A stablecoin is a type of cryptocurrency whose value is pegged to an asset. This asset can be another cryptocurrency (or basket of cryptocurrencies), fiat money such as the U.S. Dollar and Euro or even commodities such as gold. Stablecoins aim to reduce volatility compared to other cryptocurrencies such as Bitcoin or Ethereum, and offer buyers and sellers better certainty that the value of the asset they just traded will not rise or crash unexpectedly. Depending on the underlying asset backing the stablecoin, different types of advantages and disadvantages can arise, as shown in the following sections.
While in many cases the desired price (i.e. peg) of the stablecoin is the same as the price of it’s backing asset (i.e. collateral), there are cases in which these can be different. A good example of this is the DAI stablecoin by MakerDAO. DAI is designed to maintain its price as close to USD as possible, but the collateral used to do so can be Ether or some other cryptocurrency.
Fiat Backed Stablecoins
As the name implies, fiat-backed stablecoins (FBS) are tokens which are associated with the value of a particular fiat currency. Usually, these tokens are based on the U.S. dollar and hold their value fixed at a 1:1 ratio. The stability of the fixed value comes from the fact that the company offering the stablecoin has a sizable reserve of the backing fiat currency, and will only mint a number of stablecoins that exactly reflect this reserve amount.
While users need to trust such a third party which is offering the stablecoins, FBS are relatively easy to understand and have generally been less volatile compared to their alternatives. Another key concern with FBS in the cryptocurrency ecosystem is that since they are affiliated to fiat currencies, they are by extension affected by the control and policies of the government issuing the fiat currency, i.e. they are prone to the structural problems of centralisation.
Cryptocurrency Backed Stablecoins
Cryptocurrency Backed Stablecoins (CBS) are those which use crypto-assets as their stabilising reserve. The working principle is similar to FBS, with the key difference being that the backing process for FBS takes place off-chain, i.e. in traditional financial and legal systems, while with CBS the backing takes place on-chain, i.e. the backing asset is completely independent of traditional finance and lives on the blockchain (e.g. Ether). This is of great advantage in terms of trust, as the amount and nature of the reserve currency is open to public scrutiny because of the decentralised nature of the platform.
However problems with CBS have cropped up in the past where they’ve had difficulty in maintaining their peg between the backing asset and the issued stablecoin.
Non-collateralised Stablecoins are those which maintain stability in their price without any backing asset, i.e. without the use of any collateral. The tokens rely on an algorithm which is able to change the supply volume of the token if required to maintain the token’s price. Non-collateralized stablecoins rely on smart contracts to sell tokens if the price falls below the peg (i.e. the desired stable price) or to supply tokens to the market if the value increases. In this way, the token remains stable and holds its peg.
The clearest advantage with Non-collateralised Stablecoins is that since they do not rely on any pool of backing assets, they do not carry any of the downsides of centralisation. Instead, investors can scrutinise and place trust in the design of the smart contract. However, the mechanisms used here tend to be quite complex, which means that it is not always clear to everyone if the outcome will be as planned.