The recent collapse in the price of Iron Finance’s partially-collateralized Titan token has served as a tale of caution for the crypto community. What went wrong? A detailed post-mortem attributed the crash to a so-called “large-scale bank run” that impacted the mechanism behind the algorithm supporting its stablecoin. Not all stablecoins are created equal, and as new iterations emerge, investors need to weigh out the risks and rewards associated with their use.

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Since the first stablecoin was created in 2014, they’ve seen remarkable growth, reaching a total market cap of US$118.3 billion — a tenfold increase just over the past year. Stablecoins have rightfully earned their name by providing investors a safer option to invest in crypto, amidst times of market volatility. While each type of pegged asset comes with its own pros and cons, we can’t deny that they now play a central role in the DeFi ecosystem and even beyond that.

Collateral categories: variations of stablecoins

Over the past seven years, stablecoins have grown into four main variations, each with their own working mechanisms, advantages, and shortcomings.

Fiat-backed stablecoins owe their market domination status to their high stability, as most of them are pegged to popular fiat currencies such as the U.S. dollar, the euro or the British pound sterling. While they are deemed the most stable of digital assets, fiat-collateralized tokens are not always immune to market volatility. Even market leader USDT has fallen below US$1 in the past due to a strong demand for Bitcoin.

Meanwhile, commodity-based stablecoins are backed by commodities such as gold, silver and other precious metals. For example, Tiberius Coin (TCX) is a commodity-collateralized stablecoin backed by a combination of seven precious metals commonly used in the production of hardware, such as solar panels and electric cars. Another example is Digix Gold (DGX) — an ERC-20 token backed by physical gold bars stored in Singapore and Canada.  

For those seeking a more decentralized alternative, users can consider cryptocurrency-backed stablecoins. These stablecoins are comparatively more decentralized as all transactions happen on the blockchain. However, token holders will also be more exposed to volatility due to unpredictable price movements in the underlying asset.

Looking at the more decentralized end of the spectrum, there are algorithmic or non-collateralized stablecoins, which rely on mechanically generated algorithms encoded into smart contracts to adjust the supply volume to maintain the desired price. While the obvious advantage of this class of stablecoin is that collateralisation is not required, relying on algorithms comes with its own risk, case and point, Iron Finance.

Dominating DeFi

During bearish markets, stablecoins offer investors a safer means to earn yield on their digital assets through lending or liquidity mining in the DeFi market, while mitigating the impact of price volatility that other types of cryptocurrencies are exposed to. For example, if an investor chooses to only stake ETH on a protocol to earn interest, a sudden drop in ETH might offset the yield earned or even leave them with a net loss position. However, if the same user opts for a stablecoin such as USDC instead, the value of the underlying asset would remain unaffected as it is pegged to the USD.

Because of their risk-hedging properties, stablecoins pegged to fiat currency have become an integral subset of the burgeoning DeFi ecosystem, offering participants a safer alternative to earn yield. Unsurprisingly, digital dollar stablecoins are becoming increasingly important assets in the DeFi lending markets. 

There has also been an emergence in algorithmic stablecoin projects in the space such as Ampleforth (AMPL) and Empty Set Dollar (ESD), two of the most popular tokens in this category. As the mechanisms behind algorithmic stablecoins continue to mature, they have the potential to rival other types as a store of value and as a staking token in the DeFi ecosystem.

With the total amount of stablecoins circulation surging by 1,00o% in just over one year, stablecoins have brought a significant share of liquidity and resilience to the DeFi ecosystem. As some investors slowly recover from the recent sell-off this past May, the yields offered by stablecoins on DeFi platforms make them more attractive to diversify away from riskier crypto assets.

Accelerating digital asset adoption

While much has been said about the role of cryptocurrency in driving a cashless society, the reality remains that volatility is one of the obstacles in mass adoption. Especially for people who live paycheck to paycheck, there needs to be a degree of certainty in how much their money is worth weeks, months or even years down the road. Taking that into account, stablecoins have the potential to transform the lives of millions of people in developing countries through inexpensive remittance alternatives. Instead of paying the global average of 6.4% to traditional intermediaries to transfer salaries back home, migrant workers can instead transfer stablecoins through crypto wallets, which often charge less than 1%.

As the global remittance market is estimated to be worth more than US$930 billion by 2026, mainstream tech players such as Facebook have also taken note of this lucrative segment. In 2019, the social media giant introduced its Libra project to the world, which received a mixed reception. Since then, the tech giant has been preparing to launch a U.S. dollar-backed stablecoin renamed Diem in an effort to venture into the e-commerce and global payment industries. 

The advent and proliferation of stablecoins have been nothing short of a game changer for the crypto industry, as they serve to mitigate unpredictable, and extreme price swings while simultaneously offering a safer token to earn yield from staking and lending activities. With the crypto ecosystem now looking beyond its echo chamber, stablecoins and their utility in other spheres will be essential. As digital payments and an increasingly cashless financial system come to the fore, stablecoins are likely to play a pivotal role in shaping how we earn, transact, and trade, for the foreseeable future.