What are the classifications of various stablecoins?

Stablecoins are cryptocurrencies designed to maintain a stable value. Stablecoin implementations can be divided into three broad categories: fiat stablecoins, cryptocurrency-backed and algorithmic stablecoins.

Stablecoins supported by legal currency

A fiat-backed stablecoin is a digital asset designed to mirror the value of traditional currencies, of which the U.S. dollar and euro are the most common. Issuers of such stablecoins claim that they retain sufficient reserves of liquid assets to support their value on the blockchain. Ideally, these reserves exist in the form of cash or cash equivalents (such as Treasury bonds), and the amount of reserves should at least equal or exceed the circulating supply of the stablecoin. USDT and USDC are typical examples of stablecoins backed by fiat currencies.

Stablecoins backed by legal currencies are widely used in activities such as transactions, remittances, and lending in the field of decentralized finance. However, the centralized nature of these stablecoins means that their reserves may contain volatile and risky assets while lacking independent third-party audits, thereby adding additional risks. Nonetheless, fiat-backed stablecoins remain popular, highly liquid, and somewhat resistant to price manipulation, underscoring their importance in the cryptocurrency space.

Cryptocurrency-backed stablecoin

A stablecoin is a cryptocurrency whose value is backed by other cryptocurrencies as collateral. However, due to the price volatility of cryptocurrencies, stablecoins often require over-collateralization to ensure their stability. For example, if the collateralization requirement is 150%, then a user would need to deposit $150 worth of cryptocurrency into the system to mint $100 of stablecoins. MakerDAO’s DAI is the most famous of the cryptocurrency-backed stablecoins. It is currently the largest stablecoin by market capitalization and its value is backed by Ethereum as collateral. The issuance of DAI is realized through smart contracts. When the value of collateral drops, the system will automatically increase the collateral requirements to maintain the stability of the value of the stablecoin. Cryptocurrency-backed stablecoins play an important role in the digital currency market. They provide a relatively stable digital asset that can be used to trade and store value without being affected by large swings in cryptocurrency prices. Still, it's important to note that the cryptocurrency market itself carries higher risks and investors should approach it with caution.

Cryptocurrency-backed stablecoins are decentralized and trustless, but there are still risks. As the collateral backing the stablecoin fluctuates, it is possible for the peg to break, with the underlying collateral automatically liquidated upon collapse.

Algorithmic Stablecoin

Algorithmic stablecoins maintain price stability through algorithms and incentive mechanisms, unlike collateralized or over-collateralized stablecoins. Algorithmic stablecoins do not need to rely on asset reserves to maintain value and can function normally even if they are undercollateralized.

The stability of algorithmic stablecoins is mainly determined by market demand. If demand drops below a certain threshold, the entire system may be at risk of collapse. Last year, the TerraUSD stablecoin suffered a major decoupling event that caused its price to fall below $1, triggering a massive sell-off and causing the price of Luna, the governance token of the Terra blockchain system, to drop. The crash wiped out more than $40 billion from investor wealth in just a few days. Therefore, the stability of stablecoins requires a high degree of attention to fluctuations in market demand to ensure the stable operation of the system.

Despite potential drawbacks, the transparency and decentralization of algorithmic stablecoins are attractive to users because operations are controlled by auditable code.

There are also some stablecoins, such as Paxos Gold and Tether Gold, which claim to be backed by physical reserves of precious metals and provide stability with tangible assets.

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