Types of Stablecoins: Their Evolution, Use Cases, and Taxes

Stablecoins play a critical role in crypto. From trading to powering decentralized applications (dApps), they serve as a bridge between traditional finance (TradFi) and the digital asset industry.

Currently, multiple types of stablecoins are present on the market. However, they all serve the same goal: to minimize crypto volatility and expand the use cases of digital assets.

Exploring the different types of stablecoins, this article will cover the following key points:

• Stablecoins and their role in crypto

• The different types of stablecoins and their unique characteristics

• The potential use cases of stablecoins

• Stablecoin taxation and a method to simplify the process

What Are Stablecoins?

Stablecoins are digital assets pegged to the value of a single or a basket of financial instruments to minimize the volatility risks of cryptocurrencies.

In most cases, the stablecoin follows the value of major fiat currencies like the USD, EUR, or GBP. But there are also types of stablecoins that are pegged to the price of gold and other commodities.

This peg or link can be established in multiple ways based on the stablecoin's type.

For example, the issuers of fiat-backed assets hold fiat currencies in their reserves to establish and maintain a peg with the underlying instrument. On the other hand, algorithmic stablecoins achieve price stability through an algorithm.

By closely following a less volatile asset's price, stablecoins are not subject to standard cryptocurrencies' frequent and often extreme price fluctuations. Simultaneously, they reside on the blockchain and retain most non-stable digital assets' key attributes, such as:

• Peer-to-peer (P2P) transfers without intermediaries

• Transparent, publicly-available on-chain records

• Instantaneous and cost-efficient transactions

• Cryptographic security

• Smart contract programmability

Considering the above, stablecoins can effectively bridge an important gap between crypto and fiat without relying on the traditional finance infrastructure.

What Are the Different Types of Stablecoins?

Based on the price stability mechanism, we differentiate four different types of stablecoins:

1. Fiat-backed stablecoins

2. Crypto-backed stablecoins

3. Commodity-backed stablecoins

4. Algorithmic stablecoins

Fiat-Backed Stablecoins

Examples: Tether (USDT), USD Coin (USDC), TrueUSD (TUSD)

As one of the most popular types of stablecoins, fiat-backed stablecoins maintain price stability with the underlying asset through physical collateral. To achieve this goal, the issuing company holds as much fiat currency in its central off-chain reserves as the total value of the stablecoin currently in circulation.

In theory, if an issuer has $100 million of reserves, it can only mint and distribute $100 million of stablecoins to achieve 1:1 fiat backing. However, the actual size of physical collateral depends on the issuer's transparency, crypto audits, and regulatory compliance.

Regarding that, fiat-backed assets are the most subject to regulation among all types of stablecoins due to holding physical reserves in national currencies.

For example, the New York State Department of Financial Services' (DFS) guidance requires all locally-regulated fiat-pegged stablecoins to be fully backed and redeemable by investors. Moreover, issuers must also submit to monthly audits by independent CPAs.

Concerning redemptions, some fiat-backed stablecoin issuers offer holders the ability to redeem their digital assets for cash at 1:1. However, certain conditions may restrict this activity's scope at a few providers.

Crypto-Backed Stablecoins

Examples: DAI, Liquity USD (LUSD), Magic Internet Money (MIM)

Unlike their fiat-backed counterparts, crypto-backed stablecoins don't require physical reserves to achieve price stability. Instead, a centralized issuer is replaced by a DAO that leverages smart contracts and on-chain transactions to collateralize the stablecoin with cryptocurrency.

As a result, crypto-backed stablecoins' price stability mechanism is both decentralized and transparent. But issuers had to sacrifice a degree of capital efficiency to minimize financial risks and ensure the safety of users.

Like DeFi loans, crypto-backed stablecoins are over-collateralized to protect against digital asset volatility. So, users can mint less stablecoins than the value of their cryptocurrency collateral.

For example, you must deposit at least $1,700 of ETH in a Maker Vault as collateral to mint $1,000 of DAI at a minimum collateralization ratio of 170%.

