Cryptocurrencies typically experience high volatility due to the complexities in valuing them and their smaller market size as compared with traditional fiat currencies.
This high volatility makes it less suitable for applications especially those involving financial products and services. (Imagine having a 20% increase in prices right when you're about to repay a loan! 🤦♂️)
Stablecoins Solve the Problem of Price Volatility
Stablecoins are designed to minimize price volatility relative to another asset by pegging to another currency (fiat / crypto) or commodity and are easily redeemable for their respective collateral
There are 4 Categories of Stablecoins, 3 of which are backed by collateral (Fiat, Cryptocurrency, Commodity) and 1 which is not backed by any collateral (Seigniorage-style):
1️⃣ Fiat-Collateralized Stablecoins
Centralized fiat-backed stablecoins which are 1:1 backed by fiat in a bank account offer the greatest security and ease of mind.
Fiat-collateralized stablecoins are pegged to one or more currencies (usually the US Dollar) through a regulated financial institution which holds custody of the backing asset. The amount of currency used for backing should reflect the circulating supply of the stablecoin.
USD Coin (USDC)issued by Circle in partnership with Coinbase is one of the best examples of a centralized fiat-backed stablecoin. This means that for every USDC issued, there is 1:1 US dollars in the entity's bank account available for redemption.
This greatly reduces the risk of default and holding onto these stablecoins as there is now a centralized entity liable for the custody of the backing asset.
Some other examples are: PAX, TUSD, USDT
2️⃣ Cryptocurrency Collateralized Stablecoins
Crypto-backed stablecoins with collateralization done on the blockchain without a centralized entity enables permissionless programmable money and complete transaparency.
Without a centralized entity issuing a Crypto-backed stablecoin, issuance is done on the blockchain ("on-chain") in a decentralized manner through smart contracts.
DAI issued on Ethereum by Maker is one of the best examples. DAI can be issued permissionlessly by anyone choosing to lock up collateral (usually ETH) and receiving DAI for a fee known as the Stability Fee.
These loans need to be overcollateralized so that they can be seized and liquidated in the event of severe price drops in the backing asset.
Take a look at the video below to understand more:
Stability Mechanics of the Dai Stablecoin System by MakerDAO
Why would someone take on an overcollateralized loan for a high fee?
For example, a user locking up $150 worth of ETH as collateral to receive $100 worth of DAI can now use this stablecoins while retaining his or her long position in ETH.
By leveraging existing assets, a user is able to free up liquidity to spend on during the duration of the loan - much like taking a valued item to a pawnshop for a loan.
If the price of ETH falls below the collateralization ratio, the MakerDAO protocol will liquidate the ETH to get back the loan amount thereby protecting the system.
TL;DR While Crypto-backed Stablecoins might seem more complex than fiat-backed ones, a user of DAI does not need to understand the complexity behind it. However, due to the complexity of collateralization, there is smart contract risk associated with issuance and the risks of stablecoin losing its peg.
Stablecoins that do not have collateral but utilize algorithms to control the money supply similar to central banks printing and buying back currency.
Seigniorage shares uses a smart contract to simulate a central bank in which monetary policy attempts to keep the currency value at $1. The network issues new coins if the price of the stablecoin is too high and burns them when it is too low.