A Stablecoins is a cryptocurrency linked to a physical or digital asset or other fiat currencies, like US dollar, gold, or another cryptocurrency.
Stablecoins come with all the benefits of standard cryptocurrencies. They allow us to send money directly and instantaneously to other people on the planet, whether it is as payroll for the employees, buying something, or having a crypto asset pegged to USD/Euro, and it’s immune to fluctuations of standard cryptocurrencies.
They are compelling because of their stability (hence the name), each has a unique mechanism behind them, but in general, the essentials are the same as they are pegged to another asset.
This type has the most straightforward design as their value is pegged to a fiat currency in a fixed ratio i.e., 1 Token == 1 USD. This type of tether is realised through banks or other financial instruments, all happening off-chain (not on a blockchain). How much fiat-based currency issuer wants to use for backing the stablecoin reflects how many tokens will be in a supply.
Not only fiat can be used for such currencies. Precious metals can also be utilized. Every fiat currency and ETCs can be used as collateral for the issuance of new stable coins.
The only downside of such Stablecoins is the centralization of a coin. There is one company that controls the supply, and banks are involved as a third party. Suppliers of such currency need to follow all required AMM regulations, maintain the cost of legal compliance, and maintain reserves in a bank.
As with every centralized entity, if trust is lost, then nobody will want to use that coin. Another potential issue the loss of value of backing the currency.
Here’s also a great article on why USDC is The fastest Growing Stablecoin.
Like the previous type, the only changes are backing assets, and the peg is executed on-chain via smart contracts. The main difference can be put like this: Fiat-backed collateralization happens off-chain, while for cryptocurrency-backed Stablecoins, all is done on-chain. It means such coins are decentralized as all is happening on the blockchain, trustless.
The supply of stablecoin is regulated through smart contracts. * The price stability is achieved by introducing auxiliary instruments and incentives, not just the collateral.
The main stablecoin from this category is DAI. The price of DAI is kept in check through a system of smart contracts automatically executing themselves. If the price of DAI fluctuates too far from one dollar, Maker (MKR) tokens are burned or created to stabilize the price of DAI. MKR tokens are auxiliary instruments in this case.
More of how the DAI works, The Defiant has a short video just about that.
The development of such stablecoins is much more complex than fiat-based. The whole issuance system, backing, incentives, and managing auxiliary instruments needs to be developed and implemented into smart contracts. Smart contracts need to be secure, and many safety mechanisms need to be included if collateral asset loses all of its value.
This brings us to the main issue, the value of the collateral asset. As we know, Bitcoin, Ether, and other cryptocurrencies fluctuate a lot in their price, which adds difficulty in maintaining the stable value of a coin in the mid and long term.
Algorithmic stablecoin is the most prominent and fully decentralized, digitalized, and non-reliant on any collateral. The code controls its value and supply.
There is two primary mechanisms how such algorithmic stablecoin can be programmed.
- Seigniorage shares: This is a two token system. Stablecoin and seigniorage shares tokens. When demand for stablecoins increases, new stablecoins are issued to offset demand and keep prices flat. The new stablecoins are issued proportionally to seigniorage shareholders based on the percentage of shares they own. When demand decreases and price falls, shares are put for sale in exchange for stablecoins. More info can be found here.
- Elastic supply: Very simple idea. When the price is above the peg (1USD), the total amount of stablecoins increases, minting of new coins, which leads to inflation. When the price is low, the supply is reduced, which leads to deflation. By constantly checking the peg and controlling the supply system is able in the mid-long run to stabilize the peg.
All of that looks like a dream, but reality can still hit you hard. Algorithmic stablecoins promise the future we want, but there wasn’t still an excellent implementation of it. Every month we’re coming closer to having a genuinely working and not volatile algorithmic stable coin, but we are not quite there yet.
Most prominent examples
- Empty Set Dollar (ESD)
- FRAX (Frax Finance)
- Ampleforth (AMPL)
- Dynamic Set Dollar (fork of ESD)
More info on the current landscape of stablecoins:
Stablecoins are how we can use cryptocurrency in real life as a valid alternative to fiat money, with most, if not all, benefits of cryptocurrencies.
Ethereum is a go-to blockchain for experimenting and creating new Stablecoins. All of the coins mentioned in the article were created on Ethereum, utilizing its powerful smart contracts.
Ethereum is home to new financial instruments created in DeFi, a settlement layer for most apps, and the platform of choice for the entire ecosystem of digitally stable money. As Consensys states in its Q1 Report for DeFi:
Total stablecoin supply on March 31st was approximately $42 billion, more than a 4x increase than the total supply at the end of Q4.
Traditional financial services see a great opportunity in this space. Visa’s partners will reportedly be able to exchange USD Coin (USDC) over the credit card’s payment network to clear transactions made in fiat currency.
Stablecoins are here to stay. They will only evolve, and I hope we will see one algorithmic stablecoin emerging and be the new default in the near future. As a side note, in my career, I even worked on one algorithmic stablecoin and audited a few of the algorithmic coins mentioned in the article. That’s why I may be biased towards this exact type of the stablecoins 😉