What Are Decentralized Stablecoins? Examples, Benefits & More

Cryptocurrency and decentralized finance are fairly new fields, with many concepts that still puzzle the majority of investors. The technology is new and the assets are volatile, which makes for a steep learning curve. That’s where decentralized stablecoins come into play.

They represent a bridge between the worlds of traditional finance (TradFi) and decentralized finance (DeFi). On the one hand, decentralized stablecoins bring much-needed stability to a fickle ecosystem. On the other hand, they aren’t owned by any single entity that can misuse or exploit them for personal gain.

Learning about these cryptocurrencies is essential, as it helps both short-term traders and long-term investors better understand and navigate the DeFi space. Let’s find out how decentralized stablecoins might shape the future of crypto!

What Are Decentralized Stablecoins?

A decentralized stablecoin is a cryptocurrency created to maintain a stable value. A common way of achieving that is by having stablecoins pegged to other assets, most commonly fiat currencies, such as the US dollar. The goal is to have a DeFi currency that’s not susceptible to explosive crypto market movements.

This stablecoin characteristic gives them many use cases. Investors buy them to stay in the crypto sphere while protecting their portfolio during the bear run. They are commonly used in many trading pairs, as it’s much easier to trade against a stable asset than between two highly volatile ones. Stablecoins can also be used in everyday transactions, payments, and more.

Another crucial aspect of these cryptocurrencies is decentralization. Decentralization is a core crypto principle, as the goal is to have an alternative monetary system freed from the influence of banks, governments, and other centralized bodies. Decentralized stablecoins represent a vital step in that direction.

Essentially, they aim to combine the best of TradFi and DeFi. Decentralized stablecoins blend the constancy of fiat with the security, transparency, and permissionlessness of cryptocurrencies.

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Pro tip: While stablecoins have the word “coin” in their name, they are actually tokens since they don’t operate on native blockchains.

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Centralized vs. Decentralized Stablecoins

Centralized and decentralized stablecoins are similar types of cryptocurrency that maintain constant value by being pegged to other stable assets. The main difference between the two is centralization.

Centralized stablecoins are issued, minted, governed, and burned by a single governing authority. These are also some of the biggest cryptocurrencies in terms of market capitalization. The most popular examples include Tether USD (USDT), issued by Tether Limited Inc., and USD Coin (USDC), issued by Circle.

Both of these cryptos are pegged to the US dollar and are used in many trading pairs on centralized (CEX) and decentralized (DEX) exchanges. However, the downside is that owning them involves having a dose of trust in the companies that issue them. There have been some transparency concerns, especially with USDT, regarding collateralization.

On the flip side, decentralized stablecoins embrace the core principles of cryptocurrency and operate without central authority. There are always multiple points of control, meaning no single person or entity can manipulate or exploit them. One of the prominent examples is DAI, which is governed by a decentralized autonomous organization called MakerDAO.

To maintain value, as well as issue or burn tokens when necessary, decentralized stablecoins use algorithms and smart contracts. These self-executing programs operate transparently and autonomously, leveraging blockchain’s security features. That makes these tokens resistant to censorship and tampering and more in line with the DeFi ideology.

How do Decentralized Stablecoins Work?

Decentralized stablecoins work using algorithms and smart contracts to maintain their stability. That means there isn’t a centralized authority overlooking the currency, governing its issuance, and maintaining its value.

Instead, decentralized stablecoins operate autonomously by leveraging blockchain mechanics. That approach ensures security and transparency, while programmable smart contracts facilitate operations.

Most of these tokens are pegged to the US dollar using different mechanisms. A common approach to maintaining the peg is with collateral. Essentially, DAOs have reserves of other cryptocurrencies as collateral. In many cases, these reserves need to exceed the value of issued tokens since crypto assets are highly volatile and can unpredictably drop in price.

Algorithms and smart contracts come into play to maintain the asset’s price and control its supply. If the value of a pegged token falls below the preprogrammed amount, smart contracts will burn a certain number of tokens to increase its price. Conversely, if the value increases, more tokens are minted to reduce their value.

