Stablecoins Explained

Stablecoins Explained

What are stablecoins (fiat-collateralized like USDT, crypto-collateralized, and non-collateralized ones), and problems they are named to solve: basic guide and examples

In recent years digital currencies, and blockchain technologies in a broader sense, have garnered much attention and sparked wide interest. Despite this, the cryptocurrency market remains highly volatile. Even technical analysts with years of experience often cannot give confident predictions. Take a look at today’s chart: in the last 48 hours bitcoin dropped from $7,380 down to $6,360 after a steady week-long climb, not to mention altcoins, which suffered a much painful fall percentage-wise.

Reason for existence

If cryptocurrencies are ever going mainstream, they must find a solution to this problem. In an effort to address this problem, people came up with stablecoins. A price-stable cryptocurrency is a digital currency that is pegged to an asset. Each token of such cryptocurrency is usually backed by a reserve.

There are three types of stablecoins:

  • fiat-collateralized,
  • crypto-collateralized,
  • and non-collateralized.

Fiat-collateralized

Fiat-collateralized stablecoins have reserves in fiat currencies, or commodities. For example, Each USDT token corresponds to $1, each DGX — to 1 gram of gold, each petro — to a barrel of Venezuelan crude oil. So whenever you buy, say, a USDT token, your dollar gets deposited to the USDT reserve, and you can redeem your dollar at any time by selling your USDT.

These stablecoins are usually issued and managed by a central organization, which is obviously a big deal breaker for many. Another drawback of fiat-pegged stablecoins is that they are not very scalable in that one would need a lot of money as collateral for tokens that can be minted practically out of thin air.

Crypto-collateralized

A crypto-collateralized stablecoin is backed by a reserve in one or more cryptocurrencies. At first one may think that this does not make any sense but it does. These stablecoins are overcollateralized so as to remedy any possible price fluctuations of the underlying asset. And those who buy these stablecoins are normally incentivized through interest payments.

Reserves of these stablecoins are usually controlled by decentralized organizations, or DAOs. For example, Dai, pegged to USD but collateralized in ETH, is issued by MakerDAO. Havven uses a more sophisticated dual-token system where Havven tokens, accumulated through fees, act as collateral for USD-pegged nUSD.

Though many complex mechanisms are implemented to ensure stability of these stablecoins, crypto-collateralized cryptocurrencies are still a risky investment.

Non-collateralized

Non-collateralized stablecoins, as you would suspect, do not have any collateral in reserve. Instead, they mirror fiat currencies using a complex mechanism called seigniorage shares. Without going into technicalities, we can explain the mechanism as a smart contract that maintains the stable value of the coin by decreasing or increasing the supply. It works according to the fundamental economic law of supply and demand.

If the coin is more expensive than the underlying asset, the contract simply mints new coins. If, however, the coin trades at a lower price that the asset it is pegged to, the smart contract buys out a portion of coins, using accumulated excess profits. This decreases the total amount of coins in circulation, which in turn increases the coin’s value.

However, these contracts often do not have sufficient funds to buy enough coins to even the prices out, which is a major drawback of non-collateralized stablecoins. Projects like Basis and Saga are ambitious and yet they have a lot to work on.

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