cover the following:
- Defining Stablecoins
- The Utility of Stablecoins
- Exploring Types of Stablecoins
- Stablecoin Risks
Suggested Prior Reading:
Introduction
Volatility is a major issue in the cryptocurrency world, and therefore in DeFi as well. Most of us still transact daily with the official fiat currency of wherever we live. While that fact may change in the near future due to the increasing popularity of digital currencies, it is very much a reality. This is why having tokens whose value is tied to a fiat currency is extremely useful.
USDT, USDC, BUSD and DAI are the largest stablecoins by marketcap. As some of their names suggest, these tokens are all pegged to the value of the US dollar. However, there are many other stablecoins spanning different fiat currencies or other assets that utilize different strategies to maintain their valuation.
Types of Stablecoins
You can simplify the types of stablecoins into the 4 strategies used to maintain their value:
- Fiat-Backed
- Crypto-Backed
- Commodity-Backed
- Algorithmic
Fiat-Backed
These stablecoins are tokens backed directly by some type of fiat currency. For USD-based stablecoins, for example, this means that for every token minted (created) on the blockchain, there is $1 in USD somewhere being held by the company issuing the stablecoin. This is the most common type of stablecoin, and is how tokens such as USDT, USDC, BUSD, GUSD, TUSD and others maintain their peg to the US dollar.
These tokens have centralized issuers, but because of their 1:1 fiat backing, can suppress much of any possible price volatility of the token. There has also been much controversy regarding fiat-backed stablecoins due to some lack of transparency in terms of the funds backing the tokens; however, there has been great improvement in that regard. Regardless, there is still a lot of concern around the increasingly high risk of US regulators cracking down on these stablecoin issuers.
Crypto-Backed
These stablecoins are tokens backed by some form of cryptocurrency collateral. This means that through a smart contract, users can deposit collateral in some other token in order to mint a certain amount of the stablecoin. Different stablecoins use different strategies of over-collaterization and liquidations to maintain the stability of the token. This is necessary since the underlying collateral is still volatile. This type of backing is used by tokens such as DAI or TSD.
These tokens are fully decentralized, which makes them transparent and much safer from regulatory overreach. They have also gained a lot of popularity in recent times due to the growing mistrust of the large centralized stablecoin issuers, resulting in much better liquidity in most chains. There is, however, more room for volatility in the stablecoin's price, due to its supply not being directly controlled by a centralized entity.
Commodity-Backed
These stablecoins are tokens backed by some other physical resource. These are very similar to fiat-backed counterparts in their centralized nature, but can be pegged to different types of assets. PAXG, for example, is a stablecoin pegged to the value of gold bars. These tokens have seen much less adoption since they don't provide the same utility as other stablecoins when it comes to buying and selling other tokens in DeFi, denominated in a commonly used fiat currency. They can, however, be a great way to get exposure to the asset the token is backed by.
Algorithmic
These stablecoins are tokens with a supply controlled entirely through a smart contract and its underlying algorithm. This means they don't require collateral, and should theoretically be very resistant to price changes relative to the assets they are pegged to. There are not too many of these in the DeFi ecosystem yet, but some have had great success in recent times. An example of this new type of stablecoin is the FRAX token, although some of its tokens are still backed by collateral as it was once a fully crypto-backed stablecoin.
Closing Thoughts
Utilizing stablecoins can greatly benefit DeFi users through great liquidity in DEXs and limiting exposure to crypto's volatility when desired. Products such as Axial's stablecoin liquidity pools can also provide a much better place to store your dollars compared to the minuscule interest rates offered by most banks worldwide. Knowing the risks of holding stablecoins though is always important, especially with the recent moves by the US government to investigate and ultimately regulate some fiat-backed stablecoins.
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