Stablecoins: Ensuring Stability in the Volatile World of Cryptocurrency
This article is tailored for budding IT entrepreneurs navigating the complex landscape of digital finance, particularly those intrigued by the mechanism of stablecoins.
Stablecoins represent a unique category within the cryptocurrency domain, characterized by their stable value against a basket of assets (e.g., fiat currencies, other cryptocurrencies, precious metals, etc.). This stability is paramount, providing a hedge against the inherent volatility of the cryptocurrency market and serving as a reliable medium for exchange.
To comprehend the essence of stablecoins, one can classify them into centralized and decentralized variants:
Centralized Stablecoins: An exemplar in this category is USDT (Tether), issued by a central authority often in exchange for fiat currency. This type, however, often faces criticism for its lack of transparency regarding the actual reserves backing the stablecoin.
Decentralized Stablecoins: DAI stands out as a prime example, where governance is almost entirely automated through pre-set smart contract rules, boasting transparency in reserve holdings to maintain asset pegging.
Additionally, the legitimacy and utility of a stablecoin as a payment method are upheld by a "support" mechanism, usually another valuable asset, to which it can be exchanged. This support system is known as collateralization.
Stablecoin Classifications
By Pegging Type:
Fixed Pegging: For instance, USDT, DAI, and USDC are pegged to the US dollar, meaning 1 USDC is equivalent to 1 USD, with a corresponding dollar held in reserve for each USDC token.
Floating Pegging: These have no direct market asset tie and rely on algorithms to maintain stability through supply and demand adjustments, such as RAI.
By Stability Mechanism:
Governed: Centralized control by an entity involves direct involvement in the minting and burning of stablecoins, e.g., USDT, USC, TUSD.
Algorithmic: Stability is maintained through transparent, mathematical algorithms without external intervention, exemplified by DAI, RAI, FRAX, UST, and LUNA.
By Collateral Amount:
Partially-collateralized: Such as UST, backed by LUNA tokens while also incorporating an algorithmic aspect for stability maintenance.
Fully-collateralized: E.g., USDT, USDC, BUSD, where each token is backed by an equivalent in US dollars.
Over-collateralized: Like DAI, where the collateral exceeds the token's face value, offering extra stability and reducing de-pegging risks.
By Collateral Type:
Exogenous Collateral: Formed off-chain, outside the protocol, like ETH for DAI, ensuring that issues with DAI do not impact ETH's broader usability.
Endogenous Collateral: Generated on-chain, within the protocol, like LUNA for UST. The collapse of LUNA following UST's issues showcased the inherent risks of this model.
Over-collateralized Stablecoins
In the evolving digital economy, over-collateralized stablecoins stand as a testament to innovation, providing a bulwark against the volatility so common in the cryptocurrency world. These stablecoins are backed by assets exceeding their value, a strategy known as over-collateralization, offering an additional layer of security and stability.
A pioneering example of such a stablecoin is DAI, created by the MakerDAO protocol, pegged 1:1 with the U.S. dollar. The issuance and stability of DAI are governed by the protocol's lending system, where users must over-collateralize with assets, typically at a 150% ratio, to borrow DAI. This means for every $100 of DAI desired, assets worth $150 must be locked in a smart contract.
At first glance, this requirement might seem counterintuitive or less capital efficient. Why lock up more value than you're borrowing? The answer lies in several key benefits:
Resistance to Volatility: The crypto market is known for its swift and dramatic price movements. Over-collateralization ensures that the stablecoin remains stable even amidst significant market fluctuations, acting as a safety net in "black swan" events.
Enhanced Trust: This model significantly boosts user confidence in the stablecoin. Users are assured that the stablecoins they hold are backed by a reserve substantially exceeding their circulating value.
Interest Rates and Financial Opportunities: Platforms like MakerDAO reward users for providing collateral, offering avenues for additional earnings. This setup also paves the way for engaging with various financial instruments such as mining, staking, and voting.
