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Glossary

Collateralized Stablecoin

November 21, 2023 - Around 4 mins mins to read

A stablecoin is a type of digital asset that is built on the blockchain and is designed to maintain a fixed price, typically $1. It is a cryptocurrency that is designed to have low volatility compared to other cryptocurrencies like Bitcoin or Ethereum. Stablecoins are primarily used for transactions and as a store of value in the crypto ecosystem.

To ensure their usability and credibility as a form of payment, stablecoins must be backed by collateral. Collateral refers to assets that are held to guarantee the stability and value of the stablecoin. This backing is necessary because it provides a guarantee that the stablecoin can be redeemed for a specified value, typically the equivalent of $1.

A “Collateralized Stablecoin” is a stablecoin that is fully or almost entirely backed by collateral held in a reserve. Examples of fully collateralized stablecoins include Tether (USDT), USD Coin (USDC), and Dai (DAI). These stablecoins are backed by assets such as cash, commercial papers, or other digital tokens that can be exchanged for them.

For instance, Tether (USDT) is backed by fiat currency reserves, with each USDT token representing one US dollar held in reserve. This means that for every USDT in circulation, there is an equivalent amount of US dollars held in a bank account to back it up.

In the case of Dai (DAI), it is backed by a combination of cryptocurrencies and smart contracts. The MakerDAO protocol, which governs the creation and management of DAI, allows users to lock up their Ethereum (ETH) as collateral and mint DAI tokens. The collateral is over-collateralized, meaning users need to lock up more ETH than the value of the DAI they want to mint. This helps maintain the stability of DAI even in volatile market conditions.

The collateral committed to these stablecoins can consist of various assets such as cash, commercial papers, and bond purchases. In some cases, the collateral can also be utilized for additional investment purposes to enhance capital efficiency. Stablecoins that fully allocate their collateral to on-chain assets like cryptocurrencies, rather than traditional financial bonds or papers, are often referred to as “decentralized stablecoins.”

Decentralized stablecoins, such as DAI, leverage the transparency and security of blockchain technology to ensure the stability and trustworthiness of the stablecoin. By utilizing smart contracts, these stablecoins can programmatically adjust their supply to maintain a stable price. For example, if the price of DAI falls below $1, the smart contract can trigger mechanisms to incentivize users to mint more DAI, thereby increasing its supply and restoring the peg.

One limitation of collateralized stablecoins is that they require significant amounts of capital to establish legitimacy and trust. To ensure that stablecoins maintain their value, the issuers must hold sufficient collateral reserves to redeem the stablecoins. The stability of collateralized stablecoins is also dependent on the underlying collateral. If the collateral loses value or becomes illiquid, it can affect the stability of the stablecoin.

As a result, many collateralized stablecoins implement over-collateralization. Over-collateralization means that more assets are held as collateral than the face value of the stablecoin in circulation. This acts as a buffer against price fluctuations and potential default. For example, if a stablecoin is 150% over-collateralized, it means that for every $100 worth of stablecoin in circulation, there is at least $150 worth of collateral backing it up.

In contrast to collateralized stablecoins, there are algorithmic stablecoins like FRAX and ESD. Algorithmic stablecoins do not rely on collateral reserves; instead, they use smart contracts and algorithms to maintain a stable price. These stablecoins dynamically adjust their supply based on market demand. If the price of the stablecoin is above its target price, new tokens are burned. If the price is below the target, new tokens are minted and sold in the market to stabilize the price.

Sam Kazemian, the CEO of Frax, is a prominent figure in the crypto industry and the founder of FRAX. FRAX is a fractional algorithmic stablecoin that is partially backed by collateral and stabilized algorithmically. It is the only fractional stablecoin that has consistently maintained its peg since its inception. FRAX aims to bring a truly trustless, scalable, and stable asset to the future of decentralized finance.

Prior to his involvement with FRAX, Kazemian co-founded Everipedia, a blockchain-based knowledge base that aims to provide a decentralized alternative to traditional online encyclopedias. Kazemian’s experience in the crypto industry dates back to 2013 when he started mining cryptocurrencies in his college dorm room at UCLA. Today, he is a respected entrepreneur and guest lecturer at UCLA, where he shares his knowledge and insights on crypto, computer science, and entrepreneurship.

