Why are DeFi Stablecoins Here to Stay?
Yes, cryptocurrencies are known to be highly volatile, but how does the idea of a fiat-backed cryptocurrency affect the way we think about them? Let’s discuss it!
Cryptocurrencies were initially devised to replace traditional fiat currencies slowly. One of the major problems hindering their adoption as a globally accepted medium of exchange is the volatility associated with most of them. They do not function too well as stores of value, especially in the long run, which is why most experts do not consider them sound financial resources (hence the term “crypto assets”).
The crypto-community did not take too long to address this issue, and stablecoins emerged as a result.
The average human likes the idea of stability (evident by factors like the search for job security), and stablecoins brought stability to a very unpredictable crypto ecosystem.
Due to their role in the crypto ecosystem, it is necessary for you as a crypto user to understand how cryptocurrencies are differentiated, how and why stablecoins differ from other token types, the types of stablecoins that exist today, and their importance.
This article would help you understand stablecoins as a type of cryptocurrency and their utility.
For that to happen, we must first start with cryptocurrencies!
Taking a Quick Dive into Cryptocurrencies
Every internet user has probably heard about cryptocurrencies, but only some understand what they are, or even why they are so hyped.
You as a reader might also have the same question many others have:
“what exactly are cryptocurrencies and how do they work?”
Well, cryptocurrencies are digital or virtual currencies that use cryptography to secure transactions.
It is a digital payment system that serves as an alternative to fiat currency, which relies on banks to verify transactions.
So rather than physically carrying and exchanging money in the real world, cryptocurrencies are financial assets that you can store in digital wallets. They also operate a peer-to-peer system that enables you and anyone anywhere in the world to send, receive and exchange these financial assets.
Stablecoins, in particular, are the most traded digital coins in the crypto space, with market capitalization reaching $152 billion by June 19, 2022. There are nearly 200 stablecoins in existence (either already launched or in development), but the most common ones are Tether (USDT), USD coin (USDC) and DAI.
What Should You Know About Stablecoins as a Potential User?
Stablecoins are cryptocurrencies backed by a stable or fairly value-stable asset (e.g., fiat currency [US dollar]). Their values are thus pegged to the value of such assets.
Stablecoins attempt to combine the stability of traditional assets (like fiat) with the flexibility of digital assets, thus reducing the volatility common to unpegged cryptocurrencies, such as Ether or Bitcoin.
“Investors turn to stablecoins as a way of retaining value without leaving the digital asset ecosystem, acting as a safe haven from volatile coins or even simply as a means of digital payment. It is the most traded cryptocurrency by far, charting more than double the volume of second-place Bitcoin over the last 24 hours at $178 billion.” — Bloomberg
As a crypto user finding ways to invest in cryptocurrencies that don’t fluctuate over time, stablecoins might just be what you were looking for!
Overview of the Types of Stablecoins and How They Operate
There are many approaches to classifying stablecoins, the most common being their collateralization and price stabilization mechanisms.
Depending on the underlying collateral structure, stablecoins are classified into four primary stablecoin types, namely fiat-backed, crypto-backed, commodity-backed, and algorithmic stablecoins.
Fiat-backed stablecoins
They are also called traditional collateral or off-chain stablecoins and are the most popular.
Backed by fiat currencies, the value of this stablecoin type remains pegged to the value of the fiat collateral. Hence, they usually serve as off-chain assets (tangible assets like cash and listed stock).
Fiat-backed stablecoins are not fully decentralized because the fiat collateral is still in the possession of a central issuer’s reserve.
The fiat collateral must always be proportional to the market supply of the stablecoin, implying that when these stablecoins are exchanged for fiat money, the corresponding stablecoins are burned (permanently removed from circulation) to avoid price fluctuation, keeping their price stable and pegged to the fiat.
For example, assume that the central issuer has 1000 USD reserved as collateral. This just means that they can only distribute 1000 dollars in stablecoins.
Common examples of this stablecoin that you would commonly come across are Tether (USDT), USD coin (USDC) and Paxos Standard (PUSD).
Crypto-backed stablecoins
They are also called on-chain stablecoins. These stablecoins are backed by another cryptocurrency as collateral. They operate without the help of central issuers and are thus decentralized through the help of smart contracts.
To own these crypto-backed variants, you lock another cryptocurrency of equivalent value as collateral in a smart contract. Besides, you only need to put the stablecoin back in the smart contract to withdraw the amount of cryptocurrency initially collateralized.
It is also noteworthy that these stablecoins are over-collateralized by 200% to compensate for market price fluctuations. Therefore, you would need to lock $200 in Ether to buy $100 DAI, which is a commonly used stablecoin.
Commodity-backed stablecoins
Commodity-backed stablecoins are backed by physically tangible assets, such as oil or real estate, as collateral.
The problem with these stablecoins is that the market price of the collateral commodities may fluctuate and lose value, meaning that your corresponding commodity-backed stablecoins could also lose value accordingly.
Tether Gold (XAUT) and Paxos Gold (PAUG) are good examples.
Algorithmic stablecoins
They use algorithms and smart contracts to keep the stablecoins stable, which also help in managing the market supply of these stablecoins; they are thus uncollateralized.
The market supply is managed by tracking a fiat currency, meaning the smart contract reduces the market supply of the stablecoin if the stablecoin’s value exceeds the price of the fiat currency it tracks and vice versa.
One of the most recent and controversial examples is Terraform Labs’ $UST. The algorithmic stablecoin crashed de-pegging its value completely in May 2022. Other common examples to consider are UXD and Ampleforth (AMPL).
Historically, algorithmic stablecoins have proven not to be resilient, lacking the architecture to be the digital substitute for money. Unlike collateralized stablecoins, algorithmic stablecoins seem “destined to fail” as they depend on a circular price stabilization arbitrage mechanism that could easily enter a “death spiral”.
