Decentralized Stablecoin

A decentralized stablecoin is a digital asset created on the blockchain with the goal of maintaining a fixed price peg, usually at $1. This eliminates the impact of market fluctuations and provides a secure and stable option for holders.

Stablecoins act as intermediaries between holding assets and converting them into fiat currency, or as a more efficient method for cross-border payments. Centralized stablecoins are typically backed by off-chain fiat collateral and are directly linked to third-party custodians like banks. Examples of centralized stablecoins include Tether (USDT) and Coinbase’s USD Coin (USDC). However, these stablecoins require trust in the third party’s possession of the corresponding dollars.

On the other hand, decentralized stablecoins are fully transparent and non-custodial, with minimal third-party control. All collateral backing is visible on a publicly verified blockchain, enhancing trust and security by eliminating reliance on a single entity. Decentralized stablecoins can be categorized into two types: crypto-collateralized and algorithmic.

Crypto-collateralized stablecoins allow for manual adjustments in supply through minting or burning tokens as needed. This means that the supply of the stablecoin can be increased or decreased based on market demand. For example, if the price of the stablecoin is trading above $1, new tokens can be minted and sold to decrease the price and bring it back to the peg. Conversely, if the price is trading below $1, tokens can be burned to decrease the supply and increase the price.

Algorithmic stablecoins, on the other hand, utilize smart contracts or algorithmic market operations controllers (AMOs) to automatically manage the supply. These stablecoins use complex algorithms to adjust the supply and maintain the peg. For example, if the price of the stablecoin is above $1, the algorithm may automatically decrease the supply by adjusting the parameters of the smart contract. Similarly, if the price is below $1, the algorithm may increase the supply to stabilize the price.

A well-known example of a crypto-collateralized stablecoin is MakerDAO’s Dai (DAI), which is backed by a diverse portfolio of cryptocurrencies. Dai maintains its stability by leveraging a system of collateralized debt positions (CDPs). Users can lock up their cryptocurrencies as collateral and generate Dai tokens against this collateral. The stability of the Dai is maintained by an autonomous feedback mechanism that incentivizes users to adjust the supply based on market demand.

One of the challenges with algorithmic stablecoins is their reliance on sophisticated algorithms to maintain stability. Examples of algorithmic stablecoins include Ampleforth (AMPL) and Empty Set Dollar (ESD). These stablecoins adjust the supply by increasing or decreasing the number of tokens held by each user, thus affecting the total supply and stabilizing the price.

It is important to note that while decentralized stablecoins offer transparency and reduced reliance on third parties, they are not without risks. The value of stablecoins can still be influenced by market conditions and external factors. Additionally, the effectiveness of the algorithmic stability mechanisms is heavily dependent on market adoption and liquidity.

Decentralized stablecoins have gained significant attention in the cryptocurrency and blockchain space, as they provide a bridge between the traditional financial system and the world of digital assets. They offer stability, transparency, and increased security compared to their centralized counterparts. As the adoption of blockchain technology continues to grow, decentralized stablecoins are likely to play a crucial role in enabling efficient and secure financial transactions.

Author: Travis Moore, CTO of Frax 

Bio: Travis Moore is an angel investor, programmer, entrepreneur, and the CTO of Frax, the world’s first fractional algorithmic stablecoin that is partially backed by collateral and stabilized algorithmically. Frax is open-source and permissionless, bringing a truly trustless, scalable, and stable asset to the future of decentralized finance. Moore is also co-founder of the blockchain-based knowledge base, Everipedia. Moore has a triple-major from UCLA in Neuroscience, Biochemistry, and Molecular, Cell, & Developmental Biology. His passions are artificial intelligence and blockchain technology, which he believes are the two industries that will impact the world the most in the coming decade.

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