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.