Stable Genius: A Synopsis of Stablecoin Mechanism Design (Part 1)
Introduction
The world is a complicated place, filled with complicated creations. Stablecoins are one of those creations, this paper, and the subsequent posts that follow, seek to simplify stablecoins for the reader.
Stablecoins are cryptographic assets that seek to maintain a stable set price regardless of market phenomena. They underpin over $170 billion of the cryptocurrency ecosystem and will only grow with continued crypto adoption. Despite their widespread usage within cryptocurrency and large body of academic work, the public understanding of the inner workings of these assets and their respective risks are foggy. This series seeks to describe the evolution of stablecoins by condensing the body of academic work systemizing stablecoins into three articles each focusing on a different stablecoin design an outlining their asset models, mechanistic design, and fundamental risks. We simplify stablecoin designs into three mechanistic paradigms: Custodial Reserve-Backed Stablecoins (USDT and USDC), Algorithmic Leveraged-Based Stablecoins (Dai and Frax), and Algorithmic Reserve-Backed Stablecoins (Celo, Fei, and Gyroscope). This work seeks to better educate the general public on the inner workings and risks of stablecoins to broaden understanding, develop healthy skepticism, and encourage further innovation.
Cryptocurrencies and digital assets are some of the most volatile financial instruments in the world. Their volatility is a deterrent for new users. It is inconvenient to denominate prices in something constantly shifting in value which in turn makes it difficult to fairly and predictably compensate someone during payment for goods or services. As a consequence of this volatility, new users take on more risk when investing and using cryptocurrency in comparison to an institutional investor with deeper pockets. This creates a barrier of entry that continues to restrict the adoption of cryptocurrencies to this day. Stablecoins attempt to be price stable to a peg to mitigate volatility. Stablecoins may be pegged to a variety of prices like the price of gold and silver, or in fiat currencies like USD, or EUR.
Custodial Reserve-Backed Stablecoin Mechanism
Custodial Reserve-Backed Stablecoins maintain a pegged price by having a trusted custodian maintain a reserve of assets (USD, Bonds, Stocks, Gold, etc.) backing the stablecoin off-chain (Bank or reserve). The custodian issues digital tokens representing on-chain tokens of an asset held in this reserve. Users send collateral (funds, assets, etc.) to the reserve which issues (mints) a new stablecoin on-chain and stores the collateral at a financial institution such as a bank. They can then redeem their share of the reserve by sending their tokens back to the reserve to redeem the underlying reserve asset which is then removed from circulation (burned). These actions expand and contract the number of the stable coins in circulation, decreasing or increasing the scarcity of the stablecoin in response to market demand increasing or decreasing the price.
This mechanism of one-to-one exchange supports the pegged price target of the Stablecoin asset by creating a reliable redemption value for users and retaining a balance between the circulating supply of the stablecoin and its backing. Users are incentivized to maintain the pegged price of the stablecoin by profiting off deviations in the stablecoins price in respect to its peg. If the value of the stablecoin is trending above its peg, users can send funds to the reserve to purchase stablecoin tokens at a discount adding tokens to the supply, increasing the price back to the peg. Likewise, if the price of the stablecoin is above the peg users will redeem their stablecoins for a profit, decreasing supply and lowering the price back to the peg. As users’ expectations (users believe the price of the stablecoin is 1 dollar as the collateral backing held in the reserve is tied to $1) are centered around the pegged price of the stablecoin, the peg is maintained. A key assumption of a Custodial Reserve-Backed model is that users must trust that the custodian is maintaining a solvent and stable reserve backing of the stablecoin, otherwise, users would doubt the value of their stablecoins and seek to withdraw them, leading to the depletion of the custodied reserve.
The price of the stablecoin is further reinforced by users performing arbitrage: the process of actors in the market taking advantage of price discrepancies of an asset across different exchanges to earn a profit. Arbitrageurs (external actors not directly using the protocol to mint/redeem tokens) seek to profit off these discrepancies by purchasing a stablecoin at an exchange that lists it for a lower price and selling it at another exchange that lists it at a higher price. In the case that a stablecoin suddenly drops below its peg, an arbitrageur can rapidly buy the stablecoin in the market where it is lower and sell it at another exchange for a higher price, therefore causing the price to increase towards the intended peg. Ultimately, profit-seeking arbitrageurs contribute to maintaining the pegged price of the stablecoin and more importantly normalize the price of a stablecoin across many unique exchanges.
Issues
The flaws of Custodial Reserve-Backed Stablecoins are a consequence of the reliance on the trusted custodial reserve. This trust leads to concerns tied to bank runs, centralized blacklisting, and general business transparency which can in turn affect users’ confidence in the stablecoin. Like in traditional finance, if users lose confidence in the value of stablecoin they will seek to redeem it through the custodial reserve much like a bank. In the case of an extreme loss of confidence in the stablecoin’s value; such as insolvency concerns around its collateral backing, users may try to mass exit by redeeming their stablecoins at once. This phenomenon, known as a “bank run”, may lead to the depletion of the reserve, a loss of user funds if the reserve lacks a sufficient backing, or the reserves default. Therefore, custodial reserve-backed stablecoins should strive to maintain a one-to-one reserve backing for the stablecoins to ensure user confidence, prevent bank runs, and in case of a bank run can ensure users can redeem stablecoins for their deposited funds.
