The value of a crypto-backed stablecoin is tied (or pegged) to the value of another asset. The underlying asset in this case is cryptocurrency, which is not conventionally safe and can be highly volatile.
The term used to describe these kinds of stablecoins is “over-collateralization”. This means that a relatively large amount of reserve cryptocurrency may be needed to issue even a small number of assets.
How does a cryptocurrency-backed stablecoin work?
Cryptocurrency-backed stablecoins are backed by another cryptocurrency (usually ETH). Instead of relying on a centralized bank to store reserves, cryptocurrency-backed stablecoins use smart contracts.
To account for the unpredictable nature of cryptocurrency market volatility, many decentralized cryptocurrency-backed stablecoins are over-collateralized. E.g., MakerDAO's DAI stablecoin requires a minimum of 150% collateral for security.
Thus, for every $100 USD in DAI we want to borrow, $150 USD worth of ETH needs to be locked in the smart contract. This ensures that DAI maintains its value peg, even during times of intense market volatility.
Is this kind of stablecoin stable?
Stablecoins backed by another cryptocurrency offer better decentralization compared to stablecoins backed by fiat currency. They could help processes become more trustworthy through better security and transparency. Decentralization offers the advantage of not needing to trust a single entity with control over everyone’s money.
In addition, some stablecoins of this kind have multi-cryptocurrency support to ensure effective risk distribution. However, they are one of the most complex stablecoin types currently in use.
- They are a more decentralized version of stablecoins backed by fiat currency
- There is no need to go through the KYC process to buy these stablecoins
- It still ranks among the riskier stablecoin types
- They are currently not very popular
There aren't many crypto-backed stablecoins yet, so caution is needed. DAI has proven itself and showed that such a system can work, but the basis is excessive collateralization. Before investing in another stablecoin of this kind, first check how exactly it works.
Crypto-backed stablecoins such as DAI are so-called soft pegged to the US dollar. They are not backed by dollars 1:1, but rather by locking other crypto assets in the form of collateral in a smart contract. Unlike stablecoins backed by fiat currency, they are usually issued by companies such as Maker Protocol, which is a decentralized application running on a blockchain.