What are centralized and decentralized stablecoins and how do they differ?

Stablecoins play a crucial role in cryptocurrencies’ trades and investments. Before stablecoins, users had to convert their cryptocurrencies into fiat money in bearish markets and vice versa, but this wasn’t time and cost-efficient. However, the initial stablecoins were centralized and this was their problem. Today, decentralized stablecoins have solved this problem. What do you think about decentralized stablecoins? Do you think they can surpass the centralized ones in terms of popularity?

If you are a cryptocurrency user and lover, you have definitely heard the term “stablecoin” and have used one of them. Stablecoin, as its name suggests, is a cryptocurrency with a stable price. You may now be wondering how can a cryptocurrency have a stable price? You’re right because price volatility is an inherent characteristic of cryptocurrencies. But, stablecoins use different solutions to keep their prices stable. The solution these coins use for achieving this goal makes them different. In this article, we are going through two main categories of stablecoins, namely “centralized” and “decentralized” stablecoins. Stay with us up to the end of this article to figure out what these important cryptocurrencies are and how they keep their prices stable.

Centralized Stablecoins

A large number of stablecoins peg their value to another asset and this way, their price always equals their backing asset. Some stablecoins peg their value to centralized assets like fiat money and physical assets. For this reason, they are called centralized stablecoins.

Stablecoins backed by fiat money

Stablecoins backed by fiat money like Dollar, Euro, and Yen are the simplest forms of stablecoins. It’s claimed that for each new unit of stablecoin issued, one unit of the fiat currency is added to the treasury. They get their credit from their backing asset and the country’s central bank is actually preserving these cryptocurrencies’ value.

The most famous fiat-backed stablecoin is Tether (USDT). Tether’s value is pegged to the U.S. dollar and its price is always stable at $1. At the time of writing, Tether’s market cap is more than $68,000,000,000. Other well-known fiat-backed stablecoins include USDCoin (USDC) and Binance USD (BUSD).

Stablecoins backed by physical assets

Some other centralized stablecoins don’t peg their value to fiat currencies, but to valuable physical assets like gold. Gold is the most common physical asset used as the backing of centralized stablecoins. Tether Gold (XAUT), Pax Gold, and Digix Gold are the most well-known gold-backed stablecoins. Tether Gold is also issued by the Tether Company and each unit of it equals one ounce of London Gold. Pax Gold is an ERC20 token developed by Paxos and backed by one troy ounce of London Gold. These gold treasuries are held by the Brink’s vault in London. It’s good to mention that Brink’s is approved by London Bullion Market Association (LBMA). And finally, Digix Gold is backed by 99% fine gold held in Singapore.

Decentralized Stablecoins

As you have figured out, the stablecoins we went through up to here were all centralized, because they were backed by centralized entities and assets. By the way, we have some other stablecoins that are not backed by centralized assets. Decentralized stablecoins are divided into “cryptocurrency-backed” and “algorithmic” stablecoins.

Stablecoins backed by cryptocurrencies

As their name suggests, these stablecoins are backed by cryptocurrencies. They usually exist in decentralized lending platforms. Cryptocurrency lending platforms have a special “vault” and users who want to take loans from these platforms, pay their collaterals to these vaults. Cryptocurrency lending platforms use “over-collateralization”. This means that users’ collaterals have more value than what they borrow. When the value of the collateral decreases, the platform automatically liquidates it to prevent further losses. This over-collateralization helps keep the price stable. The most well-known cryptocurrency-backed stablecoin is DAI belonging to MakerDAO lending platform. DAI’s price is stable at $1.

Algorithmic stablecoins

And finally, there are algorithmic stablecoins that by increasing and decreasing the supply when needed, keep the price stable. One big difference between algorithmic stablecoins and the other types is that they don’t have any kind of backing. So, algorithmic stablecoins are the most complex forms of stablecoins. When their price decreases, smart contracts automatically take some tokens out of circulation, and when their price increases, they produce new tokens. By balancing the supply and demand, they keep the price of their tokens stable. Terra stablecoins are the most famous algorithmic stablecoins.

Conclusion

Stablecoins play an important role in cryptocurrencies’ trading and investments. They eliminate the users’ need to convert their cryptocurrencies into fiat currencies when needed. The world’s first stablecoin was Tether, which is still the most used one. By the way, Tether’s centralized nature contradicted cryptocurrencies’ decentralized nature. This led to the development of more recent and decentralized stablecoins like DAI and Terra. Though these stablecoins are not as popular as Tether yet, they have gained acceptable success relative to their shorter life period. Do you think decentralized stablecoins will replace centralized one like Tether one day?