Stablecoins have earned their place as a popular and secure means of bridging the gap between traditional finance and digital finance. Various versions of stablecoins have iterated on one another to eliminate the financial inefficiencies that hinder traditional fiat methods in our Web3, digital-first world.
By offering the stability of traditional currencies while also allowing for the adoption of the benefits of decentralization that are inherent within cryptocurrencies – stablecoins look to be a large part of the future of finance.
Two prominent types of stablecoins are Bitcoin-backed and Bitcoin-secured. While both types are based on Bitcoin (BTC), there are fundamental differences in their underlying mechanisms, from levels of security to how they interact with the Bitcoin blockchain.
What is a Stablecoin?
A stablecoin is a type of cryptocurrency designed to keep a “stable” value in relation to a currently-used, real-world asset. These real-world assets include the US dollar, gold, and other commodities.
Unlike other digital assets, which can come with high volatility, stablecoins offer a more predictable option to users. They achieve their stability by being backed by one of the previously mentioned assets or commodities, with the underlying value of each being typically pegged one-to-one.
Having this equivalence between the stablecoin and real-world assets ensures that stablecoins remain predictable and consistent in value.
How Many Types of Stablecoins Exist?
Technically, there are four primary kinds of stablecoins:
- Fiat-backed stablecoins
- Commodity-backed stablecoins
- Crypto-backed stablecoins
- Algorithmic stablecoins
A fiat-backed stablecoin, as the name suggests, is backed by fiat currencies like the U.S. dollar. They're actually considered off-chain assets as they aren't pegged to a crypto asset, and the fiat collateral associated with them is in reserve with a central issuer.
Commodity-backed stablecoins are pegged to raw materials that are eventually made into products for consumption (this is a common definition of a commodity). A commodity like gold, for example, is a common collateral for stablecoins, as precious metals are considered commodities.
Crypto-backed stablecoins are pegged to a token via on-chain smart contracts. Unlike their fiat-backed counterparts, they do not make use of a central issuer.
An algorithmic stablecoin makes use of algorithms and smart contracts that manage the amount of tokens in circulation. These smart contracts can be tied to a cryptocurrency.
That last distinction is often why there is some confusion when it comes to differentiating between stablecoins backed by cryptocurrencies and -- like bitcoin -- and algorithmic stablecoins.
We'll use BTC to go into what the key differences are and what advantages -- and disadvantages -- are associated with each.
Bitcoin-backed stablecoins, also known as collateralized stablecoins, are backed by a reserve of BTC that acts as collateral to maintain their peg to the United States dollar (USD) or other fiat currencies. Examples of this type of stablecoin include Tether (USDT) and USD Coin (USDC), which are backed 1-to-1 by BTC.
Bitcoin-backed stablecoins work by holding a certain amount of BTC in a reserve that is equal to the value of the stablecoins currently issued. By doing this, they are ensuring that the stablecoins remain fully collateralized and can be redeemed for the equivalent amount at any time.
The top three advantages of BTC-backed stablecoins include:
- The relative ease of trading them, as they are listed on every major crypto exchange. This accessibility makes them an attractive option for traders looking to hedge against the volatility of other digital assets.
- Their benefits to people who want to hold U.S. dollars without relying on a traditional bank to do so.
- Cross-border payments can occur more quickly and cheaply through them since they can be sent instantly over the blockchain without the need for intermediaries.
But Bitcoin-backed stablecoins have some drawbacks as well.
Since they are backed by BTC, they can be subject to the volatility of the BTC market. If the value of bitcoin falls significantly, the reserve may not be sufficient enough to maintain the peg of the token.
If this were to happen, it would lead to a loss of value for the stablecoin holders.
Additionally, the underlying reserves are typically held by a centralized entity, which can ultimately create counterparty risks that users might be adverse towards. If the entity holding the reserve goes bankrupt, the value of the stablecoin can become severely impacted.
Bitcoin-Secured Stablecoins (Algorithmic Stablecoins)
Bitcoin-secured stablecoins, which are algorithmic stablecoins, are backed by a set of smart contracts that utilize BTC as collateral to maintain their peg to the US dollar or other fiat currency.
One example is MakerDAO’s stablecoin DAI. DAI stablecoins are decentralized but also overcollateralized – backed by Ethereum (ETH) deposited into its smart contracts.
These stablecoins use complex algorithms to adjust the supply of the stablecoin in response to changes in demand. This process is ultimately what helps maintain the stability of the peg.
Some of the advantages of Bitcoin-secured stablecoins include:
- Not being backed by a reserve of Bitcoin, which allows them to be free from counterparty risks. Instead, relying on a decentralized network of smart contracts that automatically execute based on predetermined rules.
- Lower potential for fraudulent activities to occur or mismanagement of funds to take place due to any one centralized entity.
- Offering more resistance to market fluctuations than Bitcoin-backed stablecoins can. This is because the algorithms used to maintain the stability of the peg are designed to adjust the supply of the asset based on changes in demand.
Disadvantages of Bitcoin-secured stablecoins also come by way of the algorithms used to maintain their stable peg, as they can often be complex and carry risk of bugs and vulnerabilities in the code. If a bug is discovered, it can lead to major losses for holders of the asset.
These Bitcoin-secured assets have also seen instances of deviation from their peg, which causes sudden fluctuations in price.
Stablecoins and the Future of Finance
Stablecoins give users a look at what the next iteration of the future of finance can be from better security, less intermediaries and a trust-minimized process for transactions that impacts everything from savings plans to daily transactions.
Whether it’s developing or holding a Bitcoin-backed or Bitcoin-secured stablecoin, users will get all the benefits that come from the Bitcoin blockchain.
Ultimately, the stablecoin market extends the capabilities of BTC and other cryptocurrencies as a medium of exchange, along with the mobility of crypto assets. It also ensures that Bitcoin isn't just seen as a store of value; in fact, entire DeFi ecosystems can be built on the Bitcoin network.
Bitcoin provides a truly trustless, secure and decentralized settlement layer that is the basis for Bitcoin DeFi and other innovations. These innovations and expanding use cases demonstrate that Bitcoin can rival newer blockchains, like the Ethereum blockchain, as a base layer for applications.