Exploring the Benefits and Risks of Stablecoins
Tags: blockchain, web3, webdev, tutorial
Published: 2023-03-23 16:07:58

**What are Stablecoins**

Stablecoins are a type of digital currency that is designed to be more stable in value than other cryptocurrencies, like Bitcoin or Ethereum. They are created using smart contracts. Think of a Stablecoin as a digital version of the paper money you carry in your pocket. It is like a special kind of IOU that is programmable and can be used as a means of payment by everyone in your community.

One of the main benefits of stablecoins is that they aim to reduce or eliminate price volatility, meaning that the value of the stablecoin is less likely to change dramatically over a short period. This makes them useful for managing risk and for engaging with decentralized finance (DeFi) protocols, which are financial tools that operate on a blockchain without the need for traditional financial institutions like banks.

However, there have been concerns about the potential for fraud and manipulation with stablecoins, particularly those that are not backed by sufficient reserves of the underlying asset. One recent example of this is the controversy surrounding Binance USD (BUSD).

In May 2021, it was revealed that Binance, one of the world's largest cryptocurrency exchanges, had been using a small portion of its BUSD reserves to invest in other cryptocurrencies and other high-risk assets, rather than holding all of its BUSD reserves safely and securely. This raised concerns that Binance may not have enough BUSD reserves to back all of the BUSD in circulation, potentially leading to a collapse in the value of the stablecoin if too many people tried to redeem their BUSD at once.

In general, it is important for users to carefully research and understand the risks associated with any stablecoin before using it, and to only use reputable and well-established platforms for trading and investing in cryptocurrencies. Additionally, regulators and policymakers may need to consider more robust oversight and regulation of the stablecoin industry to protect consumers and prevent fraudulent activities.

There are five different types of Stablecoins, each of which is backed by different assets and has its own level of complexity and centralization. 

They are categorised from the most centralized/least complex to the least centralized/most complex.

1. Fiat backed

2. Commodity backed

3. Crypto backed

4. Algorithmic

5. Central Bank Digital Currencies

To understand stablecoins, you should think about three things:
What the stablecoin is backed by (type of collateral),
How much backing it has (collateralization ratio), and
How centralized it is.
Fiat Backed Stablecoins

These stablecoins are like digital versions of US dollars that are held in a bank account and audited regularly. Tether's USDT and Circle's USDC are examples of stablecoins that are backed by US dollars. They are the easiest to understand because they are collateralized with dollars and financial instruments that can quickly be turned into cash. USDT and USDC are the most popular stablecoins due to their ease of use, but they come with the risk of centralization and censorship as they can block users and freeze assets.

**Commodity Backed Stablecoins**

Commodity-backed stablecoins, as the name implies, are stablecoins that are backed by a commodity such as gold, silver, or other valuable assets. These stablecoins are collateralized by a corresponding amount of the commodity in a vault, to provide stability to the token's value.

For instance, Paxos Gold (PAXG) is an example of a commodity-backed stablecoin that is backed by gold. Each PAXG token is backed by one ounce of allocated gold, stored in a vault. The gold is audited regularly to ensure that the amount of gold held in reserve matches the number of tokens in circulation.

**Crypto-Backed Stablecoins**

Crypto-Backed Stablecoins also known as Crypto collateralized stablecoins are stablecoins that are backed by cryptocurrencies, such as Ether (ETH) or other tokens, as collateral. These stablecoins use over 150% collateral (with 250% recommended) to mitigate the volatility associated with cryptocurrencies. MakerDAO's DAI is a prominent example of a crypto-collateralized stablecoin and is well-known for introducing the concept of a Collateralized Debt Position (CDP).

One of the main advantages of crypto-collateralized stablecoins is that they can be audited by anyone at any time without permission. As the assets live on the blockchain, the entire transaction history is available for public scrutiny.

**Algorithmic Stablecoins**

Algorithmic stablecoins, also known as rebase tokens, are a type of stablecoin that self-balances through the use of incentives and algorithms, without the need for collateralization. Instead of being backed by a traditional asset or cryptocurrency, algorithmic stablecoins use smart contract logic to expand or contract the supply of tokens to maintain a stable peg to a target value, such as the US dollar. 

An example of an algorithmic stablecoin is Ampleforth's AMPL, which uses a unique supply adjustment mechanism called "rebasing" to maintain its stable value. Another example is Base Protocol's BASE, which uses a dual token system to incentivize users to maintain the token's peg to the US dollar.

**Central Bank Digital Currencies Stablecoins**

Central Bank Digital Currencies (CBDCs) are a type of stablecoin that is issued by a government and uses distributed ledger technology, such as Ethereum. CBDCs are similar to traditional fiat currencies, but instead of physical cash or bank deposits, they exist in digital form on a blockchain. CBDCs can be used for peer-to-peer transactions, just like other cryptocurrencies, but they have the backing of a government, which ensures their stability and trustworthiness.

CBDCs are being piloted in several countries, including China, Sweden, South Korea, and the Caribbean. They are made possible by several DeFi primitives, such as the ERC-20 standard for fungible tokens, escrow contracts for depositing collateral into a protocol, and the ability to alter the supply of tokens.