Advantages of asset backed cryptocurrencies are that coins are stabilized by assets that fluctuate outside of the cryptocurrency space, that is, the underlying asset is not correlated, reducing financial risk. Bitcoin and altcoins are highly correlated, so that cryptocurrency holders cannot escape widespread price falls without exiting the market or taking refuge in asset backed stablecoins. Furthermore, such coins, assuming they are managed in good faith, and have a mechanism for redeeming the asset(s) backing them, are unlikely to drop below the value of the underlying physical asset, due to arbitrage.
Backed stablecoins are subject to the same volatility and risk associated with the backing asset. If the backed stablecoin is backed in a decentralized manner, then they are relatively safe from predation, but if there is a central vault, they may be robbed, or suffer loss of confidence.
The main characteristics of backed stablecoins are:
- Their value is fixed to one or more commodities and redeemable for such (more or less) on demand,
- There is a promise to pay, by unregulated individuals, agorist firms, or even regulated financial institutions,
- The amount of commodity used to back the stablecoin has to reflect the circulating supply of the stablecoin.
Holders of commodity-backed stablecoins can redeem their stablecoins at the conversion rate to take possession of real assets. The cost of maintaining the stability of the stablecoin is the cost of storing and protecting the commodity backing.
Examples: Digix Gold Tokens (DGX) and others.
The value of stablecoins of this type is based on the value of the backing currency, which is held by a third-party regulated financial entity. In this setting, the trust in the custodian of the backing asset is crucial for the stability of price of the stablecoin. Fiat-backed stablecoins can be traded on exchanges and are redeemable from the issuer. The cost of maintaining the stability of the stablecoin is equivalent to the cost of maintaining the backing reserve and the cost of legal compliance, maintaining licenses, auditors and the business infrastructure required by the regulator.
Cryptocurrencies backed by fiat money are the most common and were the first type of stablecoins on the market. Their characteristics are:
- Their value is pegged to one or more currencies (most commonly the US dollar, also the Euro and the Swiss franc) in a fixed ratio,
- The tether is realized off-chain, through banks or other types of regulated financial institutions which serve as depositaries of the currency used to back the stablecoin,
- The amount of the currency used for backing of the stablecoin has to reflect the circulating supply of the stablecoin.
Cryptocurrency-backed stablecoins are issued with cryptocurrencies as collateral, which is conceptually similar to fiat-backed stablecoins. However, the significant difference between the two designs is that while fiat collateralization typically happens off the blockchain, the cryptocurrency or crypto asset used to back this type of stablecoins is done on the blockchain, using smart contracts in a more decentralized fashion. In many cases, these work by allowing users to take out a loan against a smart-contract via locking up collateral, making it more worthwhile to pay off their debt should the stablecoin ever decrease in value. To prevent sudden crashes, a user who takes out a loan may be liquidated by the smart contract should their collateral decrease too close to the value of their withdrawal.
Significant features of crypto-backed stablecoins are:
- The value of the stablecoin is collateralized by another cryptocurrency or a cryptocurrency portfolio,
- The peg is executed on-chain via smart contracts,
- The supply of the stablecoins is regulated on-chain, using smart contracts,
- The price stability is achieved through introduction of supplementary instruments and incentives, not just the collateral.
The technical implementation of this type of stablecoins is more complex and varied than that of the fiat-collateralized kind which introduces a greater risks of exploits due to bugs in the smart contract code. With the tethering done on-chain, it is not subject to third-party regulation creating a decentralized solution. The potentially problematic aspect of this type of stablecoins is the change in value of the collateral and the reliance on supplementary instruments. The complexity and non-direct backing of the stablecoin may deter usage, as it may be difficult to comprehend how the price is actually ensured. Due to the nature of the highly volatile and convergent cryptocurrency market, a very large collateral must also be maintained to ensure the stability.
Live stablecoins projects of this type are Havven (the pair: nUSD – stablecoin and HAV – the collateral-backed nUSD), DAI (pair: CDP – Collateralized Debt Position and MKR – governance token used to control the supply) and others. There is also Wrapped Bitcoin (WBTC), see BitGo.
Seigniorage-style (not backed)
Seigniorage-style coins utilize algorithms to control the stablecoin’s money supply, similar to a central bank’s approach to printing and destroying currency. Seigniorage-based stablecoins are a less popular form of stablecoin.
Significant features of seigniorage-style stablecoins are:
- Adjustments are made on-chain,
- No collateral is needed to mint coins,
- Value is controlled by supply and demand through algorithms, stabilizing price.
Basis was one example of a seigniorage-style coin.
Tether, the largest stablecoin by market capitalization, has faced accusations of being unable to provide audits for their reserves while continually printing millions; many have attributed their unverifiable creation of new coins to Bitcoin‘s rise in price in 2017.
Failed and abandoned stablecoin projects
Stablecoins can be prone to failure as well due to volatility and upkeep required in many cases. The stablecoin project Basis, which had received over $100 million in venture capital funding, shut down in December 2018, citing concerns about US regulation.
The Bank of International Settlements lists the possible merits of the subject as enhancement of anti-money laundering efforts, operational resilience, customer data protection, financial inclusion, tax compliance, and cybersecurity.