Originally published in the NOWNodes blog.
Before we dive deep into the topic of decentralized stablecoins, Let’s do a quick recap about stablecoins. So, what exactly is a stablecoin? It is a type of cryptocurrency. But the value of stablecoin is pegged to a fiat sometime of a country or multiple national currencies unlike the majority of cryptocurrencies. Not only national currencies but stablecoins are also pegged against physical assets. Basically, stablecoins are cryptocurrencies whose value is backed by one or more financial assets.
What are the Types of Stablecoins?
The category of stablecoins is based on the assets backing the value of stablecoins. There are four types of stablecoins:
(i) Fiat Collateralized Stablecoins
(ii) Commodity Collateralized Stablecoins
(iii) Crypto Collateralized Stablecoins
(iv) Non-Collateralized Stablecoins
Fiat Collateralized Stablecoins
The fiat-collateralized stablecoins leads the pack of stablecoins when it comes to the most common types of stablecoins. These are the stablecoins whose value is backed by one or multiple fiat currencies. The most popular fiat currencies used here are the US dollars, the Euro, and the British Pounds.
Each fiat-collateralized stablecoin is pegged at a ratio of 1:1 against the respective fiat currency. It means that a 1 USD-backed stablecoin is worth 1 unit of a US dollar. For each of the stablecoin in circulation, an equal amount of fiat currency is required to back it up. An amount backing the fiat-collateralized stablecoins is usually held in a bank account.
Let’s say that someone has 100 USD-backed stablecoins. Now, he wants to redeem the stablecoins for an equal amount of US dollars. Hence, the company that manages the stablecoins will send him 100 US dollars through their reserve into his bank account. so, what would happen with those 100 USD-backed stablecoins that the person redeemed it for fiat USD? It will either be destroyed or the 100 USD-backed stablecoins will be removed from the circulation.
Commodity Collateralized Stablecoins
Instead of being backed by fiat currencies, the commodity Collateralized stablecoins are backed by assets such as precious metals. Gold has proved to be the most common commodity in the commodity-collateralized stablecoins space. Other assets such as real estate, other precious metals, and oil are also used as collateral to create commodity collateralized stablecoins.
The advantage of holding onto commodity collateralized stablecoins is that its holder actually has a share in something that has got real value — unlike most cryptocurrencies. The holders of this type of stablecoins can also benefit if the price of the collateralized asset increases in the future.
Crypto Collateralized Stablecoins
Crypto Collateralized stablecoins are backed by leading cryptocurrencies such as Bitcoin and Ethereum. These types of stablecoins are a lot more decentralized than the ones that are backed by fiat currencies and various commodities. Overcollateralization is a big part of crypto-collateralized stablecoins. Why is it so? It acts as a hedge against the price volatility risks. It helps the crypto-collateralized stablecoins to absorb price fluctuations.
For example, to get $100 worth of crypto-collateralized stablecoins, you will have to deposit $150 worth of ETH. You can see that the collateralization ratio is 200% here. Now, even if there is a drop in the prices of the underlying asset, stablecoins would be able to withstand the price depreciation. But if the price drop is low enough then there will be automatic liquidation of stablecoins.
Do you want trustless, secure, and transparent stablecoins? Crypto-collateralized stablecoins are your best friend. It is because they are far more decentralized than the fiat and commodity-backed stablecoins. There’s no one entity calling the shots when it comes to crypto-collateralized stablecoin funds. They also have better risk distribution as they usually are backed by multiple cryptocurrencies.
If you opt for these types of stablecoins, you will also benefit from its higher liquidity. These stablecoins can also be converted into the underlying crypto assets at cheap rates. But they are also one of the most complicated stablecoins and hence, they haven’t seen the kind of traction that fiat-backed cryptocurrencies have.
Do you know which crypto-collateralized stablecoin is the most popular one? You must likely have heard about it. Yes, I am talking about MakerDAO’s Dai. It is a stablecoin whose value is backed by ETH. Dai’s face-value is pegged to the US dollar and the collateralized ETH is held in smart contracts.
Their name must have already disclosed that there are no assets backing the value of non-collateralized stablecoins. This may raise many eyebrows considering what the stablecoins actually are. Take the US dollar for example — Each USD used to be backed by gold in the past. But it changed and the US dollar hasn’t been backed by anything for decades now. Did the US dollar become unstable at any point of the time? Of course, it did not! non-collateralized stablecoins use the same concept.
The seignorage model is at the core of how non-collateralized stablecoins supply works. The algorithmically governed approach controls the supply of these stablecoins. If demand for non-collateralized stablecoins increases, new coins are created. It leads to a reduction in the prices and soon the price is at the normal levels again. The opposite happens when the price of a non-collateralized stablecoins becomes too low. You can see, market supply and demand keeps the prices of these stablecoins stable.
When it comes to the most decentralized stablecoins in the market, non-collateralized stablecoins take the cake. Even if fiat currencies such as the US dollar or the Euro crashes along with the crypto market, non-collateralized stablecoins will still stay strong and survive the crash. But there’s a big issue with non-collateralized stablecoins — The stablecoin holders won’t be able to liquidate in case of a crash. It is because there’s no collateral involved in these types of stablecoins.
So, which type of stablecoins is decentralized? The crypto-collateralized and non-collateralized stablecoins are the truly decentralized stablecoins. Let’s know more about Dai as it is the most popular decentralized stablecoin in the crypto market currently.
A Quick Intro About Dai — The Most Popular Decentralized Stablecoin
DAI is a crypto-collateralized stablecoin as described above. It is an ERC20 token. Dai is the central part of the MakerDAO lending platform. All MakerDAO users require Dai to borrow and pay back the loans. You can easily transfer Dai across Ethereum wallets.
The smart contracts automatically execute themselves to keep the prices of DAI in check. Maker tokens (MKR) are burned when the price of DAI increases more than one dollar. In case, the price of DAI decreases considerably against one dollar, then more DAI tokens are created to stabilize the prices.
There’s no need to depend on anyone to keep DAI steady — You must be thinking, why is it so? Well, the reason is that all the work is done by MakerDAO’s algorithms. It is the algorithm that manages the prices of DAI.
Do you want some DAI for yourself? The thing about DAI is that it is created only when one takes a loan from the MakerDAO platform. Once the loans are paid back, DAI is destroyed. So, you can take out a loan from the Oasis platform of MakerDAO to get DAI. This is the most direct way of getting DAI. Another way is to trade DAI on MakerDAO’s Oasis platform. You can also trade DAI on any centralized exchange.
Why is Decentralized Stablecoins Important?
When it comes to decentralized stablecoins, we can rest assured that they are very transparent about their operations and funds. It is because all the details about their funds are on the public blockchain and everyone can verify it.
Stablecoins play a very important role in the crypto trading market. The traders and crypto enthusiasts that are afraid of the volatile nature of cryptocurrencies can still get involved in the crypto industry. Yes, it’s possible through the stablecoins. They can hold on to stablecoins as they are not volatile like other cryptocurrencies are.
As of now, fiat-collateralized stablecoins hold the biggest market share in the cryptocurrency market. But decentralized stablecoins are closely following the fiat-collateralized stablecoins. We expect decentralized stablecoins to keep up the growth momentum. With the increasing popularity of DeFi, it’s just a matter of time for decentralized stablecoins to overtake fiat-backed stablecoins in the market.