Author

Coincu

Glossary

Collateralized Stablecoin

A stablecoin is a type of digital asset that is built on the blockchain and is designed to maintain a fixed price, typically $1. It is a cryptocurrency that is designed to have low volatility compared to other cryptocurrencies like Bitcoin or Ethereum. Stablecoins are primarily used for transactions and as a store of value in the crypto ecosystem.

To ensure their usability and credibility as a form of payment, stablecoins must be backed by collateral. Collateral refers to assets that are held to guarantee the stability and value of the stablecoin. This backing is necessary because it provides a guarantee that the stablecoin can be redeemed for a specified value, typically the equivalent of $1.

A “Collateralized Stablecoin” is a stablecoin that is fully or almost entirely backed by collateral held in a reserve. Examples of fully collateralized stablecoins include Tether (USDT), USD Coin (USDC), and Dai (DAI). These stablecoins are backed by assets such as cash, commercial papers, or other digital tokens that can be exchanged for them.

For instance, Tether (USDT) is backed by fiat currency reserves, with each USDT token representing one US dollar held in reserve. This means that for every USDT in circulation, there is an equivalent amount of US dollars held in a bank account to back it up.

In the case of Dai (DAI), it is backed by a combination of cryptocurrencies and smart contracts. The MakerDAO protocol, which governs the creation and management of DAI, allows users to lock up their Ethereum (ETH) as collateral and mint DAI tokens. The collateral is over-collateralized, meaning users need to lock up more ETH than the value of the DAI they want to mint. This helps maintain the stability of DAI even in volatile market conditions.

The collateral committed to these stablecoins can consist of various assets such as cash, commercial papers, and bond purchases. In some cases, the collateral can also be utilized for additional investment purposes to enhance capital efficiency. Stablecoins that fully allocate their collateral to on-chain assets like cryptocurrencies, rather than traditional financial bonds or papers, are often referred to as “decentralized stablecoins.”

Decentralized stablecoins, such as DAI, leverage the transparency and security of blockchain technology to ensure the stability and trustworthiness of the stablecoin. By utilizing smart contracts, these stablecoins can programmatically adjust their supply to maintain a stable price. For example, if the price of DAI falls below $1, the smart contract can trigger mechanisms to incentivize users to mint more DAI, thereby increasing its supply and restoring the peg.

One limitation of collateralized stablecoins is that they require significant amounts of capital to establish legitimacy and trust. To ensure that stablecoins maintain their value, the issuers must hold sufficient collateral reserves to redeem the stablecoins. The stability of collateralized stablecoins is also dependent on the underlying collateral. If the collateral loses value or becomes illiquid, it can affect the stability of the stablecoin.

As a result, many collateralized stablecoins implement over-collateralization. Over-collateralization means that more assets are held as collateral than the face value of the stablecoin in circulation. This acts as a buffer against price fluctuations and potential default. For example, if a stablecoin is 150% over-collateralized, it means that for every $100 worth of stablecoin in circulation, there is at least $150 worth of collateral backing it up.

In contrast to collateralized stablecoins, there are algorithmic stablecoins like FRAX and ESD. Algorithmic stablecoins do not rely on collateral reserves; instead, they use smart contracts and algorithms to maintain a stable price. These stablecoins dynamically adjust their supply based on market demand. If the price of the stablecoin is above its target price, new tokens are burned. If the price is below the target, new tokens are minted and sold in the market to stabilize the price.

Sam Kazemian, the CEO of Frax, is a prominent figure in the crypto industry and the founder of FRAX. FRAX is a fractional algorithmic stablecoin that is partially backed by collateral and stabilized algorithmically. It is the only fractional stablecoin that has consistently maintained its peg since its inception. FRAX aims to bring a truly trustless, scalable, and stable asset to the future of decentralized finance.

Prior to his involvement with FRAX, Kazemian co-founded Everipedia, a blockchain-based knowledge base that aims to provide a decentralized alternative to traditional online encyclopedias. Kazemian’s experience in the crypto industry dates back to 2013 when he started mining cryptocurrencies in his college dorm room at UCLA. Today, he is a respected entrepreneur and guest lecturer at UCLA, where he shares his knowledge and insights on crypto, computer science, and entrepreneurship.

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