Navigating Stability: The Vital Role of Stablecoins in Web3

Introduction

In the fast-paced world of cryptocurrencies, the need for stability has led to the emergence of a groundbreaking financial instrument — stablecoins. These digital assets hold the promise of providing a secure and reliable store of value while navigating the volatility of the crypto market.

In this article, we will delve into the critical role stablecoins play in managing risk and providing liquidity, all without the burdensome reliance on expensive fiat off-ramps. We will explore the differences between centralized and decentralized stablecoins, the risks linked to smart contracts, collateral usage, and the advantages of over-collateralized stablecoins over under-collateralized stablecoins.

Moreover, we will introduce you to Virtue’s over-collateralized stablecoin vUSD, which embodies the best of both security and stability (www.virtue.money).

The importance of stablecoins

One of the key advantages of stablecoins lies in their ability to manage risk effectively. The cryptocurrency market is notorious for its price volatility, which can lead to significant gains but also expose traders and investors to substantial losses. In this context, stablecoins provide an option to hedge against sudden and dramatic price fluctuations.

Beyond their risk management capabilities, stablecoins play a crucial role in ensuring liquidity provision within the cryptocurrency market. Liquidity is vital for traders seeking to capitalize on market opportunities or execute transactions swiftly. However, dealing with highly volatile cryptocurrencies can pose liquidity challenges due to limited trading pairs and fragmented markets. The liquidity-enhancing aspect makes stablecoins an indispensable tool in the crypto user’s toolkit, facilitating seamless trading and enhancing market efficiency.

Moreover, stablecoins offer an advantageous alternative to traditional fiat off-ramps, which involve converting cryptocurrencies back into fiat currency through exchanges. This process can be time-consuming and expensive, with fees and processing times varying significantly depending on the (centralized) platform. By using stablecoins, users can circumvent these costly intermediaries and access a more cost-effective process of converting cryptocurrencies within the crypto ecosystem.

Last but not least, stablecoins present an efficient means of transferring USD value within the crypto space. This opens up a wide range of opportunities for cross-border transactions and seamless payments within decentralized finance (DeFi) platforms. The decentralized nature of stablecoins empowers users with greater control over their funds and eliminates potential delays associated with centralized systems and traditional finance, making it a more efficient and accessible option for global transactions.

Centralized and Decentralized Stablecoins

While stablecoins have emerged as a revolutionary financial instrument within the cryptocurrency ecosystem, not all are created equal. They can be broadly categorized into two distinct models: centralized and decentralized. Let’s delve into the differences between them, exploring their unique characteristics, advantages, and risks.

Governance and Control

• Centralized stablecoins: A single entity or organization typically manages the issuance and operations of the stablecoin. This central authority holds full control over the coin’s supply, reserves, and key decision-making processes.
• Decentralized stablecoins: On the other hand, decentralized stablecoins are governed by smart contracts and distributed consensus mechanisms, removing the need for a central authority. Decisions related to the stablecoin’s operations are determined collectively by the network participants or pre-set within the smart contracts.

Trust and Transparency

• Centralized stablecoins: Often require a higher level of trust in the issuing entity, as they rely on this entity’s ability to maintain the stablecoin’s peg to its intended value. Increased risk of mismanagement, potential fraud, or malicious actions that could compromise the system’s stability and user funds.
• Decentralized stablecoins: Promote a higher degree of trustlessness, as they are built on transparent and auditable smart contracts, allowing users to verify the system’s integrity and reserve holdings independently.

Proof of Reserves

• Centralized stablecoins: Regular publication of reserves’ evidence assures users that their stablecoins can be redeemed at the pegged value. Users rely on the trustworthiness of this authority and audit firm to manage and verify the reserves properly and ensure the stablecoin’s stability and redeemability.
• Decentralized stablecoins: Trust relies on the assurance that the mechanisms used for stabilizing the stablecoin’s value are reliable and secure. Audits, testing and battle-testing of the protocols allow users to gain confidence in the stability and pegging mechanics.

Collateral Risks

• Centralized stablecoins: Many centralized stablecoins deploy collateral in centralized finance (CeFi) platforms to earn a yield or hold custody of reserves, which introduces reliance on third-party platforms and exposes the stablecoin to risks associated with the performance and security of those platforms. A recent example of such a risk was USDC’s reliance on Silicon Valley Bank, which had a bank run with significant reserves at risk that required US government intervention to resolve but not before it had a significant negative impact on the peg of USDC before returning to parity.
• Decentralized stablecoins: The most popular stablecoins are designed to maintain a stable value by pegging their price to a reserve asset (collateral), thereby reducing volatility. They utilize smart contracts on blockchains to automate their stability mechanisms. These smart contracts ensure that the supply of stablecoins adjusts dynamically based on demand and supply conditions, maintaining the peg to the chosen asset or algorithmic formula without the need for a central authority. This decentralization aspect fosters trust, transparency, and accessibility, making decentralized stablecoins appealing for various use cases.