Fractionalization & Solvency:
However, like a traditional bank, custodial stablecoins may lend, borrow, or purchase different assets using their reserve as collateral in order to earn a profit and incentivize themselves. This “Fractionalization” of their reserve leads to the stablecoin protocol’s reserve ratio being less than one-to-one, drawing concerns of insolvency in the case potentially leading to user distrust and a bank run. A more concerning point is that in the process of fractionalizing its reserve a custodian may purchase assets that require regular interest (or funding payments for options) or make them counter-party to bad investments, further expanding insolvency risk. In the case of USDT, assets such as loans and corporate bonds bring in potential extra revenue, and subsequently break their one-to-one backing. Moreover, custodial, reserve-based stablecoins hinge on centralization and could close down trading in the instance of a mass exit, locking in losses further.
Blacklisting:
Custodial stablecoin protocols carry important controls over users. When users deposit funds into the custodial reserve the custodian exerts full control over the collateral. Specifically, these protocols reserve the right to blacklist users’ accounts at their own discretion. A blacklisted account cannot send, receive, or redeem the asset in question, rendering whatever assets it holds worthless. USDC and USDT have both participated in blacklisting accounts in the past, freezing assets valued in total over hundreds of millions. Both companies have carried out these processes in accordance with government laws and recurring investigations. As it stands, this is not the most pertinent threat for the average user, but elicits concern that at any point in time any user’s funds could be locked indefinitely and without due process. Furthermore, it highlights that when users deposit collateral they surrender full control of that collateral to the custodian which may do as they see fit such as invest in risky assets, illegal business, or restrict access to users funds in times of crisis.
Transparency:
The most pressing issue regarding custodial reserve-backed stablecoins is transparency. Unlike many on-chain Defi protocols, where reserves are publicly auditable via the blockchain, custodial reserve-backed stablecoins like USDT have refrained from making this information public, generating concerns regarding their solvency and counter-party risk. Of course, there are U.S regulations and transmission laws that work around this issue and force custodians to publish their list of assets in accordance with U.S. Government regulations on some USD-backed applications (i.e. USDT, USDC). However, most custodial stablecoin protocols have not sought to abide by such strict regulations and therefore leave the decision to invest and take on such risks solely up to the individual investor. A prime example of this being Tether’s empty promise to provide a full financial audit of their protocol. Although, to this day this promise has been left unfulfilled as no full audit has been released, only supplemental documents that are self published. This lack of transparency has brought about regulatory attention to custodial reserve-backed stablecoins, and by having a foothold in both the currency and fiat worlds makes them a prime suspect of a regulatory crackdown and total loss of users’ funds.
Conclusion
Custodial reserved-backed stablecoins represent the first evolution in stablecoin design. Their relative simplicity and alignment with a traditional finance model has led to their dominance in the stablecoin space. However, their underlying centralized mechanism presents legitimate concerns regarding solvency, control of users’ funds, and transparency. These factors motivated the development of algorithmic stablecoins utilizing smart contracts to eliminate the need for a centralized custodian. These algorithmic stablecoins seek to operate without the need of any custodial oversight or any intervention from an outside party relying solely on the interactions of market actors (such as users and arbitrageurs) with the smart contracts to initiate control mechanisms that adapt the price of the stablecoin and maintain a stable peg. This leads to their own unique challenges stemming from the immutable nature of these systems. Once deployed to the blockchain, the mechanisms of algorithmic stablecoin are unable to adapt to changing long term market regimes and are virtually powerless to intervene in times of crisis for the stable assets. The next article in this series will begin our discussion on algorithmic stablecoins by describing the challenges of Leverage-backed Algorithmic Stablecoins.
Sources:
- Tether, “Transparency”, Last updated: 03/07/2022 https://tether.to/en/transparency
- Court Filing from Tether admitting that they are not 100% backed, 04/30/2019, https://www.scribd.com/document/408190969/Zoe-Phillips-Filing-4-30
- “Digital Dollar”, Circle , https://www.circle.com/en/digital-dollar-stablecoin-solutions-for-defi
- Manoylov, “Centre Consortium Blacklisted Seven USDC Addresses Wednesday”, The Block, 04/23/2021 https://www.theblockcrypto.com/linked/102761/centre-consortium-blacklisted-seven-usdc-addresses-wednesday
- Ledger Insights, “Circle Publishes details of USDC Stablecoin Asset Backing”, 07/21/2021, https://www.ledgerinsights.com/circle-publishes-details-of-usdc-stablecoin-asset-backing/
- “Stablecoins”, The Block Crypto, https://www.theblockcrypto.com/data/decentralized-finance/stablecoins
- Klages-Mundt et al, “Stablecoins 2.0: Economic Foundations and Risk-based Models”, 06/12/2020. Proceedings of the 2nd ACM Conference on Advances in Financial Technologies (AFT ‘20), https://ssrn.com/abstract=3633542
- Sirer et al, “A Classification Framework for Stablecoin Designs” Cornell University, 09/18/2019, https://doi.org/10.48550/arXiv.1910.10098
Authors:
Written by the Unstable Geniuses: Patrick (Reads to Much), Jacob (The Idea Guy), Niko (We can’t Pronounce his Last name), Rohan (Always has a Hot Date), and Yughen (Our in house Pable Picasso) are all students at UW-Madison and lead a stablecoin research group. If you like their work be sure to donate to the club crypto wallet badgerblockchain.eth