For instance, to acquire $100 worth of DAI, one needs to provide collateral, say in ETH, worth $150 or other assets approved by the protocol. This over-collateralization ensures that every DAI in circulation is backed by an excess of assets, with interest accruing over time on the borrowed DAI. Upon repaying the borrowed DAI and interest, the user can retrieve their collateral, with the returned DAI being burned.
Should the market value of the collateral fall, the MakerDAO protocol has an automatic liquidation mechanism to auction the borrower's collateral to cover the debt, transitioning from an English to a Dutch auction model in its updates.
It's important to note that lending protocols generally follow this principle, requiring borrowers to over-collateralize loans with specified assets. Examples of such protocols include Aave, Compound, and Liquity.
The DAI stablecoin offers the possibility of adjusting interest rates through the protocol's DAO, making it partially governed. However, its stability and pegging are algorithmically managed through smart contracts, combining governance with algorithmic regulation for a stable, trustworthy digital currency.
Algorithmic Stablecoins
In the rapidly evolving digital economy, algorithmic stablecoins emerge as innovative solutions, leveraging smart contracts to dynamically adjust supply in response to demand and supply fluctuations, thereby maintaining their peg and price stability.
These algorithmic stablecoins can be broadly categorized into three models:
Rebase Model
Seigniorage Model
Fractional Model
The Rebase Model
The rebase model aims to regulate the price of the stablecoin by automatically adjusting its circulating supply. If the stablecoin's market price deviates from its target peg, the protocol triggers a rebase operation, either increasing or decreasing the quantity of the stablecoin in each holder's account over a predetermined period.
This model capitalizes on the principles of inflation and deflation to influence the stablecoin's price, making it an elegant yet straightforward solution to maintaining price stability.
Ampleforth's AMPL is a prime example, implementing the rebase model to perfection. The supply adjustments are based on the token's daily volume-weighted average price (TWAP), allowing every holder to proportionately share in the supply changes.
For instance, if Alice owns 100 AMPL before a 10% supply increase, she'll have 110 AMPL post-rebase; similarly, if Bob had 10 AMPL, he'll find himself with 11 AMPL after the adjustment.
Ampleforth embeds the rebase functionality directly into the token contract, through a rebase() function, callable only by a pre-specified monetary policy address. This function adjusts the totalSupply based on the supplyDelta parameter, indirectly affecting each user's balance by updating a private variable, _gonsPerFragment, which recalculates user balances, effectively increasing or decreasing them as needed.
The rebase model is founded on two compelling principles: simplicity and equity. Its elegant, straightforward approach has made it a contender for the fairest implementation model for algorithmic stablecoins, allowing token holders to maintain their network share post-rebase. However, there's a perspective that true stability should encompass not just price but also the quantity of holdings. While the rebase model addresses the former, it leaves the latter unattended, making the purchasing power of a stablecoin holder subject to the whims of their wallet's fluctuating balance.
The Seigniorage Model
In the innovative realm of cryptocurrency, the seigniorage model presents a unique approach to managing stablecoin value through a rewards system that impacts market dynamics. Essentially, this model maintains its peg by modulating the quantity of stablecoins in circulation.
When the stablecoin's price exceeds its peg, new tokens are minted and distributed to protocol participants who contribute liquidity. Conversely, if the price drops below the peg, token minting ceases, and a supply contraction mechanism is activated. Participants can then purchase special coupons in exchange for burning the base token, effectively reducing supply. These coupons may later be redeemed for a greater number of tokens, but only when the price returns to or surpasses the target peg.
This "coupon" mechanic necessitates the introduction of an additional token, isolating the primary stablecoin from direct market fluctuations.
The Empty Set Dollar project, with its DSU stablecoin and ESS coupons, exemplifies this model. Interested individuals can explore the project's contracts for a deeper understanding.
For further exploration of tokens employing a similar model, additional resources are available.
