Stablecoins are a significant space for crypto investors to safeguard their wealth in the crypto market.
According to DeFillama data, the total market capitalization of stablecoins has reached $133.79 billion, meaning that a substantial amount of $133.79 is currently held in the form of mixed stablecoins.
To put this into perspective, the market capitalization of USDT (Tether), a stablecoin, ranks third, just below Bitcoin and Ethereum.
This implies that, after Bitcoin and Ethereum, crypto investors still prefer to store their funds in the crypto market in the form of USDT compared to other cryptocurrencies.
This preference is because stablecoins can be utilized for various strategies, including seeking passive profits in the DeFi sector or simply holding before identifying a potential crypto to purchase.
This strategy is commonly employed, especially during bear markets when market movements are unclear and often filled with corrections. In such times, investors who still want to leverage crypto market technology choose stablecoins to seek profits.
Stablecoins are used in bear markets due to their relatively stable movements, making them considered a safe haven for wealth storage. However, not all stablecoins are equally secure, as some types carry higher risks.
This article will elaborate on the three most commonly used types of stablecoins in the crypto and blockchain world, along with potential risks associated with each type.
Fiat-Based Stablecoins
The first type is fiat-based stablecoins. These stablecoins have assets tied to them in the form of fiat currency. The value of these stablecoins is directly linked to a fiat currency, such as USDT, which is based on the US Dollar (USD). For example, 1 USDT is equal to $1.
This currency is issued by Tether, giving it the name USDT. In issuing USDT, Tether must always have a reserve of US dollars corresponding to the amount issued. This means that if Tether issues 1 million USDT, they must have a reserve of $1 million USD stored in their reserves.
Another example is EURC, which is a stablecoin based on the Euro. 1 EURC has a value of $1 EUR due to the connection between the stablecoin and the underlying fiat currency.
EURC is issued by Circle, so if Circle wants to issue 52.2 million EURC, they must have $52.2 million EUR in storage, as is the current reality. This mechanism is implemented to ensure that the issuer of the stablecoin does not arbitrarily issue and adjust the amount of stablecoin in circulation with the underlying fiat currency in the real world.
This condition gives crypto real value because if the issuer of the stablecoin issues it arbitrarily without being backed by the original fiat currency, the denomination value of the crypto traded with the stablecoin would collapse and become worthless. Similar to fiat currency, this type of stablecoin has inflationary characteristics, so its quantity will continue to increase over time along with the increase in the underlying original fiat currency.
It’s worth noting that this type of stablecoin is most commonly used due to the convenience it provides. For example, when depositing on an exchange, investors deposit in the form of fiat currency to then obtain stablecoin.
As an initial step for investors entering the crypto world, it is recommended to use this type of stablecoin as it does not have complicated mechanisms. Regarding risks, this stablecoin is considered the safest as it has the highest volatility risk given its value based on fiat.
Fiat-based stablecoins, like traditional fiat currency, have inflationary characteristics, and their quantity increases over time along with the underlying fiat currency. These stablecoins are widely used for their simplicity, especially for initial entries into the crypto world. In terms of risk, these stablecoins are considered the safest, as they have the highest volatility risk, given their value is based on fiat.
Commodity-Based Stablecoins
The second type is stablecoins based on commodities. Unlike fiat-based stablecoins, the value of these stablecoins is not tied to fiat currency but to commodities like gold, silver, oil, or other well-known commodities. Companies like Circle and Tether can issue these stablecoins.
Commodity-based stablecoins are often used for long-term investments by those seeking an alternative way to purchase commodities while leveraging blockchain technology. The advantage here is liquidity, as commodities bought through these stablecoins are easier to sell and cash out. However, the value of this stablecoin does not reflect the value of fiat currency but instead mirrors the underlying commodity, such as a stablecoin based on gold issued by Paxos.
So, for example, a stablecoin based on gold issued by Paxos, named PAX Gold or PAXG, has a value of $2,000. This means that 1 PAXG has a value of $2,000 because the current value of 1 ounce of gold is $2,000. Similar to fiat-based stablecoins, to issue 1 million PAXG, Paxos must have 1 million ounces of gold stored in its reserves.
This type of stablecoin is more commonly used for long-term investments by investors seeking an alternative way to purchase commodities while leveraging blockchain technology. One advantage of investing in commodities this way is liquidity, where commodities purchased through this stablecoin are easier to sell for cashing out because you only need to exchange them for fiat-based stablecoin and then withdraw funds to a personal bank account.
In terms of risk, these stablecoins have higher risk levels compared to fiat-based stablecoins, as the underlying assets (commodities) are more volatile than fiat currency.
Crypto-Based Stablecoins
The third type is crypto-based stablecoins, where the value is maintained at $1 per stablecoin but using cryptocurrencies as the underlying assets. These stablecoins are often issued by DAOs (Decentralized Autonomous Organizations) aiming to maintain decentralization while needing a stablecoin to replace fiat currency in the crypto world.
One example of this is the stablecoin called DAI, issued by MakerDAO. Unlike stablecoins issued by a central authority, this stablecoin requires participation from the community, DAO members, and crypto investors together to be created.
With DAI, issuance is carried out through a process called minting, where ETH is deposited into the DAO. Since its mechanism is not controlled by a central authority, the DAO uses smart contracts to ensure the value of DAI never falls below $1, maintaining a consistent value of 1 DAI at $1.
This is achieved by implementing a mechanism of depositing more than the value of DAI, known as over-collateralization. With DAI, to issue $1 worth of DAI, with an over-collateralization ratio of 150%, an investor must deposit $1.5 worth of ETH into the DAO Vault.
Considering the high volatility of crypto, this additional deposit acts as a precautionary measure in case the collateral value for stablecoin issuance significantly decreases.
It’s worth noting that this type of stablecoin can be created in various ways, such as through borrowing or exchanging. Currently, DAI creation involves depositing ETH into the MakerDAO Vault and borrowing DAI to release into the crypto market.
In contrast, with another example of a crypto-based stablecoin like UST experiencing a downfall alongside LUNA, investors only need to exchange LUNA for UST at that moment to acquire UST. Investors don’t have to follow the outlined process to own a crypto-based stablecoin; they can simply purchase it on an exchange. However, if they want to issue a stablecoin not yet in circulation, they need to follow the outlined process.
This type of stablecoin offers the opportunity for investors to engage in arbitrage due to its fluctuating value. For instance, considering the rapid fluctuations in the value of DAI due to underlying crypto volatility, if DAI’s value drops below $1, investors can buy 1 DAI and exchange it for 1 USDT to gain a small profit, as during the exchange, 1 DAI might be valued at $0.9991 while 1 USDT is valued at $1.
In terms of risks, this stablecoin carries the highest risk compared to fiat and commodity-based stablecoins due to the volatility of its underlying asset, crypto, and its potential for exploitation by crypto investors.
In summary, each of these three stablecoins can be used for its intended purpose. Therefore, for diversification, investors must thoroughly understand the stablecoin they intend to use.
