Decentralized Stablecoins: How They Work & Why They Matter

Despite the newfound popularity of cryptocurrencies in the past decade, speculations about their stability remain. Stablecoins were introduced as a layer of stability in this market. They are being adopted in cross-border transactions, but simply using them is not sufficient. As digital finance grows more and more complex, it’s necessary for business owners to understand what is happening under the hood.

Stablecoins operate through centralized and decentralized models. Here, we will discuss decentralized stablecoins, how they work, and how they can be used for newer use cases, like those of decentralized finance or DeFi. We’ll also look at platforms like Xflow, which can give your international business operations an edge. Let’s get started.

Before we begin, let’s define stablecoins. These are cryptocurrencies that are pegged to certain assets, which helps them retain near-constant value. Stablecoins can be of two types: centralized and decentralized.

While centralized stablecoins are issued by some central entity, like the USDC or USDT, decentralized stablecoins do not have such central control. They are made stable through assets, algorithms, or smart contracts. A decentralized stablecoin list will include DAI and FRAX, which run on decentralized blockchain platforms.

Decentralization itself has evolved over time. The end goal is to enhance the transparency of cryptocurrencies.

There are three core mechanisms through which stablecoins work – collateralization, algorithms, and governance.

Collateralization

Decentralized stablecoins gain their stability through a mechanism called “collateralization”. Assets like cryptocurrencies are wrapped up in smart contracts, after which stablecoins are issued. The value of the assets in question tends to be higher than that of the issued stablecoins. This functions as a shock absorber in cases of price fluctuations. As a result, the promised stability of stablecoins is reemphasized.

Algorithms

Another method of value stabilization is through algorithms. Simply put, algorithms adjust the supply of stablecoins as the demand for them changes.

Governance

The transparency of decentralized stablecoins shows itself through governance. Decentralized stablecoins work through community-driven governance. Adjustments in ratios and algorithms are often made through voting by the token holders themselves.

There are 5 types of decentralized stablecoins that are commonly recognized. These include elastic supply chains, self-collateralized stablecoins, bond redemption coins, collateral-redemption coins, and collateralized-dent positions.

Elastic supply chains

Elastic supply chains offer decentralized stablecoins that use smart contracts and incentives to stay at a stable price point. For example, if the price of the stablecoin drops, the issuer will encourage users to lock their coins and earn high interest. While the coins are locked, there is a reduction in their supply, and prices go back up.

Self-collateralized stablecoins

Self-collateralized stablecoins use cryptocurrency as collateral, instead of regular fiat currency. When a user deposits crypto into a smart contract, they can get stablecoins. The submitted cryptocurrency is used to back the value of the stablecoin.

Bond redemption coins

To control the supply of these stablecoins, bond-like tokens are used. As an example, if the value of the stablecoin falls, users are asked to burn their tokens and receive bonds in exchange for them. In the future, when the value rises again, these bonds can be redeemed for more coins.

Collateral-redemption coins

Users can deposit different types of assets as collateral in order to get their stablecoins. In the future, they can return some stablecoins to withdraw some of the collateral. Returned stablecoins are burned to maintain the collateral ratio.

Collateralized-debt positions

For CDPs, users can deposit cryptocurrency as collateral and receive stablecoins. To get the collateral back, however, they have to pay interest over and above. This “over-collateralization” is what keeps the stablecoin ecosystem stable.

The two types of stablecoins are differentiated on the basis of the issuer and the transparency that they are able to offer to their users. Let’s quickly look at this table to understand the key differences:

The nature of control of decentralized stablecoins has led to them being considered more “democratic”, in contrast to centralized stablecoins.

To actually maintain the promised peg stability, decentralized stablecoins work through a few stability mechanisms.

1. As discussed earlier, overcollateralization is one way. The collateral value for the stablecoins is set a little higher, so that it absorbs losses when the collateral value falls.
2. Controlling the liquidation of collateral is another stability mechanism. If the value of stablecoins changes, the stablecoin system will automatically liquidate some of the collateral to pay off any debt.
3. Decentralized stablecoins like DAI charge stability fees. They can be thought of as interest payments on top of the debt. Over time, they are able to help maintain peg stability.
4. Using arbitrage, a single stablecoin can be backed by multiple different stablecoins. Pegs can thus become more stable.
5. Finally, price oracles are responsible for getting off-chain data onto the blockchain. These oracles estimate the price of stablecoin collaterals, which is a much-needed peg stability mechanism. Note that if there is data distortion, delay, or single-point dependence on a price oracle, the amount of stablecoin being issued could be inaccurate. We’ll explore this risk in more detail in the next section.