The Fractional Model
The fractional model of algorithmic stablecoins is a hybrid that combines over-collateralization with algorithmic elements. To mint a stablecoin, part of its value must be backed by a tangible asset (such as another stablecoin), while the remainder is algorithmically secured. This method offers reduced centralization risks and showcases a higher degree of stability.
Frax.Finance was among the first to implement this model, currently supporting three stablecoins:
FRAX: A dollar-pegged stablecoin.
FPI (Frax Price Index): Pegged to a consumer goods basket.
frxETH (FraxEther): An ETH-pegged stablecoin, serving as a substitute for Wrapped Ether (WETH).
A cornerstone principle of FRAX is its guarantee that 1 FRAX can always be created or exchanged for 1 dollar. This distinctive feature sets it apart from other stablecoins, facilitating market-wide arbitrage opportunities.
The ecosystem is regulated using the Frax Share (FXS) token and the Algorithmic Market Operations Controller (AMO).
AMOs are autonomous contracts monitoring monetary policy until a peg shift occurs. Following such a shift, AMOs can engage in market operations to stabilize the peg. However, AMOs cannot conjure FRAX out of thin air.
The Collateral Ratio (CR) concept is pivotal for peg regulation, directly correlating with the stablecoin's market value. For instance, if FRAX's price is above $1, the CR decreases, and vice versa.
A 50% CR signifies that 1 FRAX ($1 equivalent) is backed by 50% FSX and 50% of another asset (e.g., USDC, as initially required by the protocol). Therefore, obtaining 1 FRAX necessitates 0.5 FSX and 0.5 USDC.
Upon minting, 0.5 FSX are burned, and 0.5 USDC are held as collateral. The reverse process is applied for burning FRAX and retrieving collateral.
Thus, AMO's role is confined to managing FXS token quantities. Since FXS partially backs the stablecoin, its supply helps maintain the peg.
Conclusion
Stablecoins, while not a comprehensive financial application on their own, play a pivotal role within the DeFi (Decentralized Finance) landscape. They serve multiple functions that are critical for the ecosystem's growth and stability:
Medium of Exchange: Stablecoins offer a stable alternative to highly volatile crypto assets, making them ideal for trading and financial transactions. This stability is crucial for users who engage in frequent trades or seek predictable value storage.
Liquidity Provision: In decentralized exchanges, stablecoins often act as a trading pair, providing the essential liquidity and stability needed for seamless asset exchange. This facilitates easier and more efficient trading operations across the platform.
Long-term Value Storage: Unlike traditional investment avenues, DeFi platforms present various opportunities for earning and investment. Stablecoins offer a secure option for storing value without the need to convert into fiat currencies, guarding against market volatility.
Foundation for Financial Instruments: By integrating into smart contracts, stablecoins lay the groundwork for more complex financial instruments, including derivatives, loans, insurance, and more, expanding the possibilities within the DeFi space.
Accounting and Auditing: The blockchain's transparency simplifies the accounting and auditing processes, as all transactions are recorded and verifiable. This transparency aims to reduce fraud risks and inaccuracies in financial reporting.
Despite these advantages, truly decentralized stablecoins have yet to make a significant impact. According to CoinGecko, Tether still dominates the cryptocurrency market, with USD Coin holding a substantial share.
However, the push for complete decentralization of stablecoins faces challenges:
Stability Concerns: Experience has shown that some stablecoins have deviated significantly from their peg, with some even losing it altogether, as evidenced by the Luna debacle.
Fraud Allegations: There have been several accusations of decentralized stablecoin teams misappropriating user funds, undermining trust in these projects.
Centralization Dilemma: Despite the aim for decentralization, many stablecoins rely on DAO systems, which can undergo changes against the community's wishes, raising questions about their true decentralized nature.
Yet, an ideal decentralized stablecoin system offers numerous advantages over centralized alternatives, governed by mathematics and resistant to third-party influences. It's believed that decentralized algorithmic stablecoins need more time to mature and succeed, highlighting the evolutionary path DeFi is on towards achieving a balance between stability, trust, and decentralization.
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