How Do Stablecoins Remain Stable?

3 min read
Creating Value Out Of Collaterals

Learn about various types of stablecoins, and the mechanism for keeping them stable.

Stablecoins stand out in the DeFi space for being unlike its other more popular cryptocurrency counterparts.

They’re secure, fast, and cost-effective.

But most of all, they’re known for their ability to maintain prices amidst being in a super volatile market.

Stablecoins are somewhat digital reserve assets in which their value stays virtually unchanged, even if the crypto market goes bullish or otherwise. They normally resist change, unlike most cryptocurrencies. They serve to minimise the effects of the crypto market’s price volatility in high-volume trading.

So, how do stablecoins do it? You know, remain stable.

How Do Stablecoins Remain Stable?#

Stablecoins can be classified into four primary types. Three of these maintain their values based on collateralisation backed by fiat currencies, cryptocurrencies, or tangible assets. Run on a totally different system, the other fourth type of stablecoin differs itself by maintaining its stability using automated algorithms.

Fiat Collateralised#

Our first stablecoin on the list is what we call fiat-collateralised or fiat-backed stablecoins. Fiat-collateralised stablecoin providers maintain their stablecoin prices with fiat currency reserves that back each of their stablecoins.

As long as the fiat currency on which the stablecoin bases its prices on remains stable, the fiat-backed stablecoin in turn also remains stable.

A few examples of fiat-collateralised stablecoins include:

  • USD Coin
  • Binance USD
  • Paxos Standard

Crypto Collateralised#

On the other hand, crypto-collateralised stablecoins peg themselves to fiat assets yet they use cryptocurrencies to help maintain their value. They use a basket of one or more cryptocurrencies and other stablecoins as reserved collateral to maintain their stable value.

Since cryptocurrencies are mostly volatile, crypto-backed stablecoins tend to be overcollateralised. Buyers will have to lock in their collateral tokens with smart contracts. When the collateral cryptocurrency or currencies drops in value far enough to disrupt stablecoin stability, users are then given the chance to provide more collateral. Otherwise, stablecoin’s circulating supply gets reduced when users redeem their stablecoins to get their original collateral back because the underlying collateral has gone down in value.

They tend to have a higher degree of decentralisation and greater liquidity than fiat-backed stablecoins.

The most notable crypto-backed stablecoin would be MakerDAO’s DAI.

Asset Collateralised#

Asset-backed or commodity-backed stablecoins are just as similar to fiat and crypto-backed stablecoins. The only difference is they peg their value on tangible assets like gold and other commodities.

These stablecoins use traditionally-valuable tangible assets such as gold, silver, precious metals, and even real estate as collateral.

Usually, these stablecoins attach themselves to certain units of the collateralised assets.

Some examples of asset-collateralised stablecoins include:

  • Pax Gold
  • Digix Gold

Algorithmic Stablecoins#

Moving on from collateralised stablecoins and onto more complex algorithmic stablecoins, this type of stablecoins makes use of algorithms via smart contracts to secure and maintain price stability.

Here, algorithms determine whether to increase or decrease the stablecoin supply to maintain the price’s stability.

In order to counter any price changes, an algorithmic stablecoin reduces the supply when its value goes below the underlying asset’s market price, sometimes fiat. This happens when users want to receive back their collateral by burning the stablecoins.

Vice versa, the stablecoin supply increases when the underlying reserve assets appreciate in value. This happens when users want to mint more stablecoins with their existing collateral that has appreciated in value.

Basically, it creates an automated price balancing system that helps maintain stable value through varying the number of stablecoins in circulation.

Several examples of algorithmic stablecoins include:

  • RAI
  • FEI
  • FRAX