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Decentralized Stablecoins: Types and How They Work

By Laurel Tincher · November 20, 2022 · 7 minute read

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Decentralized Stablecoins: Types and How They Work

What Are Decentralized Stablecoins?

Decentralized stablecoins, like any type of stablecoin, are cryptocurrencies that have a value pegged to a particular external asset, such as a national fiat currency like the U.S. dollar, or a commodity. In theory, being pegged to a real-world asset helps prevent volatility.

What makes decentralized stablecoins different from centralized stablecoins is that they have full transparency and they are non-custodial, meaning a company or centralized party doesn’t control them. Any collateral that backs the stablecoin is transparent to users, so they know it really exists.

Decentralization allows for a trustless and secure system in which a centralized party can’t tamper with the supply of the coin or pretend they have assets to back the coin that they really don’t. Instead, smart contracts and algorithms automatically control the coin’s supply.

There are a few different types of decentralized stablecoins. In this article we will look at the different types, and the pros and cons of this type of crypto asset.

The Need for Decentralized Stablecoins

Stablecoins were created as a crypto version of traditional currencies, which are typically backed by central banks and governments, and often pegged to real-world assets like cash or commodities (e.g. gold or silver).

As a result many stablecoins have a 1:1 ratio with fiat currencies like the U.S. dollar or the euro. So, are all stablecoins decentralized? No, most are still centralized.

Understanding Stablecoins

Stablecoins were launched so that traders could keep funds in an exchange to keep them available for trading, and have them in a stable asset that wouldn’t change in value.

Prior to the creation of stablecoins, any time a trader sold a coin they would have to move their money back into a fiat currency, and sometimes even move it off the crypto exchange completely, making it really inconvenient for day traders.

The emergence of stablecoins helped traders cope in periods of volatility, since they could move funds into a stablecoin temporarily, until they were ready to go back into the crypto market.

That said, having a form of crypto pegged to tangible assets (like fiat currencies) with real-world value hasn’t been a complete success. In fact, the stablecoin market has been plagued with allegations of fraud and other malfeasance, including questions of whether some coins actually had sufficient reserves.

With Decentralized Stablecoins Came More Security and Transparency

In order to make stablecoins more secure and transparent, decentralized stablecoins are being developed. (In order to understand why this is important, it helps to know what decentralized finance is, aka DeFi, and how it’s challenging traditional finance.)

Stablecoin values are kept stable through a process of controlling their circulating supply. With many stablecoins, this is done by the issuing company that created the coin. With decentralized stablecoins, this is typically accomplished using algorithms.

When the value of a decentralized stablecoin moves higher or lower than the value of its underlying asset, the algorithm adjusts the supply — sometimes by burning or removing coins — to bring it back to the desired 1:1 ratio.

Thus, decentralized stablecoins are considered trustless. Much of the reason traders are attracted to crypto is the ability to transact without middlemen and centralized parties. Therefore, stablecoins are heading in the direction of decentralization — which is how most cryptocurrencies work.

How Decentralized Stablecoins Work

Decentralized stablecoins use algorithms and smart contracts to control the supply of the token to maintain its stable value. If the price of the stablecoin starts veering up or down from the value of the asset it is pegged to, then the supply of the stablecoin can be adjusted to get the price back to where it should be.

With normal stablecoins this is done by the issuing centralized party. Ultimately, decentralized stablecoins could be created that aren’t backed by any external asset — which is basically what algorithmic stablecoins are. But it’s hard to put together a list of decentralized stablecoins right now.

Uses of Decentralized Stablecoins & the Need for Them

Decentralized stablecoins have similar uses to regular stablecoins. Day traders can easily move funds between crypto and stablecoins if they want to avoid volatility or wait to make another purchase. They provide a secure and efficient way to transfer funds almost anywhere in the world, and in some cases users can earn interest on them as well.

5 Types of Decentralized Stablecoins

What is a decentralized stablecoin, exactly? There are several types of decentralized stablecoins that provide different functionality and security for users. Below are the main types available on the market today:

1. Elastic Supply Chains

What Are They?

Most decentralized stablecoins fall within the category of elastic supply chains. These coins use automated contracts with user incentives to stabilize the value of the coin so it stays pegged to the external asset.

How Do They Work?

This type of decentralized stablecoin uses an elastic supply monetary policy. When the value of the stablecoin falls below the value of the pegged asset, stablecoin owners are incentivized to keep holding the stablecoin because they earn a high interest rate on it.

When the value of the stablecoin goes back up, the interest rate earned goes down. To earn interest, users have to lock up their coins until the value of the stablecoin goes back to the value of the pegged asset.

When the value of the stablecoin rises above the pegged value, the supply of the stablecoin is increased, and vice versa.

One risk with this type of decentralized stablecoin is that users will choose to sell off their coins instead of staking them. When this happens, the value of the decentralized stablecoin no longer matches the value of the pegged asset, and users lose trust in the stablecoin.

Examples

•   Ampleforth

•   BitBay

•   Kowala

•   NuBits

•   Xank

•   Ndau

•   StableUnit

2. Collateralized-Debt Positions

What Are They?

