Overview of stablecoins
Since the establishment of Bitcoin, a handful of different types of stable cryptocurrencies have been created, mostly designed to track fiat currencies like USD or other major commodities. These are generally backed by fiat and crypto assets – and in the latter case, the crypto-asset backing mechanisms have varied greatly in sophistication and reliability. The role of stablecoins has risen dramatically with the advent of DeFi, as much DeFi activity relies on having some relatively stable crypto-asset to use as a reserve token and as an intermediary between other crypto-financial products.
Conceptually, a stablecoin is a digital token that has low price volatility over time. So far this stability has generally been achieved as a result of being pegged to some underlying fiat currency, but this is not the only logical way to do things. More broadly, the “stability” of a token may be understood as relatively low variance over time in the number of tokens needed to purchase some standardized basket of goods and services (e.g. a pound of carrots, a rack of ribs, 1GB of 4G mobile internet minutes, a tank of gasoline, etc.). Fiat currencies are not intrinsically stable in this sense, though the fiat currencies associated with major national powers have been relatively stable in the recent past.
Cogito’s tracercoins achieve their stability via soft-pegging to non-financial indices that are not directly tied to fiat currencies or other standard financial instruments or commodities. However, they still share many features in common with conventional stablecoins.
Although there are numerous technical differences among existing stablecoins, we can characterize them in general based on the following attributes:
- 1.The peg
- 2.The collateral, which can be fiat currencies such as USD or a basket of different currencies, crypto assets, and commodities, and
- 3.The ratio of backing collateral to outstanding supply, which can be “none”, “partial”, “full”, or greater than 100% (ie. overcollateralized).
Several popular stablecoins mimic the value of the US Dollar (USD) by using it as collateral and then tokenizing associated funds. This design – an issue with many crypto investors who believe in the core values of openness, transparency, and decentralization. Scalability also becomes an issue here. The issuer must prepare the same amount of fiat currency as the outstanding stablecoin to ensure that it is always pegged and redeemable for the underlying fiat currency. However, the greater the stablecoin’s scale, the more the issuer must reserve fiat currency unless their users accept partial reserves.
Other stablecoin designs use cryptocurrencies or commodities as collateral, resulting in more decentralized systems. However, such backing assets can be highly volatile, which is why this type of stablecoin is almost always over-collateralized to avoid fluctuations that can result in insolvency and lead to the peg being broken.
There is a type of stablecoin that has no collateral – so-called “algorithmic stablecoins”, which are managed by automated smart contracts that adjust their supply based on the expectation of the future demand or the growth rate of the ecosystem.
Finally, hybrid stablecoins such as risk-weighted-reserve-backed algorithmic stablecoins have been created that attempt to combine the strengths of both approaches to provide price stability.