Suppose ETH's price takes a hit, and the total value of your deposit falls below $1,700. In this case, the protocol's smart contracts automatically liquidate a part of the collateral to cover outstanding debt and liquidation fees.

Besides over-collateralization, crypto-backed stablecoins offset volatility risk via other price stability mechanisms as well. This includes DAI's stability fee and LUSD's redemption fee.

Regarding redemption, crypto-backed stablecoins can be redeemed at face value at any time. To achieve that, holders must initiate an on-chain transaction to recover their digital asset deposit after paying all respective fees.

Algorithmic Stablecoins

Examples: Terra USD (UST), USDD

Like crypto-backed stable assets, an algorithmic stablecoin operates in a decentralized manner via smart contracts and on-chain transactions.

However, there is an important difference between the two types of stablecoins. Crypto-backed stablecoins are fully collateralized, while algorithmic stablecoins are not.

Instead of collateral, algorithmic stablecoins maintain their pegs through an algorithm-powered price stability mechanism. This process often involves a project's native token and arbitrage. Let's see an example to better understand this.

Terra's UST stablecoin aimed to hit its $1 price target in two ways.

When UST was trading above $1, the protocol repurchased the native LUNA token from the market and burned LUNA until UST's price reached $1. In contrast, the algorithm minted LUNA and used it to buy back and burn UST to restore the stablecoin's value to $1.

The whole process was powered by arbitrage. For buybacks, Terra incentivized sales by offering discounted rates for users.

With no over-collateralization (or any collateralization at all), algorithmic stablecoins improve capital efficiency without centralized off-chain reserves. However, achieving this goal comes with significant financial and systematic risks.

In fact, algorithmic stable assets are the riskiest types of stablecoins, as times of extreme market volatility can trigger a bank run. In general, such an event doesn't significantly impact a collateralized digital asset, as it only contracts the circulating stablecoin supply.

However, algorithmic stablecoins' circulating supply can only be reduced via native token minting. During a bank run, there is a chance the algorithm can't keep up with the continuous selling activity. In such a case, it can't restore the stablecoin's peg while sending the native token's price to near zero.

This is exactly what happened in May 2022, when UST's depeg wiped away nearly $40 billion of LUNA's market cap and collapsed the whole Terra blockchain.

Commodity-Backed Stablecoins

Examples: Tether Gold (XAUT), Paxos Gold (PAXG), Digix Gold Token (DGX)

Commodity-backed stablecoins function similarly to fiat-backed stablecoins. Both are collateralized with physical reserves and a central issuer and can be redeemed for the underlying assets. The only difference between the two is that a commodity-backed stablecoin follows the price of a commodity instead of a fiat currency.

From real estate, oil, and precious metals, it can be backed by a wide variety of commodities. However, the most popular commodity-backed stablecoins are pegged to gold's price.

This stablecoin type’s major benefit includes open access to commodities. This way, investors can gain exposure to gold without relying on physical bars or stock market ETFs.

Similarly to other cryptocurrencies, commodity-backed cryptocurrencies are divisible into very small units. For example, with up to 18 decimals, the smallest theoretical investment in PAXG is $0.000000000000001995 on the secondary market.

As a result, commodity-backed stablecoins can remove the barrier to entry for investors with smaller budgets and also those without access to conventional investment products.

What Are the Potential Use Cases of Stablecoins?

By bridging crypto with fiat, stablecoins serve a wide variety of use cases. The most important ones are collected in the below table:

Use CaseBenefitHedgingExchange cryptocurrencies to stablecoins to avoid excessive market volatility and bearish price movements without relying on fiat currencies or the TradFi infrastructure.PaymentsOn average, merchants pay anywhere between 1.29% +$0.05 to $3.29 + $0.10 for each credit card transaction. Also, the global average cost of remittances stood at 6.30% in Q3 2022. In contrast, stablecoin transactions feature inexpensive transactions with an average processing fee of 1% at crypto payment gateways.TradingCentralized exchanges (CEXs) and decentralized exchanges (DEXs) replace fiat-crypto pairs with stablecoin-crypto pairs to design a more seamless trading experience and avoid fiat on/off ramp fees.PayrollAs they are processed through multiple corresponding banks, an international bank transfer can cost between 3-4% and take 3-5 working days to arrive. For organizations with remote employees, stablecoins provide a better alternative for only a fraction of the costs and with instantaneous transactions.DeFiFrom lending to yield farming, stablecoins play a crucial role in the decentralized finance (DeFi) industry. They provide much-needed stability for dApps by offering a less volatile alternative for users of DeFi protocols.