Decentralized stablecoins that use Collateralized-Debt Position (CDP) systems involve user-deposited collateral and smart contracts to maintain the value of the coin.

How Do They Work?

First, a stablecoin user deposits collateral into a smart contract. Then they are loaned stablecoins equal to the value of the collateral they deposited, and they pay interest on the loan. Basically the users loan money into the pool backing the coin and by doing so they enable the coin to exist so they can use it. This is similar to the way fiat currency works using fractional reserve banking systems. However, unlike the fiat system, decentralized stablecoins are generally fully backed or over-collateralized. This is important to know when buying and selling cryptocurrencies.

Examples

•   MakerDAO

•   Alchemint

•   Augmint

3. Self-Collateralized Stablecoins

What Are They?

Self-collateralized stablecoins are similar to CDP coins, except that the collateral users deposit is crypto instead of fiat currency. Also, users of these coins don’t always have to pay interest on their loans.

How Do They Work?

First, users deposit collateral that was generated by blockchains or smart contracts. Then they receive a loan of stablecoins equal in value to the amount they deposited.

Examples

•   Sweetbridge

•   Bitshares

•   Synthetix

4. Bond Redemption Coins

What Are They?

This type of decentralized stablecoin uses a bond exchange system to keep the coin price stable.

How Do They Work?

For example, Basis is a stablecoin pegged to the value of the U.S. dollar. When the value of Basis dips beneath $1, Basis users burn their Basis tokens and in exchange they receive Basis Bonds. Once the price of Basis goes back up to $1, users can exchange their Basis Bonds back to Basis coins.

There are 25 different bonds that Basis users can choose from, and they earn $0.2 for each Basis coin they burn. Conversely, when the price of Basis goes over $1, new Basis coins are created and sent to holders of Basis Shares until the price goes back down to $1.

Examples

•   Basis

5. Collateral-Redemption Coins

What Are They?

Collateral-redemption coins are similar to CDP-based coins in that stablecoins are created when users deposit collateral into a pool. However, CDP coins require users to receive stablecoins for all of the collateral they deposit, and they must pay interest on the loan.

Collateral-redemption systems let users just receive a portion of funds from their deposited collateral without paying any stability or penalty fees. Also, collateral-redemption systems let users deposit many different types of tokens into the smart contract collateral pool.

How Do They Work?

For example, let’s say a user deposits $200 worth of Bitcoin and $200 worth of ETH. They then receive 400 stablecoins. After that, they deposit just 9 stablecoins and take out $5 worth of ETH and $4 worth of Bitcoin from the collateral pool of the stablecoin’s smart contract. The 9 stablecoins that are deposited are burned so that the coin keeps a constant collateral-to-debt ratio.

Examples

•   Reserve Protocol

Pros and Cons of Decentralized Stablecoins

There are several upsides to decentralized stablecoins but they have some downsides as well.

Pros

Cons

Increased transparency Many decentralized stablecoins are only partially decentralized and are still in an experimental phase of development.
Stable value There is a risk that a stablecoin will have a price meltdown
Increased security If the value of the external asset tanks, so will the stablecoin
More efficient than other stablecoins at maintaining value, therefore traders lose less money when trading them Many decentralized stablecoins are not yet widely adopted. There’s a chance that they won’t exist long term or won’t have high liquidity.
Traders can earn interest on some stablecoins
In the future, there is potential for a decentralized stablecoin to scale infinitely to meet any market demand.
There have been legal challenges with issuing stablecoins that are solved with decentralized stablecoins.

Multi-Currency and Single-Currency Coins

Some stablecoins are backed by one particular fiat currency, while others are backed by a basket of currencies. For instance, Libra’s original goal was to release a stablecoin backed by 30 different fiat currencies. However, they then shifted their plan to say they might still create a multi-currency asset, but it would be backed by single-currency stablecoins.

Investing in Crypto

Stablecoins are just one of many types of crypto individuals can buy. They are a useful tool for day traders who want a convenient way to keep funds in exchanges and avoid volatility, but stablecoins have been fraught with problems. Decentralized stablecoins are still evolving, and could someday change how crypto is traded.

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FAQ

Is USDT a decentralized stablecoin?

USDT, also known as Tether, is one of the first stablecoins and it is pegged to the U.S. dollar. It is not a decentralized stablecoin. It was the first fully centralized stablecoin and is managed by Tether Limited.

Are there any truly decentralized stablecoins?

There are a handful of stablecoins that claim to be fully decentralized, including: DAI, EOSDT, DeFi Dollar (DUSD), and GHO (a multi-collateralized stablecoin launched this year by AAVE). But it’s safe to say that decentralized stablecoins still face certain challenges in terms of transparency and maintaining a stable 1:1 value.

Is Bitcoin a stablecoin or not?

Bitcoin is not a stablecoin; it’s the oldest and largest form of cryptocurrency on the market. Bitcoin’s value is not pegged to the value of an external asset, but rather is determined by market forces, like any other crypto.


Photo credit: iStock/akinbostanci

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