What is a Collateralized Stablecoin?

The meaning of collateralized stablecoin refers to a type of digital token that is pegged to the value of a stable asset, such as the US dollar, and is backed by a pool of other assets, such as other cryptocurrencies, that serve as collateral.

The function of a collateralized stablecoin is to provide a stable store of value in the crypto market, where the value of many cryptocurrencies can be highly volatile. By collateralizing the stablecoin with other assets, the creators of the stablecoin can ensure that its value remains stable and can be used for transactions and as a store of value, without the volatility of other cryptocurrencies.

Simplified Example

A collateralized stablecoin is a type of cryptocurrency that is designed to maintain a stable value by being backed by a collateral asset, usually a fiat currency, a commodity or another cryptocurrency.

An analogy to understand this could be to think of a piggy bank. Imagine you have a piggy bank where you keep your allowance money, and you want to create a new type of piggy bank that always has the same amount of money, say $100, inside. To do this, you could put a $100 bill inside the piggy bank as collateral, and then issue a new type of coin that represents the value of that $100 bill.

Now, when someone wants to buy one of your stablecoin piggy bank coins, they can give you the equivalent value in other coins, such as Bitcoin or Ethereum, and you will give them one of your stablecoin piggy bank coins. This means that the price of the stablecoin will always be equal to the value of the collateral asset, and the person holding the stablecoin will be able to exchange it for the same value at any time.

Just like with a real piggy bank, if the value of the collateral asset changes, the value of the stablecoin will also change. For example, if the $100 bill in the piggy bank decreases in value, the value of the stablecoin will also decrease. Conversely, if the $100 bill increases in value, the value of the stablecoin will increase as well.

The History of Collateralized Stablecoin

The concept of collateralized stablecoin emerged notably in the cryptocurrency sphere around the early to mid-2010s. It represents a specific category of stablecoins designed to maintain a steady value by being backed with collateral assets. This approach contrasts with algorithmic or centralized models of stability. Tether (USDT), launched in 2014, was among the first collateralized stablecoins, pegged to the US dollar and backed by reserves. MakerDAO's DAI, introduced in 2017, further popularized this model by utilizing a collateralized debt position (CDP) system, allowing users to lock up collateral in smart contracts to generate DAI stablecoins. These stablecoins use various cryptocurrencies or other assets held in reserve to provide stability, ensuring their value remains pegged to a specific fiat currency or basket of assets.

The historical evolution of collateralized stablecoins reflects efforts to create stability in the highly volatile cryptocurrency market. By using collateral reserves, these stablecoins seek to offer stability while maintaining transparency and decentralization, introducing a model that addresses price volatility concerns prevalent in the broader cryptocurrency space.

Examples

DAI: DAI is a decentralized stablecoin that is pegged to the value of the US dollar and is backed by a pool of crypto assets, such as Ethereum, that are held as collateral in smart contracts on the Ethereum blockchain.

USDC: USDC is a stablecoin issued by Circle and Coinbase, which is pegged to the value of the US dollar. Each USDC is backed by one US dollar held in reserve, which is held by regulated financial institutions.

sUSD: sUSD is a decentralized stablecoin that is pegged to the value of the US dollar and is backed by a pool of crypto assets, such as Ethereum, that are held as collateral in smart contracts on the Ethereum blockchain.

Related terms

Algorithmic Stablecoin: Algorithmic stablecoin refers to a type of cryptocurrency that is designed to maintain a stable value relative to a specific asset or basket of assets.

Decentralized Stablecoin: A decentralized stablecoin is a type of cryptocurrency that is designed to maintain a stable value, despite the volatility of the crypto market.