Decentralized Stablecoins: the Lifeblood of DeFi

Paradoxically, even though bitcoin is considered to be a new evolutionary phase for finance, its high volatility prevents it from acting as actual money. Stablecoins are commonly seen as a solution to the problem, by adding market price stability to the equation.

However, not every stablecoin follows the commandments of Satoshi Nakamoto. Some stablecoins are regular e-monies, somewhat like PayPal transplanted onto the blockchain. They have very little in common with the ideology behind bitcoin, being downright centralized.

This post will take a look at the difference between centralized and decentralized stablecoins, which will help us understand why the latter is so crucial for the success of DeFi.

Centralized stablecoins: main features

On top of that, there is no real guarantee that the stablecoin is indeed fully backed with a 1:1 national fiat currency reserve. For instance, one may discover that one of the most popular stablecoin in the cryptocurrency ecosystem is actually only partially backed as, according to the media, its issuer opted to use a part of the backing to help out one of its partners.

Today, almost all centralized stablecoins are pegged to the U.S. dollar. USDT, USDC, TUSD, PAX, and GUSD account for nearly 95% of the supply and trading volume of the stablecoin market.

With the exception of USDT, most centralized stablecoins are ERC-20 tokens running on Ethereum. This is good and bad at the same time since on the one hand, it might be risky to keep all stablecoins on the same blockchain and on the other hand, it allows one to easily use them in the DeFi ecosystem that is most active on Ethereum.

Decentralized stablecoins: main features

The main difference between decentralized stablecoins and their centralized peers is that the former don’t use bank accounts for the underlying, while retaining the connection with national fiat currencies as a unit of account. In fact, there are contracts for difference backed with cryptocurrency, such as DAI. Simply put, the issuer of a decentralized stablecoin undertakes to redeem it with $1 worth of cryptocurrency.

This obligation is backed with the issuer’s cryptocurrency which is usually deposited in a smart contract. If something goes wrong, you are still able to redeem your tokens at the price of $1 per token. This is basically how emergency shutdown works in MakerDAO, the issuer of DAI.

While centralized stablecoins are banks wrapped as cryptocurrencies, decentralized stablecoins are volatile cryptocurrency wrapped in a stable cryptocurrency.

Diversity of decentralized stablecoins

However, the diversity of possible designs of decentralized stablecoins doesn’t go down to DAI alone. For instance, AEUR by Augmint is pegged to Euro and backed by ETH, and SUSD by Syntetix is pegged to USD and backed by SNX.

Terra uses its own blockchain where one can create different stablecoins pegged to different anchors. Those stablecoins would be backed by LUNA, the Terra network coin which also represents Terra mining power. Like Ethereum, Terra supports decentralized finance apps but uses DPoS instead of PoW.

Non-Collateralized stablecoins

Non-collateralized stablecoins are the least researched type of stablecoins. Currently, there are no projects that appear to have successfully implemented this model. If you are interested to learn more, take a look at NuBits, Basis, and Ampleforth.

Which kind of stablecoins is better after all?

Conversely, the main advantage of centralized stablecoins is that they are supposedly backed by a national fiat currency stored by a regulated financial institution rather than by a volatile cryptocurrency in a smart contract that can be hacked or faulty.

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