In part 1 of our series on stablecoins, we covered fiat-backed stablecoins and the role they play in the cryptocurrency industry. We talked about projects like Tether (USDT), TrueUSD (TUSD), USD Coin (USDC), the Gemini Dollar (GUSD), and the Paxos Standard (PAX), all of which are pegged to the value of the US dollar through straightforward stability mechanisms based on achieving a balance between the circulating token supply and cash USD reserves.

In Part 2 of our guide to stablecoins, we will cover all other stablecoin models, including crypto-backed stablecoins and algorithmic stablecoins. These projects generally rely on more complex stability mechanisms compared to traditional fiat-backed coins. They also come with a handful of advantages, particularly for users concerned with transparency and decentralization.

We’ll start by exploring crypto-backed stablecoins like Maker/Dai, before moving on to algorithmic platforms like Basis. By the end of this article, you’ll have a solid understanding of how these alternative stablecoin models work and the unique selling points these projects have over their fiat-backed competitors.

What are Crypto-Backed Stablecoins?

Crypto-backed stablecoins are cryptocurrencies that maintain price stability through mechanisms based on collateralized cryptocurrency, which is cryptocurrency that is ‘locked up’ in a sort of escrow account. Much as with fiat-backed stablecoins, the primary stability mechanism used by crypto-backed stablecoins is manipulation of the token supply to maintain a balance between the value of the stablecoins in circulation and the value of collateralized assets held in reserve.

The key difference between the two models is that fiat-backed coins use fiat as collateral, while crypto-backed platforms use cryptocurrency. This subtle distinction creates two systems that bear many surface similarities, but are actually quite different in their underlying mechanisms.

How are Crypto-Backed Stablecoins Different From Fiat-Backed Ones?

As described in our first stablecoin article, fiat-backed stablecoins like Tether and TrueUSD allow users to make direct trades between fiat currency and tokens that are equally valuable to that fiat currency: one USD gets you one USDT and vice versa. This simple exchange is made possible because USDT’s value is entirely dependent upon the value of the dollar. If the value of the dollar changes (in terms of its purchasing power), then the value of USDT changes along with it. The price of a fiat-backed stablecoin is therefore guaranteed to be in line with its fiat target so long as the company behind the stablecoin is appropriately managing their coin supply and cash reserves.

Most crypto-backed stablecoins are also pegged to the value of the US Dollar. However, the collateral used to obtain the stablecoin, namely cryptocurrencies like ether, does not have equal value to USD. One ether is currently worth $133.00; tomorrow it might be worth $100.00; the day after that it might be worth $200.00. This price instability means that you cannot simply deposit one ether today and be given $133.00 worth of stablecoin: because the value of one ether changes over time.

This presents a problem that every crypto-backed stablecoin must answer: How can you use unstable collateral to back a stable currency?

To answer that question, we’ll take a detailed look at the largest crypto-backed stablecoin platform on the market today, Maker.

Maker (MKR) and Dai (DAI)

Maker (MKR) is an Ethereum-based platform described on the official website as “an open platform that allows equal access to high quality financial services, including fair credit for everyone.” Currently ranked 21st in the world by market cap, Maker is the frontrunner in the crypto-backed stablecoin market, and a good example of how crypto-backed coins generally operate.

At the heart of Maker is a stablecoin called Dai (DAI), which is pegged to the value of the US Dollar. Dai’s stability is maintained by a combination of four stability mechanisms: over-collateralization, liquidation, the Target Rate Feedback Mechanism (TRFM), and an emergency Global Settlement protocol.

A word of warning before getting to the ins and outs of Maker: The Maker team is quick to point out that it is not necessary to understand Dai’s underlying mechanisms in order to use the coin. Dai can be traded for on a number of exchanges, none of which will require you to interact directly with the Maker platform. The following explanation of the Maker/Dai system is intended for readers who would like know how the platform works to maintain stability.

Over-collateralization and Liquidation

Dai is created through smart contracts on the Maker platform called Collateralized Debt Positions, or CDPs. A cryptocurrency investor looking to create Dai starts by depositing ether into a CDP, where the ether will remain until the Dai loan is repaid. This system is broadly similar to the process of creating new USDT, which involves locking up fiat USD in exchange for newly created tokens.

