Stablecoins: Fiat-backed vs Algorithmic
Have you wondered what are the differences between a fiat-backed stablecoin and an algorithmic stablecoin? Read this article to discover the answer!
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Stablecoins are a category of cryptocurrencies that attempt to offer price stability either by being backed by assets or using complex algorithms that adjust their supply based on demand. The main feature that distinguishes stablecoins from other types of cryptocurrencies is that their value is relatively stable, which is achieved by particular mechanisms. In the following sections, we will explain the two most common variants of stablecoins: fiat-backed and algorithmic.
Fiat-backed / Fiat-collateralized stablecoins
Fiat-backed stablecoins are crypto tokens associated with the value of a specific fiat currency. These tokens hold their value fixed at 1:1 ratio. For example, Tether is a stable coin which is pegged 1:1 to the US dollar. Fiat currency is deposited as collateral to ensure the stability of the fiat-backed stablecoin.
How do fiat-collateralized stablecoins remain stable?
One way an issuer of a fiat collateralized stablecoin controls its price is by backing the currency with a reserve amount of fiat currency in their bank account. The reserves in this account need to be able to pay for the number of stablecoins in circulation. For example, if there are reserves of $1 million, assuming a 1:1 peg to the USD, the number of stablecoins distributed in the market should be equal to 1 million.
Problems with fiat-backed stablecoins
Stablecoins are not without problems. Like all other cryptocurrencies, they present risks.
Loss of the 1:1 Peg
The value of a stablecoin can negatively diverge from the 1:1 parity with its fiat currency. Fiat-backed stablecoins can be influenced by market sentiments in situations where crypto markets experience a major crash. The fact that investors may lose confidence can prompt a change in value.
Stablecoins are not recognized as legal tender in most jurisdictions. That means their value is restricted to the exchanges that use them. Any restriction of access or use of crypto assets can prevent you from withdrawing cash if the need arises.
While the main advantage of blockchain technology and cryptocurrencies is decentralization, stablecoins are leaning toward a centralized structure. This is due to the need to have a centralized entity that ensures that each coin in circulation is backed by a reserve value.
Several stablecoins have been called out publicly for not being transparent with their reserves. Organizations like iFinex and Tether have come under scrutiny for being unable to prove that their stablecoins are backed by USD reserves. Such perception can result in a substantial decline in a stablecoin's value.
The most popular fiat-backed stablecoins
- USD Coin (USDC)
- Tether (USDT, EURT, GBPT)
- Binance USD (BUSD)
- Gemini Dollar (GUSD)
Algorithmic / Non-collateralized stablecoins
Algorithmic stablecoins are different because they do not have any collateral attached to them, which is why they are referred to as “non-collateralized” stablecoins. Instead, they rely on complex algorithms to keep their prices stable by balancing funds held on the blockchain with supply and demand.
In other words, an algorithmic stablecoin uses an algorithm that will issue more coins when its price increases and buy them off the market when its price falls. This is similar to how central banks function when defending the peg of their currency in the market.
How do algorithmic stablecoins work?
Algorithmic stablecoin designers use various mechanisms to help the coin maintain its peg. Below are two common models of algorithmic stablecoin illustrated, assuming a peg for US$ 1.
- Rebase stablecoins. Rebase algorithmic stablecoins typically manipulate the base supply to maintain their peg. The protocol will add (mint) or remove (burn) coins from circulation depending on the stablecoin’s price deviation from US$ 1. The protocol mints coins when the coin price is above $1 whereas it burns coins when the coin price is under $1.
- Seigniorage stablecoins. Seigniorage algorithmic stablecoins use a multi-coin system where the price of one coin price is set to be stable and at least one other coin is designed to facilitate such stability. This model works by implementing a combination of mint and burn mechanisms with free market mechanisms that will incentive participants to trade the non-stablecoin. The objective is to push the price of a given stablecoin to its peg.
Popular examples of algorithmic stablecoins
- Basis Cash (BAC)
- Ampleforth (AMPL)
- TerraUSD (UST)
Pros and cons of algorithmic stablecoins
- More decentralized structure.
- Not supported by real assets.
- Prices are more unstable compared to collateralized-stablecoins.
- Rely on the demand to maintain value.
The future of algorithmic stablecoins
At the time of writing, no algorithmic stablecoin has managed to achieve a consistent stable peg. Many, like Basis Cash and TerraUSD, have failed, sometimes spectacularly. So far, the main use case for algorithmic stablecoins has been speculative trading. At the same time, algorithmic stablecoins are innovative mechanisms that can elevate decentralized finance. They represent an opportunity for innovation and expansion of the Decentralized Finance (DeFi) space.
How to buy stablecoins in Canada?
Using a cryptocurrency exchange platform
Pick a platform
For those looking to buy stablecoins in Canada, choosing a top-rated and trusted exchange is an important first step. The two most popular choices in terms of safety and customer service are NDAX and Coinberry.
Register your account
You will need to sign up and complete the verification process.Join NDAX Join Coinberry
Fund your account and start trading
Once your account is set up, you will need to deposit funds before you can start trading. The best option is to use a Canadian exchange where you can deposit and withdraw Canadian dollars. This helps you to save on transaction and trading fees.
Using your credit card
A popular and simple way to buy stablecoins is online using your credit card. You will need a wallet address and, if it is your first purchase, proof of identity.Buy stablecoins with your credit card
For individuals and institutions alike, stablecoins let people stay in the crypto world without the risk that is commonly associated with cryptocurrencies. Moreover, many countries are currently looking to regulate stablecoins and use them as an alternative to their existing financial systems. However, if you're considering buying stablecoins, keep in mind that there is still risk involved.