Decentralized stablecoins do not come without a set of risks. Yes, they’re designed to be more transparent and more stable, but some challenges stand in the way.

• The smart contracts that decentralized stablecoins depend on can have security vulnerabilities.
• When stablecoins depend on price oracles, multiple threat scenarios are possible. The oracles can be hacked or manipulated. The data provided by the oracle can lag behind significantly. Or, dependencies on a single oracle can be dangerous, especially if the oracle itself experiences some technical malfunction.
• Market crashes can affect the value of collateral, and in turn, affect the value of decentralized stablecoins.
• Stablecoin regulations are evolving slowly. Stablecoins need to ensure compliance with these up and coming frameworks.

Finally, decentralized stablecoins have a lot of built-in complexity. It’s important that stablecoin users are aware of and educated on these mechanisms in order to build trust. Research bodies like the Bank for International Settlements provide analyses and reports on stablecoins as well as other digital currencies. They are reliable sources of information.

Despite the associated risks, decentralized stablecoins are still a fairly popular digital currency. The main reasons for this popularity can be understood through the following points:

• Decentralized stablecoins are more transparent. They work on public blockchains, transactions are easily verifiable, and the users have a say in how they function.
• Because they use smart contracts, decentralized stablecoins offer security and consistency. 
• The control over stablecoins is not within the hands of a single company, either. This absence of an absolute authority is particularly appealing to stablecoin users. In other words, decentralized stablecoins are resistant to censorship.

Next, let’s quickly glance at how these benefits translate into real-world use cases.

Decentralized stablecoins can be used for DeFi lending, on-chain settlements, and trade finance. Here's how:

DeFi lending

Perhaps the most important use case for decentralized stablecoins is “DeFi”. It is an acronym for Decentralized Finance — financial services that work exclusively using public blockchains. Companies around the world use DeFi for lending and borrowing.

On-chain settlements

Companies use decentralized stablecoins for payroll management. These transactions are settled on-chain. They’re quick, cost-effective, and efficient.

Trade finance

Much like payroll, decentralized stablecoins are also being used for paying global suppliers and in trade finance.

Businesses that operate internationally have a steady need for cross-border payments. Stablecoins are likely to become a major player for these needs. With no reliance on central banks, instant settlements (especially around the clock), and low transaction fees, decentralized stablecoins are a great option to consider for borderless transfers.

New-age payment solutions like stablecoins and other cryptocurrencies have exploded, to say the least. Businesses that are future-forward are looking for a balance between them and traditional banking solutions.

Platforms like Xflow tackle major problems like settlement speeds and compliance. Xflow offers a hybrid infrastructure that brings in the benefits of both traditional and digital finance.

The question remains: are decentralized stablecoins actually a safer payment option? Let us answer the question from a nuanced point of view.

Decentralized stablecoins offer a unique transparency to their users. They’re resistant to censorship. For people who live in tightly regulated countries, decentralized stablecoins can offer financial freedom. Many mechanisms serve as a foundation for decentralized stablecoins that help them coast through financial volatility.

But even the best designs can malfunction. Lack of regulation, security risks, and market vulnerabilities can all affect how these cryptocurrencies actually function in the real world. It’s best to understand the workings of stablecoins, in and out, before deciding to use them.

The stablecoin market is growing quickly. Governments around the world have made major changes to this regulatory environment. The European Union’s MiCA (or the European Markets in Crypto-Assets Regulation) is one such example. Stablecoin issuers will soon be expected to undergo audits, obtain approvals, and provide even more transparency.

If your business is considering using stablecoins, there are a few considerations, depending on your country (or countries) of operation:

• You might need regulatory approval from the governments where you plan to transact.
• KYC and AML compliance is a must.
• Staying updated on new regulations is critical, too. Reading industry reports, published by research bodies or by platforms like CoinDesk, is a great way to keep pace with the industry.

With this article, we carved a clear picture of decentralized stablecoins and how your business might use them. If you want to expand globally, you might consider payment platforms like Xflow, which can transform how your business operates and transacts across borders.

Xflow offers:

• Transactions in 140+ countries, supporting more than 7000 businesses
• Settlements in a single business day
• Transparent, mid-market rate pricing, saving 50% FX costs
• eFIRA generation within 24 hours
• Security that is backed by the world’s largest banks
• ISO 27001 and SOC2 certifications
• Integrations with accounting systems

All these capabilities, and more, make Xflow the ideal payment partner. Want to find out how Xflow can help with your international payments? Visit the website today to learn more.