What are Stablecoins?
A useful currency should be a medium of exchange, a unit of account, and a store of value. Cryptocurrencies excel at the first, but as a store of value or unit of account, they’re pretty bad. You cannot be an effective store of value if your price fluctuates by 20% on a normal day.
Stablecoins are cryptocurrencies designed to minimize the effects of price volatility, thus they seek to function as a store of value and a unit of account.
To minimize volatility the value of a stablecoin can be pegged to a currency, or to exchange traded commodities (such as precious metals or industrial metals). Stablecoins backed by currencies or commodities directly are said to be centralized, whereas those leveraging other cryptocurrencies are referred to as decentralized.
Types of Stablecoins
Cryptocurrencies backed by currency (fiat) are the most common and were the first type of stablecoins on the market. Their characteristics are:
- Their value is pegged to one or more currencies (most commonly the US dollar, also the Euro and the Swiss franc).
- The peg is realized off-chain, through banks or other types of regulated financial institutions which serve as depositaries of the currency used to back the stablecoin.
- The amount of the currency used for backing of the stablecoin has to reflect the circulating supply of the stablecoin.
Notable currency-backed stablecoins:
- Gemini Dollar
- USD Coin
- Paxos Standard
Cryptocurrency backed stablecoins are issued with cryptocurrencies as collateral, which is conceptually similar to fiat-backed stablecoins. However, the significant difference between the two designs is that while fiat collateralization typically happens off the blockchain, the cryptocurrency or crypto asset used to back this type of stablecoins is done on the blockchain, using smart contracts in a more decentralized fashion.
For example, MakerDAO's DAI stablecoin is generated when someone opens a collateralized debt position (CDP), deposits some ETH as collateral, and then withdraws DAI from their CDP. The ETH acts as collateral.
Notable collateral-backed stablecoins:
- MakerDAO - DAI
- Bitshares - BitUSD
- Synthetix - SUSD
Seigniorage (or algorithmic) stablecoins can be linked to a decentralized autonomous organization which controls issuance and pricing. The supply of algorithmic stablecoins is typically controlled by issuing and destroying coins depending on the market demand, until the target price is reached. In the general case, market participants are incentivized to act in a way that the price is kept at target level by issuing either bonds, in times of decreasing price or seigniorage shares when the price is above target.
Notable algorithmic stablecoins:
- Basis (project was cancelled)
Tethered (sub-type of algorithmic)
Tethered cryptocurrency assets have certain features of algorithmic stablecoins – and can be considered their sub-type, except they don’t offer incentives in form of separate instruments (bonds or shares) to holders of the “underlying” cryptocurrency and there is no governing algorithm that forces the price towards the target, except at the moment of creation of the asset.
Tethered cryptocurrency assets are issued on-chain, by holders of the native cryptocurrency, with different pegs chosen by the issuer. The peg value is imported into the blockchain by consensus and can be a number of fiat currencies and exchange-traded commodities (e.g. USD, EUR, gold, silver, etc).