Stablecoins are crypto assets that try to reduce volatility by pegging the value to another asset. They are typically backed by actual currencies or a basket of cryptocurrencies.
The most common form of stableocins are stablecoins pegged to a fiat currency such as the US Dollar. Common examples include Tether (USDT) and USD Coin (USDC).
A stablecoin such as Tether USDT is backed on a 1:1 basis with the U.S. dollar. That means for every single unit of USDT that's in circulation, $1 is supposed to be set aside and held in reserve by financial service providers.
As explained earlier, stablecoins are digital currencies that are collateralized by an underlying asset to deliver price stability. The top stablecoins are typically backed 1:1 by fiat currency (also called 'traditional collateral'). As they require an intermediary to manage the fiat reserve and issue the coins, fiat-based stablecoins are centralized by nature.
The problem with centralized stablecoins is that they are constantly under regulatory surveillance and influence. Decentralized stablecoins, on the other hand, face none of these legal restrictions.
Decentralized stablecoins can be classified into two different forms:
As the name implies, crypto-collateralized stablecoins are backed by a bunch of crypto assets as collateral. To mint these stablecoins, you are required to lock your crypto collateral into a smart contract to obtain stablecoin tokens of equal representative value. To withdraw your original collateral amount, you can simply return the issued stablecoins back into the same smart contract, where they will be burned.
Example: DAI is the most prominent stablecoin in this category that makes use of this mechanism. This is realized by utilizing a collateralized debt position (CDP) via MakerDAO to secure assets as collateral on the blockchain.
Algorithmic stablecoins are not collateralized by any kind of asset. Rather, to maintain stability, these stablecoins use an algorithm-based supply-demand elasticity mechanism. To put it simply, an algorithmic stablecoin uses an algorithm underneath which issues more coins when price increases, and buys them off the market when the price falls.
Algorithmic stablecoins are the true representation of decentralization with no regulatory bodies maintaining watch over proceedings as the code is what’s responsible for supply and demand, as well as ideal target price.
Example: TerraUSD (also known as UST) is one the top decentralized stablecoins in crypto. Terra achieves price-stability by algorithmically adjusting its supply according to fluctuations in demand using a seigniorage mechanism (here is a video explainer).