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    Gate.io Blog What is a stable coin?
    Common Knowledge

    What is a stable coin?

    27 May 15:57


    The huge volatility in the crypto market gave birth to stablecoins. A stablecoin is essentially a cryptocurrency. It is anchored 1:1 with a stable value off-chain asset such as USD, EUR, etc. As a medium of exchange, stablecoins have solved the circulation problem between digital currency and legal currency, and is one of the key elements of the crypto industry.

    We will mention three common types of stablecoins and their different peg mechanisms for maintaining value stability.
    1. Fiat currency collateral model. Deposit 1:1 with fiat currency as collateral to ensure the stability of digital assets.
    2. Digital asset over-collateralization model. Use cryptocurrency as over-collateralization then mint out stablecoins.
    3. Algorithmic mechanism. Without collateral, these stablecoins are anchored by algorithmic mechanisms such as minting and burning.



    (Source: TokenInsight)


    Fiat currency collateral model


    Taking fiat currency as collateral is the most widely used one on the market today, such as USDT, USDC, BUSD,DAI etc. The issuer promises that every time a stablecoin is issued, one dollar of funds will be deposited in a guaranteed bank account. It is technically easy.

    However, there is a problem of security and trust in centralized control. For it is difficult for users to judge whether the issuer has actually deposited the corresponding off-chain assets, such as USDT. Compared with USDT, USDC and BUSD have a better reputation because they are endorsed by big institutions like Binance and they regularly publish regulatory reports.


    (Source: Messari)


    Over-collateralization


    A typical example of over-collateralization with cryptocurrency is the stablecoin DAI issued by MakerDAO (a decentralized autonomous organization on Ethereum). Users can over-collateralize digital assets (ETH, BTC, etc.) through "Collateralized Debt Positions" (CDP) smart contracts. Users lock their digital assets in a CDP smart contract, and then they will mint the corresponding amount of DAI as their over-collateralized debt. CDP will lock this mortgage asset until users repay the debt DAI.

    In order to maintain the 1:1 peg between DAI and USD, MakerDAO has set up a unique mechanism.

    When the value of DAI falls below a dollar, the smart contract increases the over-collateralization rate. By doing so, it will become more expensive to mint DAI with CDP. Which means with the same amount of collateral assets, users can mint less DAI. Meanwhile, the assets locked in CDP can be redeemed with a smaller amount of DAI. Thus arbitrageurs can profit from it. This incentivizes users to return DAI to the CDP smart contract. And the returned DAI will then be burnt by CDP. With increasing funds involved, the price of DAI will rise back to $1.

    When the value of DAI is higher than one dollar, the CDP smart contract will reduce the over-collateralization rate. Arbitrageurs can profit from higher returns on holding DAI, increasing the demand for users to mint DAI. When the collateral assets that generate DAI continue to increase, the value of DAI will drop back to $1.

    In this way, the price of DAI is always stable and anchored with one dollar. The emergence of DAI has solved the trust problem of stablecoins issued by centralized institutions, and more and more people have begun to explore decentralized solutions.


    (Source: Messari)


    Algorithmic Stablecoins


    Stablecoins with fiat currency as collateral are gradually becoming popular and gaining widespread adoption. However, with the original coinage vision of the blockchain industry, algorithmic stablecoins emerged. The "algorithmic" mechanism in algorithmic stablecoins usually echoes the "arbitrage" mechanism. Without reserve funds and collateral,algorithmic stablecoins use minting and burning mechanisms to achieve the peg between the stablecoin and USD.

    The stablecoin TerraUSD (UST), which has recently been making waves due to de-peg, is a typical algorithmic stablecoin. TerraUSD is an "innovation" made by the Terra team to increase the application scenarios of its ecological native token Luna. It is a decentralized algorithm stablecoin on the Terra blockchain. The stability of UST is bound by a burning mechanism related to Luna which is a digital asset with no stable value. For every UST minted, LUNA worth 1 USD will be destroyed.

    When the price of UST is over 1 dollar, the UST is in short supply. At this time, the Terra smart contract allows users to mint 1 UST with Luna tokens equivalent to 1 USD, and the actual value of 1 UST obtained by users is higher than 1 USD. So users can make profit from it. The Luna used to mint UST coins will then be burnt. As the demand for UST increases, supply and demand gradually tends to balance. And finally the price of UST returns to one dollar.

    Similarly, when the price of UST is below $1, there is an oversupply of UST. At this time, it is more beneficial for users to use the stablecoin UST to buy back Luna. Users can redeem Luna tokens equivalent to $1 with 1 UST. In this way, the reduction in the supply of Luna creates scarcity, the demand for UST decreases, and the price will gradually rise until it is pegged to the US dollar. With this arbitrage mechanism, UST always keeps a stable price of $1.

    The core of algorithmic stablecoins may not be "algorithms", but how to create demand. Compared with stablecoins such as USDT, USDC, DAI and other stablecoins endorsed by assets and institutions, algorithmic stablecoins need real application scenarios and user-oriented risk compensation benefits.


    (Source: Messari)

    It can be seen that the circulation of various stablecoins is showing an upward trend year by year, as well as the demand for stablecoins in the Crypto industry. The prosperity of stablecoins has broken the barriers between digital assets and fiat currencies. It promotes the development of various DeFi products, and has a good value-added effect on cryptocurrencies. It is a track worthy of our long-term attention.


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