Ethereum

Stablecoins have become the talk of the town lately and everyone seems to be speculating about them.

But what exactly are they and how do they work? Are they even decentralized? Let's explore 🧵👇

full-stack dev / smart contract dev | i build stuff and explain how i build it

Let's first break the term down- stable and coin. They are essentially digital "coins" which inherit all the qualities of cryptocurrencies except their high volatility, hence the "stable".  But how do they manage this stability?

There are 4 main types of stablecoins and each type uses a different method to maintain stability:
1) Fiat-backed
2) Crypto-backed
3) Commodity-backed
4) Algorithmic

Let's go over each of them:

1) Fiat-backed:

These are coins pegged 1:1 to fiat currencies like the US dollar. For example, let's take USDC. It is issued by Circle, which holds cash and short-term US Treasury bonds equal to the value of all USDC in circulation, thus ensuring 1 USDC = 1 USD

If you want to generate 100 USDS, you'll need to deposit at least $150 worth of ETH as collateral (150% collateralization ratio). This over-collateralization protects the system from market volatility, ensuring stability even when crypto prices fluctuate.

If the ratio falls below 150%, liquidation can be started. Moreover, USDS also includes Real World Assets (RWAs) in the collateral portfolio (not shown in this diagram)

3) Commodity-backed:

These coins are backed by the value of physical assets such as gold and silver. These coins offer users the ability to gain exposure to commodities without directly owning them.

For example, PAX Gold (PAXG) from Paxos is a stablecoin backed by gold reserves, where each token represents one troy ounce (~31.1 grams) of gold stored in secure vault facilities.

Users can buy PAXG on exchanges, check the serial numbers of their specific gold bars online, and even redeem their tokens for physical gold if they own enough tokens.

4) Algorithmic Stablecoins:

They are not collateralized, ie they don't have reserves and maintain their price peg through code-based mechanisms instead. This price peg may be to a fiat currency or a commodity like gold.

For example, it might aim to maintain a value of $1 USD (the peg), but it achieves this through code-based mechanisms rather than by holding actual dollars.

FRAX (Fractional Algorithmic) is a hybrid between algorithmic and crypto-backed stablecoins. It uses two tokens - FRAX stays stable at $1, while FXS takes on all the market risk. The system automatically adjusts how much crypto backing is needed based on market demand

Are they decentralized?

As you may have noticed by now, decentralization does take a hit when it comes to stablecoins. In case of USDC, there is a centralized authority issuing these tokens, which is Circle. Similar arguments apply for other types of stablecoins too.

However they are still on the blockchain and all transaction that take place are visible and verifiable, like for every other token on the chain.

The possibilities are endless with stablecoins. Imagine a world with open, instant, borderless payments & no involvement of middlemen. No 10% charges, no talking to 10 different banks to set up global businesses. That is the world that stablecoins enable. Their hype is justified.

I hope you enjoyed reading this thread and learnt something new. Let me know what you think about it! Thanks a lot for reading to the end.

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2) Crypto-backed:

These are backed by reserves of other cryptocurrencies. These coins work on the principle of over-collateralization. For explaining this, we'll use the example of USDS by Sky (MakerDAO).