Unlike USDT, however, Dai and most other crypto-backed stablecoins require users to over-collateralize. That is, they require investors to deposit an amount of cryptocurrency that is worth more than the amount of stablecoin they will be given in return.

For example, if you wanted to obtain $100.00 worth of a crypto-backed stablecoin, you might have to deposit $150.00 worth of ether (a 150% Collateralization Rate). The ether held within the account is still yours, and it can be claimed at any time simply by re-depositing your stablecoins. But by over-collateralizing, crypto-backed stablecoins like Dai are able to maintain a stable price for the coins they give you, even if there are moderate drops in the value of your collateral.

Over-collateralization therefore ensures that every CDP has a large buffer against everyday volatility in the price of ether. But what happens if a CDP investor never returns their loan? Or, what happens if, due to severe changes in the value of ether, the collateral in a CDP is no longer valuable enough to cover the value of the loaned Dai?

The Maker platform combats this vulnerability by liquidating at-risk CDPs before they become under-collateralized. Network participants called “keepers” are constantly scanning the Maker platform, looking for CDPs below a certain collateralization threshold (e.g. 125% collateralization). Collateral held within these risky CDPs is then auctioned off to other network participants until enough Dai has been collected to close the CDP.

Together, liquidation and over-collateralization ensure that each Dai in circulation is sufficiently backed, which allows Dai to maintain a stable price in periods of moderate volatility.

The Target Rate Feedback Mechanism (TRFM)

In periods of extreme volatility, the Maker platform can engage an additional stability mechanism called the Target Rate Feedback Mechanism (TRFM). In short, the TRFM either raises or lowers interest rates on CDPs to incentivize investors to hold or borrow Dai.

According to the Maker white paper:

The Target Rate…can act either as an incentive to hold Dai (if the Target Rate is positive) or an incentive to borrow Dai (If the Target Rate is negative). When the TRFM is not engaged the target rate is fixed at 0%, so the target price doesn’t change over time and Dai is pegged. When the TRFM is engaged, both the Target Rate and the Target Price change dynamically to balance the supply and demand of Dai by automatically adjusting user incentives for generating and holding Dai.

In this way, Maker uses a combination of smart contracts and market forces to encourage investors to either contract or expand the supply of Dai in circulation to push Dai towards its Target Price.

Global Settlement

Finally, the last and most extreme component of the Maker/Dai stablecoin system is called Global Settlement, which is a last resort protocol in case of a complete market collapse. The Global Settlement protocol initiates a worldwide collateral exchange, in which all circulating Dai is traded for collateral at its current value, and the collateral is returned to CDP holders.

As MakerDAO describes it, Global Settlement “shuts down and gracefully unwinds the Maker Platform while ensuring that all users, both Dai holders and CDP users, receive the net value of assets they are entitled to. The process is fully decentralized, and MKR voters govern access to it to ensure that it is only used in case of serious emergencies.”

Advantages and Disadvantages of Crypto-Backed Stablecoins

The primary selling point of crypto-backed stablecoins like Maker/Dai is that the platforms are “fully decentralized.” This is in contrast to coins like Tether or the Gemini Dollar, which rely heavily on centralized third-parties in order to maintain price stability, crypto-backed stablecoins like Maker/Dai eliminate the middlemen and create systems that are much more auditable, transparent, and decentralized — all of which are valuable characteristics, especially in the cryptocurrency industry.

Maker’s other big advantage is that it can be used by investors as a source of decentralized leverage. CDPs give investors access to extra capital in the form of Dai, without having to sell their ether to get it.

However, the advantages of crypto-backed stablecoins come at the expense of some noteworthy disadvantages, the most obvious of which is their complexity. Generally speaking, the more complex a system is, the more potential points of failure it has. Tether, for example, is quite simple and has just one, glaring point of failure: Tether Limited. If Tether Limited fails to manage their cash reserves to be in balance with the USDT in circulation, the whole system collapses. But if they succeed, then there are comparatively few other ways for the platform to catastrophically fail.

The Maker/Dai system, by contrast, relies on the complex interplay of smart contracts (which can be coded imperfectly), market actors (who may behave irresponsibly), and stability mechanisms (which can have unpredictable consequences). With so many moving parts, it is little wonder why Maker has to have an emergency Global Settlement protocol in place: there is simply no way to guarantee that the platform will survive an unforeseen catastrophic event without one.