Control and Seizure

• Centralized stablecoins: Susceptible to control and seizure risks due to their reliance on a single entity. Governments or regulatory bodies could exert pressure on the issuer, leading to censorship, freezing of funds, or other undesirable actions.
• Decentralized stablecoins: Provide a higher level of immunity against control and seizure risks. Governments or regulators have limited authority to intervene or exert pressure since the stablecoin operates on a distributed network without a single point of control.

Over-collateralized and Under-collateralized Stablecoins

Apart from being categorized as centralized or decentralized, stablecoins can also be differentiated based on their collateralization methods: over-collateralized and under-collateralized. This chapter delves into the specifics of these two approaches, offering insights into security and stability aspects of both.

Over-collateralized stablecoins

Over-collateralized stablecoins are backed by a reserve of assets that exceeds the value of the stablecoins in circulation. For instance, a stablecoin might be pegged to the US Dollar and have $100 worth of collateral (assets) in reserve for every $70 worth of stablecoins in circulation. Should the value of the collateral drop to close to $70 the collateral could be liquidated to repay the debt position (stablecoins). An analogy could be to imagine if all our FIAT money was backed by a larger value of gold and you could redeem for gold if you chose.

Advantages of over-collateralization

• Stability: Over-collateralization provides a strong buffer against price fluctuations, ensuring that the stablecoin remains stable and maintains its peg even during market turbulence.
• Confidence and trust: Users have increased confidence in the stablecoin’s value as they know it is backed by tangible assets held in reserve, reducing the risk of potential sudden devaluations.
• Simpler mechanism: Does not rely on overly complicated mechanisms to maintain peg and and risk can easily be monitored for novice users using data available transparently on-chain such as collateralization ratio.

Under-collateralized stablecoins

Under-collateralized stablecoins do not maintain a one-to-one reserve ratio. Instead, they utilize complex algorithms and mechanisms to stabilize their value without fully backing each stablecoin with equivalent reserves.

Risks of under-collateralization or utility token used within collateralization

• Efficiency and Capital Optimization: require less capital to mint, enabling more efficient use of funds and reducing the overall cost of maintaining the stablecoin. In turn this allows great leverage opportunities to be achieved.
• Stability: Under-collateralized stablecoins are more vulnerable to price volatility and market fluctuations, leading to potential deviations from their intended peg. This is especially true during black swan style events such as 3AC drama and UST.
• Confidence and trust: Users may have reservations about the stablecoin’s value if they are uncertain about the effectiveness of the algorithm or smart contract mechanism to maintain peg during uncertain times.
• Systemic risks: Algorithmic stablecoins can experience complex interplays between supply and demand dynamics, potentially leading to rapid price changes and cascading effects within the ecosystem.

MakerDAO (DAI), Liquity (LUSD) and Virtue (vUSD) are examples of over-collateralized stablecoins, where users need to lock up more valuable assets as collateral than the value of the stablecoin they mint.

Examples of under-collateralized or utility tokens used within collateralization

Ampleforth was an under-collateralized stablecoin which implemented elastic demand to mint AMPL tokens based on supply and demand. Terra was used as collateral within the stablecoin UST which was hugely beneficial to Terra’s valuation, as the demand for their stablecoin was strong, however when markets turned bearish, the value of Terra dropped, causing a death spiral for the stablecoin and Terra.

Conclusion

Stablecoins are pivotal in the crypto realm, providing stability, liquidity, and seamless value transfers. They can be broadly categorized into centralized and decentralized models, and further differentiated as over-collateralized and under-collateralized.

Centralized stablecoins rely on trust in a single entity to maintain their value, while decentralized ones have a higher degree of trustlessness and offer immunity against control and seizure risks.

Under-collateralized stablecoins rely on algorithms to stabilize without full backing, whereas over-collateralized ones provide stability by backing assets exceeding their value.

The past has demonstrated that centralized and under-collateralized stablecoins are more vulnerable to failure. For this reason, Nakama is proud of its recent announcement of Virtue (vUSD), a prime example of a decentralized and over-collateralized stablecoin. Virtue operates on transparent smart contracts, eliminating the need for a central authority and fostering trustless operations. By backing its stablecoin vUSD with assets exceeding its circulation value, Virtue ensures stability, reducing the risk of depegging during market turbulence.

Remember: Before investing in any stablecoin, conducting thorough research and due diligence is crucial. Understanding the underlying mechanisms, collateralization, and potential risks associated with the stablecoin is essential to make informed investment decisions.