The Importance of Stablecoins to DeFi
Stablecoins play a critical role in accelerating the adoption of DeFi, as they protect investors from the potential risk of losing financial value due to fluctuations in the crypto market. It is also important for enterprises utilizing blockchain technology to maintain a parallel proportion between their product and price.
Moreover, stablecoins ensure that stakeholders generate yield on their crypto assets while taking full advantage of smart contracts and their associative benefits.
“Stablecoins are cryptocurrencies with a stable price in fiat currency. Albeit still a small segment of the USD 2.3 trillion crypto asset market, their market capitalization increased multifold to about USD 170 billion in 2021. More importantly, though, they are the most traded coins in the entire crypto space.” Heike Mai, Deutsche Bank Research Analyst
These benefits are not just limited to resolving the issue of volatility; rather, stablecoins inherit some of the most powerful properties of unpegged cryptocurrencies, such as accessibility, transaction speed, security and programmability. They are essential facilitators of DeFi services provided by many dApps and protocols, with services ranging from trading and staking to lending and borrowing crypto assets.
The anchor of financial perdurability that stablecoins provide make risk management and investment in DeFi easier. This blend of fiat and unpegged cryptocurrencies accounts for the mass adoption of stablecoins as a plausible store of financial value, enabling stablecoins to easily compete and win against traditional payment options.
How are Oracles Involved?
Crypto-backed collateralized or algorithmic stablecoins have no access to price feed data in relation to their exchange rate to the collateralized asset because of the oracle problem (i.e., they are built on blockchains that cannot communicate information outside of their isolated environments).
Oracles are the solution to this problem because they help blockchains share data and digital assets across their separate isolated environments. Present-day blockchain oracles help to bridge the information gap between blockchain networks similar to how oracles of ancient Greek mythology bridged the communication gap between humanity and the gods.
Oracles are built to verify and feed data to smart contracts and are thus fundamental to the operation of any stablecoin. They fetch the data that centralized stablecoin issuers require to ensure that the stablecoins issued into market circulation are properly collateralized. This is performed by proof of reserve audits to ensure transparency. Oracles, therefore, form a layer of trust by linking on-chain and off-chain data.
Oracles facilitate this transparency by frequently confirming off-chain whether the amount of collateralized fiat currency is proportional to the number of issued stablecoins. Algorithmic stablecoins maintain their pegs by relying on oracles to spot price data to issuers that mint or burn stablecoins proportionally to the collateral. Ultimately, oracles enable stablecoins to maintain their pegs.
By verifying price feeds, such as interest rates, liquidity and derivatives from on-chain sources like DEXes (decentralized exchanges such as auctions and automated market makers), they protect networks from sandwich attacks and atomic price manipulation from whales and corrupt signers that attempt to artificially influence the market price or behaviour of an asset.
It is common for the value of fiat currencies to waver relative to one another and other valuable commodities used as collateral. Still, the absence of oracles could result in the compromise of entire blockchain ecosystems as trades are executed using inaccurate price data.
The Terra blockchain for example had to be halted after $LUNA’s price fell abruptly and put the network’s security at risk. The underlying reason for the fall was the de-pegging of its linked stablecoin — Terra USD ($UST) due to wrong interest rate feeds.
Without the help of DIA and other oracles in stablecoin projects, the risk of slippage becomes more apparent, which ultimately increases operation and transaction costs, as well as network congestion.
Oracles, Stablecoins, and Scalability?
Scalability has been one of the many pressing issues of numerous cryptocurrency projects. A popular solution to the scalability problem proposed by the Ethereum Foundation is rollups.
“Rollups perform transaction execution outside layer 1 and then the data is posted to layer 1 where consensus is reached. As transaction data is included in layer 1 blocks, this allows rollups to be secured by native Ethereum security” — The Ethereum Foundation
Even with this approach, data availability is still a major challenge that should be solved before scaling. Why scale a blockchain when it can’t access or interact with data from outside its own environment?
Hence, to ensure transparency for cryptocurrency projects like stablecoins that continuously need access to price data, the process of making data available should be automated using data oracles rather than trusting people’s inputs.
Stablecoins are still a budding part of the crypto economy but are worth looking out for. As blockchain technology advances, alternative stablecoin designs like multi-collateral models that do not axiomatically employ the US dollar peg model will be developed. There will also be a shift in the way these currencies access price data in order for them to become fully trustless and decentralized.
DIA is an oracle that specializes in ensuring these attributes.
DIA — an Open-source Oracle Service Provider
Its transparent, accurate and customizable price feed oracles power a couple of decentralized stablecoin projects like those of Astrid DAO, Tomb Finance, UPFI Network and Sperax, among others.
With a market cap that presently exceeds $150 billion and $61 billion in trading volume, stablecoin protocols are very important sectors of the crypto economy that drive the adoption of DeFi.
DIA feeds these protocols with unique, open-source price feed oracles to seamlessly operationalize their stablecoins. The oracles run on their native blockchain networks and help to facilitate fast and low-cost transaction updates.
Unlike other oracles that rely solely on centralized third-party data providers, DIA crowd-sources its data from both centralized and decentralized exchanges.
This trust and credibility, along with its immaculate DAO, is what makes DIA arguably the forerunner in this domain.
You can request data feeds, alongside the oracle specifications by submitting a CDR (Custom Delivery Request) on the DIA Forum.
Another interesting fact about DIA is that its oracle service, operations and governance are open source and ranks as the fifth most populous DAO on Dework at the moment!
Like millions of other crypto users, if you too are seeking stability in the crypto space, DIA might just be the answer.
To get started, join our Discord community now!
Written by Temiloluwa Hamzat
Edited by Umair Abbas
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