Are Stablecoins Taxable?

Regarding taxation, the same rules apply when calculating taxes for NFTs as for stablecoins and other digital assets. So, Web3 organizations report and pay the following taxes on stablecoins:

1. Income taxes after all the taxable revenue generated in stablecoins. Examples include interest payments, liquidity provider rewards, staking rewards, the sale of NFTs, as well as other goods and services.

2. Capital gains taxes after realizing a profit by exchanging crypto assets for stablecoins or via any disposal event (e.g., spending, selling, trading, gifting) where the sale price of a stablecoin is higher than the purchase price.

In the US, organizations can report income taxes on stablecoins via the annual corporate tax return (Form 1120, Form 1120-S, or Form 1065). For capital gains or losses, they must refer to Form 8949 and Form 1040 Schedule D.

UK-based businesses can report both income taxes and capital gains as corporation tax online or via the CT600 form.

Reconciling Stablecoin Transactions

Generally, Web3 accountants reconcile stablecoin transactions for tax purposes similarly as they do with standard crypto assets.

Both stablecoins and cryptocurrencies reside on the blockchain outside the traditional finance infrastructure. This means organizations can’t rely on their bank accounts anymore. Instead, multiple sources should be utilized for crypto tax reconciliation, including block explorers, CEX accounts, and CeFi providers.

While stablecoins' values don't fluctuate as much as cryptocurrencies', they are also subject to frequent price changes. These are very small in magnitude, often in the $0.0001 range. However, accountants still have to record them in their books by calculating the respective fiat value for each stablecoin transaction.

Consequently, the same complex crypto tax reconciliation [LINK] process applies to stablecoins as to standard cryptocurrencies.

Stablecoin Impairment Testing

Impairment testing [LINK] may or may not apply in the case of stablecoins.

Under US GAAP, most cryptocurrencies are considered intangible assets. As so, all organizations following the GAAP must test the digital assets in their balance sheets for impairment. This should be done at least once at the end of every reporting period and also in the case of major market changes.

However, the GAAP categorizes some stablecoins as financial assets instead of intangible assets. As a result, organizations are not required to periodically impair them.

But how to know whether a stablecoin is a financial or intangible asset? Under the GAAP, a stablecoin may represent a financial asset if it includes a right to receive or exchange the coin for cash from the issuer.

In most cases, the above rule doesn't apply to algorithmic and crypto-backed stablecoins. While algorithmic stablecoins don't have a redemption mechanism, crypto-backed tokens can't be redeemed for cash, only digital assets.

On the other hand, many fiat-backed stablecoin issuers offer owners the right to redeem their assets for fiat currencies. As so, these stablecoins could be considered financial assets.

How to Simplify Stablecoin Taxation?

Different types of stablecoins use various price stability mechanisms to maintain their pegs to underlying assets.

No matter the type, your organization becomes subject to income taxes if it receives revenue in stablecoins. Besides that, you will also have to report and pay capital gains tax after realizing a profit on a stablecoin.

Despite its minimal volatility, a stablecoin still fluctuates in price, resulting in a tedious manual tax reconciliation process. Simultaneously, a part of stablecoins must be regularly tested for impairment under the GAAP.

Integral removes the complexity of stablecoin taxation to save valuable time for Web3 organizations. With our powerful crypto accounting stack, you can:

• Reach blazing-fast month-ends with automated workflows

• Calculate capital gains/losses automatically

• Gain real-time visibility over your organization's treasury with minute-by-minute pricing

• Impair all your assets with a single click

• Set up automatic impairment tests for custom reporting periods

Book a demo with Integral, and our team will show you how to save resources on stablecoin taxation!