Collateralized Stablecoin

November 21, 2023 - Around 2 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. To ensure their usability and credibility as a form of payment, stablecoins must be backed by fiat cash, cryptocurrency, or on-chain tokens that can be exchanged for them. This backing is known as collateral.

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 USDT, USDC, and DAI. The collateral is used to allow token holders to redeem their tokens for U.S. dollars or other real-world assets.

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.”

One limitation of collateralized stablecoins is that they require significant amounts of capital to establish legitimacy and trust. Additionally, their stability is dependent on the underlying collateral. As a result, many collateralized stablecoins implement over-collateralization to absorb fluctuations in value. This is in contrast to algorithmic stablecoins (e.g., FRAX, ESD), which utilize smart contracts to respond to supply and demand by buying, selling, or burning tokens to maintain a fixed price.

Author: Sam Kazemian, CEO of Frax

Sam Kazemian is the founder of FRAX, 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 is an open-source and permissionless project that aims to bring a truly trustless, scalable, and stable asset to the future of decentralized finance.

Kazemian has extensive experience as a prominent blockchain entrepreneur and cryptocurrency enthusiast. He is also the co-founder of Everipedia, a blockchain-based knowledge base. Kazemian’s involvement in the crypto industry began in 2013 when he started mining cryptocurrencies in his college dorm room at UCLA. Today, he is a frequent guest lecturer at UCLA, where he covers topics such as crypto, computer science, and entrepreneurship.