While a decentralized approach encapsulates what the cryptosphere is all about, it isn’t without challenges. The security and transparency provided by the blockchain make these tokens highly sought-after, but there’s still plenty of complexity and vulnerability when it comes to governance and stability.

Types of Decentralized Stablecoins

There are four different types of decentralized stablecoins, so let’s examine each one.

#1. Overcollateralized Stablecoins

Overcollateralized stablecoins are supported by an oversupply of crypto collateral. This approach is essential due to the volatility of crypto assets. That way, even if collateralized crypto drops in price, stablecoins can maintain their peg.

Smart contracts conduct token burning and minting. Anyone can take part in these ecosystems through DeFi platforms and dApps to lend and borrow tokens, while ecosystems are generally governed by decentralized autonomous organizations.

The most notable example in this category is MakerDAO’s DAI. This Ethereum-based stable token accepts multiple cryptocurrencies as collateral, requiring users to submit 101–175% of the value in crypto to obtain DAI. Other prominent examples include Aave’s GHO stablecoin and Curve’s crvUSD.

#2. Algorithmic Stablecoins

As their name suggests, algorithmic stablecoins rely entirely on algorithms to control their supply and price. This approach stands in contrast to overcollateralized stablecoins, as there’s no collateral to support their value.

Instead, most algorithmic decentralized stablecoins utilize a dual token system: a stablecoin is paired with a purpose-built, volatile cryptocurrency. Depending on the current value of volatile crypto, algorithms mint or burn decentralized stablecoins to maintain their peg.

One of the most popular examples is Tron’s USDD, which is mainly backed by TRON. Another example that quickly gained notoriety in the crypto sphere is Terra’s USTC. USTC experienced a huge de-peg, with its value dropping to $0.32, resulting in more than $40 billion in losses for holders.

#3. Fractional Algorithmic Stablecoins

Fractional algorithmic stablecoins are only partly backed by collateral, while the rest are managed by algorithms. That gives them more flexibility and resistance to a volatile market since collateral price drops don’t impact stablecoins as much as when fully collateralized.

The whole concept was invented by Frax Finance, which issued FRAX (USD-pegged stablecoin) and FPI (US CPI-pegged stablecoin). These two tokens are managed by two separate DAOs.

Initially, FRAX had a 50% collateral ratio, with users having to submit $0.5 worth of USDC for every token. However, the community voted toward full collateralization, which means they aren’t confident in an algorithm-backed system.

#4. Non-Pegged Stablecoins

Non-pegged stablecoins are different from other types. They aim to maintain stable value, but not in connection with other assets, such as fiat or precious metals. Instead, the price is governed solely by the current supply and demand conditions in the market.

The most famous example is Reflexer Finance’s RAI token, which is backed solely by Ethereum. The main goal behind RAI is to have a stable decentralized currency completely independent of traditional finance. However, the downside is that RAI’s price fluctuates quite a bit compared to conventional stablecoins, which results in low demand in its current state.

Advantages of Decentralized Stablecoins

Decentralized stablecoins offer several notable advantages to individual investors and the broader ecosystem. Here are the key ones:

• Resistance to volatility. One of the key benefits of stablecoins is their ability to maintain value regardless of market movement. That makes them suitable for preserving assets during market downturns. Moreover, they are favorable in trading pairs, as their stability makes calculating gains and losses easy.
• Increased transparency. Unlike centralized stablecoins, where holders need to trust the issuers that their coins are fully collateralized, decentralized tokens have all that information on display. All transactions, minting, burning, and current balances are readily available on the blockchain for everyone to see.
• Decentralization. Another benefit of decentralized over centralized stablecoins is their resistance to a single point of failure. Instead of having to rely on third-party entities to maintain the token’s value and control its supply, decentralized stablecoins employ algorithms and smart contracts that are tamper-proof.
• Enhanced efficiency. By removing the human factor from the equation, decentralized stablecoins become more effective and capable. Their minting and burning happen quickly and automatically, with minimal use of resources. There’s also little-to-no chance of errors and mishaps.
• Financial inclusion. Decentralized finance allows anyone with an internet connection to participate. As a result, individuals who might not have access to TradFi stable assets, such as gold or fiat currencies, can obtain their digital versions.

