This system ensures 100% stability of stable coin but for a very high price – Centralization and high risk of a fraud. Basically, somebody has to control this system and ensures the correct amount of stable coin units in circulation.
Example project: Tether.to Whitepaper
If the price of Ether drops by 30% to 700 USD, our 500 units of stable coins are still collateralized by the worth of 700 USD in Ethereum. We can liquidate them now if we want that we giving 500 USD in Ethereum to the owner of the stable coins, and the remaining 200 USD in Ethereum, we just return back to the original depositor. So, the basic mechanism is, that your stable coins are over-collateralized and if the price drops enough, the stable coins get liquidated. This can be done completely in a decentralized way based on smart contracts.
It is necessary to mention, that this system can be completely decentralized and transparent, which is a very strong advantage against Fiat-collateralized stable coins. But on the other hand, it is very vulnerable to hacks or price crashes. The only way, how to prevent the potential crash is a strong algorithm, which ensures price stability of stable coin.
Example project: Maker DAO with stable coin Dai, Whitepaper of stable coin Dai
What if smart contract works like central bank system, where coin supply is driven only by strict rules based on the smart contract? Target price and the ideal of this stable coin is 1 USD but how it works, when the price will be for example 3 USD? Very simple – the smart contract will create more supply to decrease price and when the price is below 1 USD, the smart contract can bid these coins on the open market to buy (decrease coins supply and increase price) with extra profit. In history, when governments do this, these profits were called the seignorage.
Example project: Basecoin, Whitepaper (draft)