Having thoroughly covered crypto-backed stablecoins, we can now move on to algorithmic stablecoins. Thankfully, these projects rely on similar principles as crypto- and fiat-backed coins, and are a little more intuitive.

What are Algorithmic Stablecoins?

An algorithmic stablecoin is a cryptocurrency that achieves price stability by algorithmically expanding and contracting the coin’s circulating supply in response to market behavior. If the price of the stablecoin begins falling beneath its peg, the system will reduce the supply of coins in circulation, thereby increasing demand (and value) for the remaining coins. On the other hand, if the price of the stablecoin climbs above its peg, the algorithm will release more coins into circulation, effectively devaluing each individual coin.

The logic behind these systems is based largely on the quantity theory of money, which states that “the general price level of goods and services is directly proportional to the amount of money in circulation.” This means, for example, that if you were to double the amount of money in circulation, then the cost of goods would double over time as well. Likewise, if you reduced the amount of money in circulation, the cost of goods would decrease proportionally.

The quantity theory of money is also fundamental to the practices of modern central banks, which manipulate a country’s money supply in response to changes in the price of goods (inflation or deflation). Algorithmic stablecoins actually make use of many of the same techniques used by central banks, and are sometimes described as having an “algorithmic central bank” for this reason.

Now that we understand the basics of algorithmic stablecoins, we will take a detailed look at one highly anticipated stablecoin platform, Basis.

Basis

Basis is a soon-to-be-released algorithmic stablecoin that achieves price stability using a three-token system. The platform’s primary token, called Basis, is pegged to the US dollar and is intended to be used as a medium of exchange. As described above, the supply of Basis is expanded and contracted in order to maintain its peg with USD. The Basis platform’s remaining two tokens — bond tokens (called bonds for short) and share tokens (called shares) — are used to incentivize network participants to give up their Basis tokens during a supply contraction.

According to the Basis white paper, bonds “are auctioned off by the blockchain when it needs to contract Basis supply. Bonds are not pegged to anything, and each bond promises the holder exactly 1 Basis at some point in the future under certain conditions. Since newly-created bonds are sold on open auction for prices of less than 1 Basis, you can expect to earn a competitive premium or ‘yield’ for your bond purchase.”

Shares are similar to bonds in that they can be redeemed in exchange for newly-created Basis. The key differences are that shares are worth significantly less Basis than bonds are, and can only be redeemed if all outstanding bonds have been redeemed first.

How do these tokens fit together to ensure Basis maintains a stable price?

The process is as follows: The Basis platform’s central bank tracks the price of Basis tokens to determine whether the token’s price is too high (and therefore in need of a supply expansion) or too low (and in need of a contraction). Expansions are carried out by redeeming bonds in the order in which the bonds were issued, with the oldest bonds being redeemed first. If all bonds have been redeemed before the necessary amount of Basis has been created, then the remaining amount will be distributed among the shareholders.

Contractions, on the other hand, prompt the system to create and sell more bond tokens in exchange for Basis. Purchasing bond tokens with Basis destroys the Basis, which reduces the overall token supply and boosts demand.

Advantages and Disadvantages of Algorithmic Stablecoins

Basis and other algorithmic stablecoins share many of the same advantages as crypto-backed models, namely that they are fully decentralized and provide opportunities for savvy investors to turn a profit while supporting the platform’s overall stability. Algorithmic stablecoins also come with the unique advantage that they do not derive their value from any secondary asset that resides outside of the system, which means they do not have to worry about crashes in the price of ether sending them into a talespin.

Algorithmic stablecoins also come with their fair share of flaws, the most obvious being that the system depends on the ability of an algorithm to correctly respond to changing market forces. A particular concern for algorithmic coins is ensuring that the algorithm cannot be manipulated.

Conclusion

This concludes our two-part series on stablecoins. If you have read both parts from start to finish, you should have a solid understanding of the three basic stablecoin models, along with their advantages and disadvantages. It is not clear at this point whether any of the models is objectively superior to the others. What is clear, however, is that stablecoins are likely to play an increasingly significant role in the overall cryptocurrency industry. In fact, by combining the benefits of blockchain technology with the stability of traditional fiat currencies, stablecoin projects could one day serve as the foundation for a mainstream cryptocurrency economy. Only time will tell.