Under the hood, stablecoins are entries on global shared digital ledgers that can be transacted on decentralised, peer-to-peer global networks – just like any other cryptocurrency.
Most Stablecoins don’t run their own networks. Instead, they run on top of established blockchains, such as Ethereum or Binance Chain. This enables Stablecoins to be launched without the complexity of starting a network from scratch. Trading an Ethereum-based Stablecoin, for example, is no different than trading Ether itself
But the key property of a Stablecoin is, of course, stability. Different stablecoins use different approaches to achieve stability, falling into the following broad categories:
- Fiat collateral-based
- Crypto collateral-based
- Algorithmic-based seigniorage
- Central Bank Digital Currencies (CBDCs)
Each approach has their own pros and cons. Let’s take a brief look at each approach and how they work.
Fiat collateral-based Stablecoins
This is the most intuitive and straightforward way to achieve stability. It was the first model to be used, and it’s by far and large the most prevalent today.
Fiat collateral-based stablecoins are issued by companies on-chain against corresponding bank deposits in fiat currency (collateral) – usually redeemable on a 1:1 basis at the issuing company.
This means that each unit of this type of stablecoin is just a representation of an existing unit of fiat currency in its issuer’s bank account.
For example, for each unit of Tether (the currency) in circulation, there is a corresponding US dollar in Tether’s (the company) account.
Supply is determined by the amount of collateral held by the company. The issuance of new units requires new money to be deposited by the company, or by a customer. Conversely, redeeming stablecoins for fiat lead to reduced supply.
It’s worth noting that this type of relationship can be extended to collateral other than money – commodities (like gold or silver) and even more complex financial products can (and have started to) be “tokenised” this way – that is, kept as collateral and released as a token on a blockchain.
Working examples of this approach include Tether, Gemini, Paxos, and TrueUSD (pegged to the US dollar), Digix (backed by gold), and Globcoin (based on a basket of currencies).
| Pros | Cons |
| Reliability: tokens are backed by actual time-tested assets | High trust required on the issuing company to honour redemption |
| High liquidity: most can be directly redeemed | Transparency issues surrounding existing deposits |
| Scalability: the model is easy to replicate with little effort | Financial regulations may change, leading to freezing of funds |
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