Exploring Stablecoins

The total market cap of all stablecoins is close to $200B. This represents around 10% of the entire crypto industry. They have quickly become a critically important piece of most DeFi products. There are several ways to create a dollar-pegged token, and each strategy comes with some tradeoffs.

TL;DR:

• Fiat pegged tokens are a necessary piece of DeFi.
• There are pros and cons to the different strategies used by stablecoin protocols to maintain their pegs.
• Access to trustless, decentralized stablecoins is a good thing.
• We’re witnessing the simultaneous experimentation and iteration of many strategies for keeping tokens stable.

The leading strategies

Stability mechanisms must be implemented for a token to stay pegged to its assigned fiat equivalent. Here are the most common:

Fully backed and over collateralized — Every stablecoin issued is backed by reserve assets in a vault that represents more than 100% of the total Stablecoins issued.

Algorithmic — The value and supply of algorithmic stablecoins are controlled by code. If the demand for the coin starts to increase rapidly, the protocol automatically creates more coins to bring the price down. If the value drops too low, some of the supply is burned to bring the price back up.

One major downside of over-collateralized stablecoins is a loss in capital efficiency. If there isn’t a strong enough incentive to justify tying up extra capital, rational actors won’t participate.

Another concern exists for stablecoins issued by centralized parties like USDT and USDC. The reserves backing the circulating supply are verified by independent auditing firms that could be bribed or otherwise coerced into altering the numbers.

The downside of algorithmically controlled stablecoins is the risk of losing peg. This can happen from a bank-run situation: If everyone wants to redeem their supply of stablecoins on the same day, the demand can overwhelm the protocol’s stability mechanisms.

Hybrid — Some projects like Frax Finance use a hybrid approach to find a balance between these issues. The peg to USD is algorithmically maintained, but they also have reserves available to handle periods of extreme volatility and market demand. This strategy seems the most likely to survive long term.

We’ve compiled a list of the most popular and most interesting stablecoin issuers we could find to better understand and compare the pros and cons of each model.

$DAI (MakerDAO)

MakerDAO is an Ethereum-based protocol that issues $DAI, an algorithmic stablecoin that is soft-pegged to the U.S. dollar. You can mint $DAI on the Maker Protocol by depositing Ethereum-based tokens as collateral.

Collateral is not a new concept in finance. When you seek a loan, most lenders will ask you for collateral that can be used to recover the loan if you default. $DAI is a crypto-collateralized stablecoin, which means that it accepts crypto as collateral rather than other stablecoins like $BUSD that use fiat as collateral.

A smart contract is designed to govern the acceptance of crypto as collateral and the issuance of $DAI. An example is when the smart contract dictates “issue X amount of $DAI for Y amount of $ETH deposited.” The same smart contract will provide that “Return Z amount of $ETH when Z amount of $DAI is given back.” The exact amount of collateral needed will depend on the project issuing the token. The collateral’s asset’s risk and volatility will determine the issuance ratio.

All new $DAI created by MakerDAO is backed by a mix of other stablecoins and volatile crypto assets. All loans must be over-collateralized enough to handle rapid and extreme fluctuations in price. If a project demands $400 in ETH for a 400 $DAI loan, and then the price of $ETH assets drops by a considerable amount, the lender is likely to suffer a loss. To avoid this, $DAI is always overcollateralized and will require something like $600 in $ETH for a 400 $DAI loan.

The project also employs collateralized debt positions (CDP) to ensure sustainable loans. Smart contracts control $DAI generation. The system doesn’t require human intermediaries. You must lock up crypto in a CDP smart contract if you want to borrow $DAI stablecoin. The CDP will set a liquidation ratio, for example, 1.7X, which means that to borrow $100 of $DAI, you need to deposit $170 in $ETH as collateral.

Users can add more collateral to reduce risks associated with crypto volatility. If the collateral amount falls below 170%, the user will need to contribute more collateral — users who fail to add additional collateral to their position risk liquidation.

$ICHI (ICHI Finance)

Although ICHI Finance crashed and burned recently, it’s worth highlighting the novelty of its mechanics.

ICHI allows any community to create a branded dollar. This branded dollar is minted with the native token of each platform, and it is redeemable 1-for-1 for USD Coin ($USDC).

A typical cryptocurrency has four challenges: get new users, build an ecosystem of businesses supporting their protocol, grow the protocol’s total value locked, and accrue value to their token. ICHI attempts to solve these problems through:

• Onboarding new users. Understanding a protocol’s native token and its utility might be complicated for newbies. A branded dollar is simple to understand and requires the users to buy the native token and then mint it.
• Helps grow the value of the protocol. The protocol that mints these Branded Dollars is also the owner. Such a project then locks these tokens in its native assets treasury to acquire Protocol Owned Liquidity (POL).
• Builds an ecosystem. Decentralized finance projects are organizations with both operational and business needs. With Branded Dollars, projects can pay for bounties, workers, and grants. The beauty of these tokens is that they remain stable, and the receiving party has no pressure to hold volatile cryptos.
• Value accrual. Mechanisms that route some of the fees generated from interacting with the protocol into a treasury are put in place. The uses and distribution of the funds in the treasury are determined by governance.

