Quick Guide to Stablecoins in DeFi

Stablecoins play an extremely important role in the DeFi ecosystem. Cryptocurrencies such as Bitcoin, Ethereum or Litecoin provide a variety of benefits from not requiring intermediaries to complete online payments, to the autonomy that cryptocurrency provides its holders. But cryptocurrencies suffer from extreme price fluctuations and volatility that make it hard for everyday people to consider using them in day-to-day life. You never know when the market will rise or fall.

People generally want to know that the day-to-day money they use will be worth a very similar amount in a few days. This is especially true in the world of finance and investing where trying to predict future performance is key to investor confidence.

Stablecoins emerged in 2015 as an alternate solution to this issue in the cryptocurrency world. As the name suggests, stablecoins have price stability unlike cryptocurrencies. Stablecoins are cryptocurriencies whose price is pegged to the value of another, generally more stable, underlying asset; stablecoins frequently are pegged to the US Dollar, gold or other cryptocurrencies. Stablecoins were invented to bring us all of the value of cryptocurrency with the stability of fiat currencies, making it less stressful to complete transactions.Asset-backed cryptocurrencies are that coins are stabilized by underlying assets that are not correlated to the wider crypto market, reducing financial risk. Bitcoin and altcoins are highly correlated, so holders of any coin will experience price falls if they do not exit the market or use stablecoins when prices begin to dip. Most importantly, with asset-backed stablecoins, you are able to exchange the cryptocurrency for the backing asset (in theory).

Because of the above considerations, the demand for stablecoins have reached incredibly high peaks. As of April 1, 2021 the market cap of all stablecoins was $64 Billion USD. Stablecoins are used as the base currency on DeFi platforms and can be the global payment system for cost-effective payments without delay, free from intermediaries.

Even with all of these positives, stablecoins still do have defects that signal risk, and there are innovations that can be made with them.

Fiat- Backed Stablecoins

The most used stablecoins are fiat-backed stablecoins. These were the first introduced to the market. The value of the asset is directly tied to the value of a specific fiat currency such as the Japanese Yen or the US Dollar.

Centralized stablecoins were first introduced in 2015 with Tether (USDT), previously known as RealCoin. Centralized stablecoins are issued by an organization that collateralizes every stablecoin issued. In the case of USDT and similar coins, they claim to hold an equivalent amount of cash in their reserves as the coins that they issued. For every 1 USDT, they hold $1 USD in their reserve. This is a simple and straightforward way of issuing a currency, similar to the Gold Standard.

Centralized stablecoins have the big problem of being centralized — antithetical to the DeFi ethos. Because these coins are issued by a central organization, it is hard to confirm reserve claims. Tether, has repeatedly faced accusations that their reserve claims are exaggerated or untrue and the overall crypto community remains skeptical. They’ve also endured investigations by the New York Attorney General’s office over their practices resulting in a fine being imposed on relevant stakeholders.

Commodity-Backed Stablecoins

Commodity- backed stablecoins are very similar to fiat-backed stablecoins. The coin value is pegged to the value of a real asset, such as gold in the case of Digix Gold Tokens (DGX). Holders of commodity-backed stablecoins can redeem their stablecoins at the conversion rate to take possession of real assets, therefore the circulating supply must reflect the amount of the commodity on hand. The cost of maintaining the stability of the stablecoin is the cost of storing and protecting the commodity backing.

Crypto-Backed Stablecoins

Cryptocurrency-backed stablecoins are issued with cryptocurrencies as collateral, somewhat similar to fiat-backed stablecoins. But while fiat collateralization and reserve storing would happen off of the blockchain in regular accounts, crypto assets used to back crypto stablecoins is done on the blockchain using smart contracts.

MakerDAO’s DAI is the best example for us to explore how this works. Maker is a DeFi lending protocol and it issues the stablecoin DAI, which is pegged to the value of the USD.

DAI is issued when users take out a cryptocurrency loan by depositing and “locking” collateral (usually ETH) to a smart contract, making it smarter to pay their debt if the stablecoin decreased in value. These vaults take more in collateral than the worth of the asset being loaned; this is called overcollateralization and guards against situations where the value of collateral drops quickly. The smart contract is also able to liquidate positions should the value of the collateral becomes too close to the value of the loan.

Maker regulates the supply of DAI by controlling interest loan rates which changes the behaviour of borrowers and lenders, so that its price is always equivalent to the USD. Unlike fiat-backed stablecoins, cryptocurrency collateral is verifiable and can be viewed publicly on the Ethereum blockchain, maintaining trust.

However, crypto-backed stablecoins do have specific drawbacks. The complexity of the smart contract and interest-rate balancing process, along with non-direct backing makes it difficult for the average user to understand how price is ensured.

Additionally, due to crypto volatility, over-collateralization is needed to maintain the integrity of the system. Over-collateralization limits capital efficiency, which makes it harder to scale as more and more people want to use DAI.

For example, an ETH vault which has a collateralization rate of 120%, would require the equivalent of $1.20 to mint 1 DAI. In high demand times, this can lead to DAI’s price increasing above the peg because they could not generate enough collateral.

Balancing DeFi’s goal of decentralization with creating a currency that can reliably maintain its peg is difficult. Centralized fiat stablecoins are useful, but using them requires trust in central organizations which provides us with many of the same issues that we have in traditional finance. Crypto-backed stablecoins are capital-inefficient due to over-collateralization and fail to meet demand. Maker and other organizations that issue crypto-backed stablecoins are implementing many methods to overcome these challenges, but new types of stablecoins called algorithmic stablecoins may be in line to be a better fit.

Algorithmic Stablecoins

Algorithmic stablecoins use algorithms to control a coin’s money supply, similar to how central banks print and destroy currency. Adjustments to the coin are made on-chain, no collateral is needed to issue new coins, and price value is controlled through algorithms that balance supply and demand. Instead of a Federal Reserve with humans making decisions, they have lines of code executing specific actions.

Most algorithmic stablecoins’ prices are pegged to fiat currency, such as the US dollar. Some also have moving pegs, which classify them as algo-stableassets. Certain algo-stablecoins, like UST are collateralized by their own token and not a third-party token (DAI uses ETH or USDC for collateral) which requires them to use algorithms to stabilize price. Algorithmic stableassets are DeFi’s way to create digital collateral.

There are a wide range of algorithmic stablecoins in the market, but to this point only a few have been able to retain their stability due to a variety of factors. With more user uptake and improvement in the algorithms, we are bound to see them become more stable and heavily used.

Rebase

Some of these stablecoins use the rebase model. The rebase model controls the price by adjusting the entire supply of a coin. The protocol automatically increases or decreases the amount in every holder’s wallet to move the price towards the peg. By controlling the supply in this manner, price can be adjusted using inflationary or deflationary economic modeling.

Seigniorage

Most algorithmic stablecoins use the seigniorage model. The seigniorage model uses a reward system that influences price by influencing market participants. If the price is above the peg, new tokens are minted and given to staked users. If the price is below the peg, users can purchase tickets that are used to burn some supply; these tickets can be redeemed in the future for coins when more supply is needed.

Algorithmic stablecoins using these models, and others, are still in their infancy. Over the next few years with a longer time horizon, more demand, and more transactions, we will see if they are able to address the holes in the current stablecoin market.