Beanstalk Series — Types of Stablecoins Ch.1

Primer — Beanstalk is a permissionless fiat stablecoin protocol. Beanstalk relies on credit as opposed to collateral and is designed to remedy the rent-seeking collateralized stablecoin market. It aims to create a decentralized, liquid, blockchain-native asset that is stable relative to the value of a non-blockchain-native asset.

Disclaimer — This article is the second of the series about Beanstalk. I am writing this as part of Beanstalk’s community grant program.
Ch.0 — Beanstalk Series — Rising from the Ashes Ch.0

Introduction

Stablecoins are touted as a critical component in bringing together the best of the decentralized, volatile, and anonymous world of cryptocurrency and the volatility-free world of fiat currency. Crypto’s highly speculative nature makes it attractive to several investors. However, this compelling characteristic restricts its use in payments and trade. In addition, the extreme volatility in the cryptocurrency market is a significant deterrent to its mass adoption and acceptance.

The aforementioned volatility and instability inspired the inception and design of Stablecoins. Stablecoins, as the name suggests, refer to a class of assets that provide price stability and steady valuation. These coins are traded on blockchain and pegged to the value of another currency (typically the US dollar). The arrangement enables stablecoins to eliminate volatility and achieve a relatively stable price, unlike other coins that experience massive fluctuations.

The peg/price stability is achieved via collateralization or through algorithmic mechanisms. Different stablecoins deploy different methods to achieve stability.

However, every stablecoin exists along the below-mentioned spectrum:

1. Stability- refers to the ability of the stablecoin to remain at its peg (sans large variances) irrespective of market conditions.
2. Efficiency- describes the amount of capital required to secure the stablecoin. Locking up more than $1 of collateral to create $1 of stablecoin is deemed inefficient and can lead to stablecoin supply constraints.
3. Decentralization- refers to the extent to which the stablecoin depends on centralized systems/entities.

Price stability is of utmost importance, and unfortunately, achieving high price stability comes with a trade-off in either the system’s decentralization or capital efficiency. As a result, none of the stablecoins have been able to embody all three characteristics.

Together these three constitute what is referred to as the stablecoin trilemma. The trilemma prevents the stablecoin design from optimally balancing these trade-offs.

Types of Stablecoins

Stablecoins can be categorized into the following groups:

1. Fiat-backed coins (1:1 collateralization)

The most popular amongst all, fiat-backed coins refer to coins backed by fiat currencies such as the US Dollar. Examples include USD coin (USDC) and Tether (USDT). Under this method, a custodian/centralized organization/central issuer holds the fiat collateral/currency in proportion to the number of coins in circulation. This is done in order to guarantee the issuance as well as redemption of the coins. However, this setup is largely centralized and subject to government regulation and intervention.

2. Crypto-backed coins (overcollateralized)

Crypto-backed coins are similar to fiat-backed coins, except for the underlying collateral being another cryptocurrency instead of a fiat currency. In this setup, there is no central entity/custodian as the coins are issued on-chain employing smart contracts and are therefore decentralized in nature. Their purchase entails users over-collateralizing their position, meaning a coin of higher value is locked in to issue a lesser-valued stablecoin. The over-collateralization serves as a buffer against the collateral coin’s volatility. A popular example belonging to this category is DAI.

3. Commodity-backed coins

As the name implies, these coins are collateralized with commodities like precious metals/oil/real estate. Gold is the most popular commodity to be collateralized, as it enables individuals to invest in gold sans the hassle of actually buying or storing it. This category includes Tether Gold and Paxos Gold (most liquid gold-backed stablecoins). These coins facilitate investments in assets that would otherwise be out of reach for certain retail investors.

4. Algorithmic coins (Undercollateralized)

These coins maintain price stability by using specialized algorithms and smart contracts instead of being backed by any real-world asset/commodity. The algorithm is designed to burn/remove or mint/create new coins to modulate the supply and maintain equilibrium.

Stablecoins are a critical component of the DeFi infrastructure and are by far the most borrowed assets on crypto markets.

Utilities

• Store of value and medium of exchange (cross-border payments, remittance, and e-commerce)
• Serve as a major entry and exit point in the crypto capital markets
• Most trading pairs (on both CEXs and DEXs) are denominated in stables
• Used for trading in and out of other currencies without going off-chain
• Used to access yield in crypto capital markets
• Popular derivatives offered by perpetual protocols are mostly collateralized against stablecoins

Challenges

The popularity of stablecoins is surging owing to their ability to offer the best of both worlds- the privacy and speed of the cryptosphere and the stable valuations of traditional money. However, one cannot ignore the problem of CENTRALIZATION in the case of fiat-backed coins, OVER-COLLATERALIZATION in the case of commodity-backed coins, and INSTABILITY in the case of undercollateralized algorithmic coins.

In addition, existing stablecoins can’t scale to meet the growing demand owing to the COLLATERAL REQUIREMENT. Increased demand for stablecoins means an enormous amount of collateral needs to exist. The problem is insufficient collateral, both on-chain as well as off-chain, to meet this demand. Thus, there is a huge shortage of stablecoins in DeFi today compared to the demand. This phenomenon has resulted in limited supply and high borrowing and lending rates.

While fiat-backed coins are ideal and allow for significant scaling, they’re inherently centralized. Crypto-backed coins are decentralized and relatively stable, but they aren’t capital efficient and harder to scale because they need to be overcollateralized. Algorithmic coins address poor capital efficiency and scalability (not backed by collateral and can expand supply to meet demand) but at the expense of losing the peg. Several iterations of algorithmic coins (over the years) have collapsed and lost their value. The most recent of which was Terra’s UST. The catastrophic collapse of UST has made people lose faith in the ability of undercollateralized algorithmic coins to return to peg in the face of volatility.

Enter BEANSTALK. A protocol that aims to solve the stablecoin trilemma. Beanstalk is decentralized, collateral-free, and credit-based. Of course, it is a work in progress as Rome wasn’t built in a day.

A permissionless fiat stablecoin protocol, it relies on credit as opposed to collateral and is designed to remedy the rent-seeking collateralized stablecoin market. In the following article, I shall explain how the Beanstalk protocol works and maintains its peg.

Stay tuned for the next chapter!

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