Stablecoins have seen explosive growth along with Defi.
Two main reasons are their demand for borrowing and their productivity in Defi.
Borrowing stablecoins is attractive since they are pegged assets, meaning their value - and therefore a loan- won’t change over time.
Borrowers are willing to pay attractive interest rates and give lenders great risk-free return on stables.
In the past year, we have seen many new and innovative projects with different applications for stablecoins, such as self-repaying loans with Alchemix and Degenbox on Abracadabra.
The simplest and the adopted method of the largest stablecoins by market cap USDT and USDC, coins minted are kept at a 1:1 ratio with reserves in USD. The downsides are its centralization, subject to regulatory risk, and lack of transparency.
Overcollaterlization - Maker DAI
In this method, each coin is backed by excess collateral reserves on Ethereum to maintain a soft peg. Dai achieves a level of decentralization as it is managed through MakerDAO, which consists of Maker governance token holders. While various forms of collateral are accepted, DAI is still subject to censorship risk as the majority (~51%) of DAI has been generated by USDC (at the time of writing).
Smart contract as central bank
The minting (expanding) and burning (contracting) of token supply are controlled by a smart contract. With code on-chain, it offers the highest level of transparency. Changes are made through governance.
There are a few different approaches:
Algorithmic approach - UST
Introduces systems truly trustless pegged assets without a central intermediary. The disadvantage is more difficulty in maintaining the peg (see ESD, DSD, Basis cash).
Hybrid approach - FRAX
Keeps a percentage supply of USDC. When peg below $1, buys own tokens with USDC. When peg above $1, sells tokens for USDC. More detail here. But reintroduces trust risk.
Something different? - RAI
Rai is an attempt at a truly decentralized store of value. To achieve that, it is backed 100% by eth and not pegged to the dollar (loses value from inflation). Similar to Maker, it offers a governance token FLX that is distributed to holders of RAI.
RAI is an abstraction on the ETH which is intended to be more stable than the ETH, while maintaining its trustlessness.
This article (written March 3, 2021) is a great primer to stablecoins, their uses, and their different types. EDIT, 07/17/22: Since the writing of this article, significant changes in the stablecoin market have occurred. The collapse of UST from a death spiral has been a large blow to the credibility of algorithmic stablecoins.
Thanks for reading! If you would like, follow me on Twitter~