The more we learn about cryptocurrencies, it seems, the less we know. For example, we last reported that there were about 9,000 cryptocurrencies in 2021. That number has doubled in a year and now stands at around 18,000 (https://www.sofi.com/learn/content/understanding-the-different-types-of-cryptocurrency/). There are three basic types of cryptocurrencies — coins, security tokens, and utility tokens, each with different characteristics and uses. Coins, like Bitcoin, which is the largest in terms of market value of all the cryptocurrencies, were designed to function as currency and are created within either a centralized or decentralized blockchain. Their creation requires solving an equation (called mining) and now involves huge amounts of energy and billions of dollars of computer technology. Security tokens are similar to stocks and are treated as a security, giving the holder an ownership interest. Utility tokens provide a digital claim on an asset or service. Utility and security tokens are not generally mined, like coins, but rather are normally issued all at once. Utility tokens can provide access to a service like electricity or to certain software applications or even products. There are hundreds of different kinds of utility tokens, each with different functions, and they are often confused with other kinds of tokens and coins. No two are alike.
A key set of coins are called stablecoins. Who wouldn’t want a “stablecoin” as opposed to an “unstable coin”? After all, stability is one of the key attributes to a well-functioning currency that serves as a unit of value and a medium of exchange. What are so-called stablecoins? They are cryptocurrencies that are pegged to some other asset. There are four basic types of stablecoins — those pegged to a fiat-currency such as the dollar or the Euro, those backed by another cryptocurrency or asset, those backed by a commodity or set of commodities, and those whose value is determined by an algorithm that adjusts value to assure low volatility.
Fiat-Currency-Backed Stablecoins
Typically, fiat-currency-backed stablecoins are pegged one-to-one to a government-issued currency like the US dollar or the Euro. The fiat currency is maintained in a reserve with a central insurer or financial institution, and it may or may not be fully collateralized. At present there are about 10 countries that have launched digital currency backed by their fiat currency; 19 of the G20 countries are exploring digital currency; and about 105 countries are looking into the possibility of establishing a digital currency. The Federal Reserve Bank of New York has initiated a pilot program involving major US financial institutions.
Cryptocurrency-Backed Stablecoins
Cryptocurrency-backed stablecoins are collateralized by one or more cryptocurrencies. To reduce volatility, there will often be overcollateralization in the form of an excess reserve. This means that circulation will be less than the amount held in the reserve. As an example, the cryptocurrency backed DAI is a so-called stablecoin that is pegged to the dollar but backed by several other currencies at 150% of the outstanding coins.
Commodity-Based Stablecoins
Commodity-based stablecoins, as the name implies, are collateralized by commodities such as gold. In some instances, such as gold-backed PAXG, the stablecoin can be redeemed for either the underlying commodity or cash. Other examples of commodity backing include silver, platinum, palladium, aluminum, copper, nickel, diamonds, real estate, and even oil.
Algorithmic-Based Stablecoins
Unlike the other stablecoins, algorithmic-based stablecoins rely upon computer technology to dynamically control outstanding supply of the coins to ensure stability. There may or may not be a reserve asset holding as a backup. The algorithms don’t always work, as illustrated by what happened to UST, whose value declined some 60% relative to its target peg to the US dollar.
How Stable Are Stablecoins, Really?
The decline in UST raises the question, how stable are stablecoins, relative to other coins like Bitcoin, whose volatility index recently hit 100%, and do they vary by type? This issue was recently addressed in a research paper by K. Jarno and H. Kolodziejczyk, “Does the design of stablecoins impact their volatility?” (https://www.econstor.eu/bitstream/10419/239459/1/1745195734.pdf). The authors attempt to examine the volatility of 20 stablecoins with anywhere from 30 to 1893 data points. All coins in the sample were collateralized and required the posting of additional collateral as market movements occurred. They looked at eight token currencies, nine collateralized coins, and three algorithmic coins. The findings suggest that the token coins had the lowest volatility, while both the algorithmic and collateralized coins were substantially more volatile. The eight token coins had a volatility of 2.2%; and if the one outlier is excluded, the volatility is 1.04%. This result compares with 7.5% for the algorithmic coins and 9% for the collateralized. So it is clear that not all so-called stablecoins are alike, and it is dangerous to simply rely upon a name. If these numbers hold true for the universe of stablecoins, then it is clear that the other variants of cryptocurrencies are likely to be much more volatile and risky, since their value is determined solely by supply and demand.
Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
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