A DAO known as a Decentralized Monetary Authority (DMA) was customized to each community deployed by ICHI to give them a dollar branded token pegged to USD.

$FRAX

Frax is a fractional-algorithmic stablecoin protocol, where $FRAX is its stablecoin, and $FXS, a utility, share, and governance token, manages the protocol and distributes the revenue generated. FRAX is open-source, trustless, and entirely on-chain.

By being fractional-algorithmic, FRAX is the first stablecoin to have parts of its supply algorithmic and parts of its supply backed by collateral. It is the first stablecoin to have some of its supply unbacked/floating. The name FRAX is coined from fractional-algorithmic.

The ratio of collateralized to algorithmic $FRAX depends on the market pricing of the FRAX stablecoin. The protocol will increase the collateral ratio if $FRAX is trading below $1. On the other hand, the protocol decreases the collateral ratio when FRAX is trading above $1.

How arbitrage keeps FRAX price-stable

FRAX stablecoin can always be minted and redeemed from the protocol for a $1 value, allowing arbitrageurs to balance supply and demand for FRAX tokens in the open market. Suppose FRAX’s market price is above $1. In that case, there is an arbitrage opportunity where arbitrageurs can mint FRAX tokens by placing $1 worth of value to the protocol, mint $FRAX, and then sell the minted $FRAX for over $1 in the open market.

If the FRAX tokens are trading below $1, then an arbitrage opportunity to buy $FRAX cheaply and redeem them for $1 in the system exists. A user can at any time redeem $FRAX for $1, and the difference goes back to the redeemer as Frax Shares ($FXS).

The Frax Share token ($FXS) is a non-stable utility token of the Frax ecosystem. $FXS is meant to be volatile and holds governance rights and all protocol utility. The creators have adopted a governance-minimized approach similar to Bitcoin's to create a trustless money system. However, unlike MakerDAO with active management, FRAX creators believe that a governance-minimized approach lowers the instances of community members’ disagreements.

$UST (Terra/Luna)

Terra’s stablecoin, $UST, is a decentralized stablecoin that maintains its peg through algorithms, unlike centralized stablecoins with vast cash and debt reserves. UST is pegged to the U.S. dollar, and this is made possible through arbitrageurs, who buy and sell $LUNA, the Terra blockchain’s volatile cryptocurrency.

Terra mints and burns tokens to maintain the equilibrium of its stablecoins while at the same time incentivizing arbitrage. $UST must be minted. You pay the going rate in $LUNA. The protocol takes those $LUNA and burns them. This approach constricts the supply of $LUNA, and the price of $LUNA goes up just a bit. If you need $LUNA, you will first convert $UST to $LUNA, and then $UST gets burned, and $UST’s price will go up slightly.

Traders who profit from small price discrepancies, arbitrageurs, help keep the price of $UST in check by selling $UST to buy $LUNA when the price of $UST is more than $1 and selling $LUNA to buy $UST when the price of $UST is less than $1.

$UST is built on the Cosmos ecosystem, a blockchain framework shared by Cosmos Hub, Cronos, and Thorchain. Users can use $UST with any applications built on the protocol as Terra is a smart-contract blockchain protocol.

$MIM (Abracadabra)

Magic Internet Money ($MIM) is a stablecoin on the Abracadabra protocol. MIM is backed by interest-bearing tokens (ibTKNS). Examples of interest-bearing tokens include $yvYFI, $yvUSDC, $yvUSDT, $xSUSHI, and $yvWETH. ibTKNS have been selected as collateral for $MIM as they accrue interest and increase in value based on the market predictions, thereby increasing profits.

The interest-bearing tokens increase in value as users pay back interest on the portions they had earlier borrowed from the lending pools. These tokens are then collateralized, after which they are injected back into the system and then minted into $MIM tokens.

In a typical yield farming scenario, users stake or deposit assets such as $USDT or $SUSHI on yield farms like Sushi and Yearn and receive assets such as $yUSDT and $xSUSHI to act as ‘receipts’ for the original tokens that they have deposited.

Abracadabra allows users to deposit ibTKNS such as $yUSDT and $xSUSHI as collateral and mint Magic Internet Money (a liquid asset). The protocol makes it possible to farm stranded capital and turn illiquid assets liquid.

