A stablecoin is a digital asset built on the blockchain that is designed to maintain a price peg at a designated price, most often $1. In order to maintain their use and legitimacy as a payment method, they must have some backing in fiat cash, cryptocurrency or on-chain tokens that it can be redeemed/swapped against. This backing is called collateral. 

A “collateralized stablecoin” is a stablecoin that is entirely or almost entirely backed by collateral held in a reserve. Notable examples of fully-collateralized stablecoins include USDT, USDC and DAI. The collateral is used to provide holders of the token with an opportunity to redeem the tokens for U.S. dollars or other assets that can then be used in the real world. 

Collateral that is committed to these stablecoins can vary between cash, commercial papers, bond purchases and more. The collateral itself can often be used for further investment purposes to improve capital efficiency. Stablecoins that fully commit their collateral to onchain assets like crypto rather than traditional financial bonds/paper are often referred to as “decentralized stablecoins.” 

One limitation of collateralized stablecoins is the fact that they require such large amounts of capital for legitimacy and trust, and their ability to remain stable depends on the underlying collateral. This means that many collateralized stablecoins require over-collateralization so fluctuations in value can be absorbed. This differs from algorithmic stablecoins (ie: FRAX, ESD, etc.) which use smart contracts to respond to supply and demand by buying, selling and/or burning tokens to maintain a peg.

Author: Sam Kazemian, CEO of Frax 

Sam Kazemian is the founder of FRAX, a fractional algorithmic stablecoin that is partially backed by collateral and stabilized algorithmically, and the only fractional stablecoin that has maintained its peg since its conception. FRAX is open-source and permissionless, bringing a truly trustless, scalable and stable asset to the future of decentralized finance. 

Kazemian brings a wealth of experience as a leading blockchain entrepreneur and crypto enthusiast, as the co-founder of the blockchain based knowledge base, Everipedia. Kazemian’s crypto journey started at UCLA in 2013 where he began mining crypto in his college dorm room and today is a frequent guest lecturer at UCLA covering crypto, computer science and entrepreneurship.