Cons of Decentralized Stablecoins

Decentralized stablecoins aren’t without risks and cons, which is why centralized stablecoins are still much more prominent. Here is a list of decentralized stablecoin drawbacks:

• Complexity. One of the biggest barriers to the broader adoption of decentralized stablecoins is the user experience surrounding them. Centralized versions operate akin to TradFi fiat, which is much easier to understand and get into. Decentralized tokens require certain levels of knowledge about Web3, DeFi, crypto wallets, and more.
• Collateral concerns. Crypto-backed decentralized stablecoins and collateral risk go hand-in-hand. Even Bitcoin, the most stable cryptocurrency, can experience price drops, which can go upward of 50%. As a result, even overcollateralized decentralized stablecoins aren’t fully protected from de-pegging.
• Smart contract vulnerabilities. Smart contracts, while mitigating the risk of human error and malpractice, aren’t always a foolproof solution. They can be prone to hacks and exploits. Moreover, their creators can deliberately include vulnerabilities to take advantage of in the future, which is why thorough vetting is mandatory.
• Regulatory uncertainty. Stablecoins tend to be very similar to TradFi assets, which are heavily regulated. As a result, there’s always the risk of centralized entities stepping in to impose rules and regulations. They can impact everyone, from token developers to holders.

The Future of Decentralized Stablecoins

In the future, we’ll likely see technological advances and innovations related to decentralized stablecoins. As the cryptocurrency landscape continues to grow, so will the need for stability and an improved user experience.

We might see improved algorithms and smart contracts that could reduce or outright remove some of the drawbacks, such as collateral concerns and code vulnerabilities. That could result in better integration with traditional finance, which will likely draw in more investors, further facilitating the progress of DeFi.

Still, there are many challenges to overcome if decentralized stablecoins are to dethrone their centralized counterparts. Financial inclusion and cross-border transactional capabilities still aren’t enough to convince less technology-savvy investors.

Furthermore, regulation remains an ongoing concern as various government and legal entities continue to work on frameworks surrounding the entirety of the crypto space. Traditional regulation can slow the progress of decentralized stablecoins and clash with cryptocurrency's core principles.

On the other hand, it might result in a broader long-term adoption by risk-averse investors who wait for stability and structure before joining the DeFi market.

Key Takeaways

As you can see, decentralized stablecoins represent another step toward financial inclusion and autonomy. They embrace the core aspect of the crypto sphere while bringing out the best of what TradFi has to offer.

Still, there’s a long road ahead, filled with regulatory concerns and technological challenges. At the moment, centralized stablecoins still lead the race since they are much more user-friendly and reliable, at least on the surface level.

Going forward, we can expect this type of token to evolve, providing a broader audience with more utility and stability. A complete detachment from the realm of traditional finance is still in the distant future, but decentralized stablecoins are leading the way forward!

Decentralized Stablecoins FAQ

• What is the safest decentralized stablecoin?

  The safest decentralized stablecoin is DAI. The MakerDAO organization and Maker Protocol govern more than 5 billion DAI tokens pegged to the US dollar. That makes this crypto 17th by market capitalization in the global cryptocurrency market.

• Is Bitcoin a stablecoin?

  Bitcoin is not a stablecoin. Bitcoin is the first cryptocurrency and the biggest one by market capitalization. While it is one of the most stable cryptocurrencies, its value still fluctuates, with price rises and drops that go up to triple digits in percentages.

• Is USDT a decentralized stablecoin?

  USDT is not a decentralized stablecoin, as it is issued by a company called Tether Limited. As a centralized entity, Tether Limited keeps the fiat reserves as collateral for USDT. They are solely responsible for minting new tokens and burning existing ones.

• How can I get a decentralized stablecoin?

  The simplest way to get a decentralized stablecoin is to purchase it on a centralized exchange (CEX). For instance, you can obtain DAI on exchanges like Binance and Kraken. Other methods include trading on decentralized exchanges and minting straight on the issuing DeFi platforms.