Concept

A crypto-backed stablecoin is defined as a stablecoin backed (collateralized) by reserves of other cryptocurrencies (or cryptoassets). In essence, a stablecoin is a cryptocurrency (or a digital token) that derives its value from real-world assets (RWAs), such as commodities, precious metals, real estate, or other tangible assets, intangible assets or financial assets. It is a digital asset whose value is pegged to a reference asset, which is either fiat currency, exchange-traded commodities (such as precious metals or industrial metals), or another cryptocurrency. Stablecoins (also, asset-backed cryptocurrencies) are created by establishing a sort of link between the value of the digital token to the underlying asset using blockchain technology. The value of this asset-backed token (ABT) or backed crypto asset is referenced to the performance and market value of the asset it represents.

Underlying principle

Crypto-backed stablecoins operate on the principle of overcollateralization — meaning that the value of assets held in reserves (that of the cryptoassets) exceeds the value of the pegged stablecoin. In this context, overcollateralization aims to mitigate the inherent volatility of the reserve assets (underlying assets). Users lock up their cryptoassets, on the blockchain, via a smart contract and receive an equivalent value in stablecoins that is usually lower than the value  of backing cryptoassets. This means that if cryptoassets go down in value, the value of the collateral will be less, and drives certain positions to default on payment. The additional amount of collateral  can account for this adverse scenario, and if the value of the collateral drops even further, the protocol automatically liquidates a portion of the collateral to cover the stablecoin issued.

The prices of crypto-backed stablecoins are pegged to a broad set of assets, not necessarily fiat currencies, and hence users can reasonably mitigate the effect of inflation or regulatory measures on performance of such coins. For example, since Bitcoin is a decentralized currency, its value does not correlate to that of fiat currencies like the dollar or euro. In times of high uncertainty, crypto-backed stablecoins may provide a better venue for market participants.

Main types

In addition to crypto-backed stablecoins, the main types of such crypto coins include algorithmic stablecoins and fiat-backed stablecoins (for more, see: types of stablecoins).