BEAN (Beanstalk Farms)

Beanstalk Farms is a decentralized credit-based stablecoin protocol built on Ethereum. Although Beanstalk got chopped down by a governance attack recently, we think it’s worth highlighting the mechanics used by this protocol. Unlike most stablecoin platforms that use collateral, Beanstalk uses credit to create a decentralized, blockchain-native, liquid asset, which is stable relative to the value of a non-native asset. Protocol-native financial incentives exist that encourage participation in governance and peg maintenance without requiring action from everyday Bean users.

How Beanstalk works

The protocol has three ERC-20 tokens:

• $STALK. A yield generating governance token.
• $BEAN. The Beanstalk stablecoin.
• $SEEDS that yield 1/10000 Stalk every Season.

Beanstalk’s native timekeeping mechanism is Seasons, where each season is ∼1 hour long.

Beanstalk has three interconnected parts: a decentralized price oracle, the Field, and the Silo:

Decentralized Price Oracle — Beanstalk utilizes two liquidity pools from Uniswap, USDC:ETH and BEAN:ETH, to create a decentralized price oracle. The price of 1 $BEAN is considered equal to $1 when the ratio of the two pools is identical. Beanstalk calculates a Time Weighted Average Price for 1 $BEAN over each season.

The Field (Decentralized Credit Facility) — A decentralized community of lenders maintains the stability of the $BEAN price. The stability of $BEAN relies on how fast Beanstalk can attract creditors. The Field is where $BEAN lending takes place.

• There must be Soil in the Field whenever Beanstalk wants to issue a loan.
• The pre-approved number of $BEAN that can be lent to Beanstalk is known as Soil.
• Any $BEAN not in the Silo is rentable to Beanstalk in exchange for Pods (the Beanstalk’s s-native debt asset). A typical $BEAN loan has an unknown maturity date and a fixed interest rate.

The Silo (Decentralized Governance Mechanism) — The Beanstalk Decentralized Autonomous Organization is responsible for the robust governance of the protocol. As the supply increases, those who hold $STALK can submit and vote for various improvement proposals and get a portion of $BEAN.

How Does Beanstalk Create Stability?

A set of diverse participants such as arbitrageurs, Bean Farmers (Lenders), and Silo Members (Depositors) are needed on Beanstalk. The protocol aligns the incentives of every participant to create a diverse, decentralized community and maximize price stability.

Until the on-chain governance attack on April 17, Beanstalk’s model worked exactly as designed. This might not be the end for Beanstalk Farms. They’re trying to raise new funds to compensate victims of the governance attack and bootstrap new pools to get Beanstalk growing again.

$USDC

$USDC is one of the most popular stablecoins available on several chains. It is issued by Centre, a joint venture between Circle and Coinbase. $USDC is backed by U.S. dollar assets held at audited and regulated U.S. financial institutions.

Users with a U.S. dollar bank account can always redeem 1 USDC for $1. The reports of USDC reserves are audited by Grant Thornton LLP, a U.S.-based accounting firm that releases monthly attestations on the USDC reserves.

$USDT

$USDT is a US-dollar pegged cryptocurrency issued by Tether company. $USDT’s peg to USD is attained by maintaining a sum of commercial notes, reserve repo notes, cash, treasury bills, and fiduciary deposits in reserves that are equal to the number of $USDT in circulation.

$USDT was launched in 2014 and was initially known as Realcoin, later renamed USTether, and finally USDT. Through the Omni platform, $USDT was created as a layer 2 coin on top of the Bitcoin blockchain. Later, it could be expanded to other blockchains such as Ethereum, Tron, EOS, OMG, and Algorand.

Tether guarantees USDT’s value to remain pegged to the U.S. dollar. Whenever the protocol issues a new USDT token, it ensures that it allocates one dollar to its reserves. However, concerns over whether Tether has reserves equivalent to the USDT tokens in circulation have been an issue since the company has never been subjected to a public audit.

$bUSD (Binance)

BUSD is a stablecoin created by Binance in partnership with Paxos. This stablecoin is pegged 1:1 to USD and approved by the New York State Department of Financial Services (NYDFS). Paxos Trust Company is the custodian of USD reserves for every BUSD issued. BUSD is supported on both ERC-20 and BEP-2 standards.

$kUSD (Karura)

$kUSD is a decentralized, collateral-backed, and trustless stablecoin issued by The Karura network. It has Vaults where users can lock collateral (other cryptocurrencies) and mint $kUSD.

Keep it stable

This list is far from exhaustive but gives a decent overview of the most common and popular types of stablecoins currently in use. The simultaneous experimentation we see from these different strategies and protocols accelerates our collective advancement towards creating a decentralized and trustless standard that can give all participants secure and reliable access to the tools required to take charge of our financial circumstances. They’re not perfect yet, but we believe they’ll come close very quickly.

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