If we try recreating traditional financial products on a blockchain, we are faced with an immediate problem: price volatility. Specifically, the native cryptocurrency of the Ethereum blockchain (namely ETH) experiences large intraday swings in the USD/ETH exchange rate, sometimes moving 10% or more in a single day.

An instrument with this degree of price volatility is less than ideal for a number of traditional financial products. For example, if you take out a loan, you don’t want loan payments to oscillate by 10% right before a payment. That degree of volatility would make it hard to plan for the future.

Stablecoins are one solution to this problem. These are cryptocurrencies specially engineered to remain “stable” at an exchange rate of approximately 1.00 units of fiat per coin. The Stablecoin Index and Stablecoin Stats provide a good list of the top stablecoins.

There are three general categories of stablecoins: centralized fiat-collateralized, decentralized crypto-collateralized, and decentralized algorithmic.

  1. Centralized fiat-collateralized stablecoins are backed 1:1 by fiat in a bank account. For example, the stablecoin USD Coin (USDC) issued by Circle is backed 1:1 by US dollars in a bank account. There is little risk to holding or using the coin as long as you trust the issuing entity and underlying fiat. Another benefit is that there is a centralized entity that is liable if something goes wrong, which many individuals and businesses prefer. While these sound like ideal features, not everyone has access to centralized stablecoins. For example, the user agreement for USDC states that it is only available in supported jurisdictions and users are prohibited from transacting USDC for certain activities.

  2. Decentralized crypto-collateralized stablecoins don’t have a central operator or user agreement. This means anyone can use them without the permission of a company or government. However, the tradeoff to not directly backing a stablecoin with fiat is increased complexity around maintaining stability. Rather than the simple model of USDC where $1000 of USDC is backed by $1000 in a bank, crypto-collateralized stablecoins back $1000 of their coin with at least $1000 of (highly volatile) cryptocurrency.

    For example, Maker is a system built on Ethereum that governs a decentralized stablecoin called DAI. DAI aims to be pegged at 1.00 USD. The way the peg works is that DAI can be “minted” by anyone within the Maker system by locking up crypto as collateral (primarily ETH) and taking out a loan of DAI. The collateral provided needs to be greater than the amount borrowed so that the loan is overcollateralized.

    For example, you can lock up $200 worth of ETH as collateral to borrow $100 worth of DAI, which you can then use to trade on an exchange. The main reason to do this is leverage - if you believe the price of ETH will not drop significantly, in which case you are getting a “free” $100 to trade on crypto exchanges. If the price of ETH drops so that your $200 worth of ETH is now below the collateralization requirement, the Maker algorithm will seize your collateral and liquidate it to get back ~$100. In this fashion the Maker algorithm tries not to lose money on a loan.

    While the Maker system is significantly more complex than something like USDC, in theory an end user of DAI who isn’t minting wouldn’t need to understand the complexity, in much the same way that users of normal US dollars don’t need to understand the intricacies of monetary policy. With that said, DAI does present its own risks, including smart contract risk and the possibility of DAI breaking the peg and trading significantly above or below 1.00 USD/DAI.

  3. Decentralized algorithmic stablecoins are the third class of stablecoins. These do not have any collateral backing their system, relying solely on algorithms to get the price to remain stable. One example includes Basis, which shut down before it was launched. A concern some have with this model is that a well funded and motivated entity could attack such a system and drive people to lose confidence in the stability of the peg. This could then lead to a death spiral and the collapse of the stablecoin.

In general, the first two types of stablecoins have proven most popular. Whether it is fiat or crypto providing the collateral, people appear to want certainty around price stability. With that said, there are ongoing experiments around the third class of stablecoin, with people looking to combine both the crypto-collateralization and algorithmic elements.

Original article by Linda Xie

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