The prices of cryptocurrencies are extremely volatile. It is common for cryptocurrencies to have more than 10% fluctuation in a day. To decrease this volatility, stablecoins which are connected to other stable assets such as the USD were created. Tether (USDT) was one of the first centralized stablecoins to be introduced. Every USDT is supposedly backed by $1 in the issuer’s bank account. However, one major darkside of USDT is that users need to trust that the USD reserves are fully collateralized and actually exist. Decentralized stablecoins aim to solve this trust issue. Decentralized stablecoins are created in a decentralized manner via an overcollateralization method, operate fully on decentralized ledgers, are governed by decentralized autonomous organizations, and its reserves can be publicly audited by anyone.
While stablecoins are not really a financial application themselves, they are important in making DeFi applications more accessible to everyone by having a stable store of value.
There are four stablecoin types according to their collateral structure: fiat-backed, crypto-backed, commodity-backed, and algorithmic.
Traditional Collateral (Off-Chain)
This kind of stablecoins are backed up by fiat money and one of the common forms of stable coin crypto. In other words, it’s a digital form of fiat money. Fiat money is the paper money people use every day to buy things and save up in banks. USD, CHF, EUR, JPY, and GBP are some examples. In this form of stablecoin coins have the same value as of regular currency. In simple term, if your currency is $1 then each stable coin crypto will have the same value $1 and the ratios will always stay at 1:1. These are centralized stablecoins because the cryptocurrencies are being controlled by the banks.
Crypto Collateral (On-Chain)
This type of stable token backed up by Cryptocurrencies. Ethereum or Bitcoin which have a lot of market value are used here. Usually, a mix of different cryptocurrencies back up these coins to prevent volatility risks. In this condition even if one of the cryptocurrencies has a massive price fall, other currencies can back up that fall. Being overly collateralized is another factor of these coins which means it is necessary to maintain the value fluctuations of the crypto market.
This type of coins is different as they use an algorithm to burn or add crypto to stabilize the value instead of having assets to back them up. A governed approach is used to ensure the expanding or limiting of coins on the network and stable value of tokens. However, making the value as close to $1is always the primary target.
This category of stablecoin is backed up by commodities such as Gas, Gold, Valuable Metals, etc. which will always have a stable value on the network. Gold is the most common one of them that has a great value in the market. Stablecoin that is backed up by gold will always have a specific value assigned to each of the coins. For instance, one gold stablecoin could represent one gram of gold but where is the physical gold itself? In most cases a third party keep this gold in a highly secured trusted vault. It is better to consider it before jumping on board with these coins.