Stablecoins are cryptocurrencies designed to minimise stablecoin’s price volatility, relative to certain “stable” asset or asset basket. A stablecoin may be attached to a cryptocurrency, fiat money, or commodities traded in exchange (such as valuable metals or industrial metals). Stablecoins redeemable in currency, commodities, or fiat money are said to be backed up, while those tied to an algorithm are called (not backed) seigniorage-style.

Backed stablecoins

The advantages of asset-backed cryptocurrencies are that the coins are stabilised by assets that fluctuate outside the cryptocurrency space, i.e. the underlying asset is not correlated, reducing financial risk. Bitcoin and altcoins are highly correlated, so that holders of cryptocurrency can not escape widespread falling prices without exiting the market or taking refuge in stablecoins backed by assets. In addition, such coins are unlikely to fall below the value of the underlying physical asset due to arbitrage if they are managed in good faith and have a mechanism for redeeming the assets supporting them.

Backed stablecoins are subject to the same volatility as the backing asset. If the backed stablecoin is decentralised, they are relatively safe from predation, but if there is a central vault, they may be stolen and lose trust.

Commodity-backed

Stablecoins backed by commodities like precious metals (gold, silver, etc.) are much less likely to get inflated than stablecoins backed by fiat. Mine gold or silver is harder than “creating money out of thin air.” Backed stablecoins have the main characteristics of:

• Their value on demand is fixed on one or more commodities and can be redeemed for such (more or less),
• Unregulated individuals, agorist firms or even regulated financial institutions promises to pay,
• The amount of commodity used to back up stablecoin must reflect the stablecoin’s circulating supply.
  

  Digix Gold Token

Holders of commodity-backed stablecoins may redeem their stablecoins to take possession of real assets at the conversion rate. The cost of maintaining stablecoin’s stability is the cost of storing and protecting the backing for the commodity.

Fiat-backed

The value of this type of stablecoins is based on the value of the back up currency held by a financial entity regulated by a third party. In this setting, the trust in the backing asset custodian is crucial to stablecoin’s price stability. Fiat-backed stablecoins are tradable on exchanges and can be redeemed from the issuer. The cost of maintaining the stablecoin ‘s stability is equivalent to the cost of maintaining the backing reserve and the cost of legal compliance, keeping licences, auditors and the regulator ‘s business infrastructure.

The most common are cryptocurrencies backed by fiat money, and were the first type of stablecoins on the market. Their features are:

• Its value is fixed in a fixed ratio to one or more currencies (most commonly the US dollar, also the euro and the Swiss franc),
• The tether is made off-chain, by means of banks or other types of regulated financial institutions that serve as depositors of the currency used to support stablecoin,
• The amount of currency used to back the stablecoin has to reflect the stablecoin’s circulating supply.

Cryptocurrency-backed

Cryptocurrency backed stablecoins are issued as collateral with cryptocurrencies which are conceptually similar to fiat-backed stablecoins. However, the significant difference between the two designs is that while fiat collateralization typically occurs off the blockchain, on the blockchain, the cryptocurrency or crypto-asset used to back this type of stablecoins is done using more decentralised smart contracts. In many cases, this work by allowing users to take out a loan against a smart-contract by locking up collateral, making paying off their debt more worthwhile should the stablecoin ever fall in value. To prevent sudden crashes, if their collateral decreases too close to the value of their withdrawal, a user who takes out a loan may be liquidated by the Smart contract.

Illustrations of crypto-backed stablecoins are:

• The stablecoin value is collateralised by another cryptocurrency or portfolio of cryptocurrencies,
• Peg is performed on-chain through smart contracts,
• On-chain supply of the stablecoins is regulated, using smart contracts,
• Price stability is achieved through the introduction, not just the collateral, of additional instruments and incentives.

The technical implementation of stablecoins of this type is more complex and varied than that of fiat-collateralized stablecoins, which introduces a greater risk of exploits due to bugs in the smart contract code. It is not subject to third party regulation which creates a decentralised solution with the tethering done on-chain. The potentially problematic aspect of stablecoins of this type is the change in collateral value and the reliance on additional instruments. The stablecoin ‘s complexity and non-direct backing may deter usage, as it may be hard to understand how the price is actually guaranteed. Because of the nature of the highly volatile and convergent cryptocurrency market, it is also necessary to maintain a very large collateral to ensure the stability.

Seigniorage-style (not backed)

Coins in the seigniorage style use algorithms to control the money supply of the stablecoin, similar to the approach taken by a central bank to print and destroy currency. Stablecoins based on seigniorage are a less-popular form of stablecoin.

Seigniorage-style stablecoins are significantly characterised by:

• Adjustments are made on-chain
• You don’t need collateral to mint coins
• Value is controlled by supply and demand by algorithms, stabilising price