Elk Academy Lesson 7: Stablecoins
Good day, and congrats on making it this far in your journey! You’re well on your way to becoming a DeFi expert.
Let’s be honest, though. There have been a few bumps along the way, right? That shiny APR we cautioned you about seemed too good to be true, but you had to find out for yourself. That’s ok. You’re a smarter investor for it — onward!
Today, we’re going to put that newfound wisdom to use by discussing one of the best tools for adding stability to your portfolio: stablecoins.
What are stablecoins good for?
A stablecoin is a token whose price is designed to remain fixed. The price of most stablecoins are linked (or “pegged”) to a traditional asset, such as U.S. dollar.
There are two questions to consider here. First, since stablecoins can be freely traded like other tokens, how do they maintain their price? And second…what’s the point? Why own a tokenized dollar rather than, say, a real dollar? We’ll get to the first in a moment, but let’s start with the second: why are stablecoins desirable?
As it turns out, there are a lot of reasons. While you may not be able to pay your parking meter with a tokenized dollar (yet…), there are many instances where stablecoins make sense.
The main benefit is price stability. If you believe that cryptocurrencies might someday replace traditional money as a medium of exchange, then this point is fairly obvious. For most people, a currency that might dip 20% overnight is unappealing for regular expenses. Stablecoins thus gain the advantages of cryptocurrencies (decentralization, ease of transfer, a transparent ledger, etc.), but they also hold a steady value. For these reasons, many countries are exploring virtual versions of their native currency.
In DeFi, however, tokens are not typically used for exchanging for goods or services (with some notable exceptions, e.g. NFTs). They can, however, become useful tools during periods of market volatility as a way to protect your portfolio, which is one of their most common applications.
But there are many other uses too. Under normal market conditions, pairing a stablecoin in a liquidity pair allows you to earn rewards with less risk, acting as a hedge for the paired token. It is also possible to farm for yield with two stablecoins, which effectively eliminates the risk of impermanent loss, since the ratio between the two tokens is fixed. Since they are less volatile, stablecoins are commonly accepted as collateral for lending and borrowing.
The tradeoff, of course, is that the yield on stablecoin pools is typically lower. Less risk, less reward. On the other hand, compared to the interest rates offered by traditional banks, the returns on stablecoin deposits can be quite attractive. Keep in mind, however, that the risks associated with each are decidedly different. Generally speaking, stablecoins are not insured in the same way that deposits in traditional banks are.
How do stablecoins work?
At the present time, stablecoins can be divided into three general categories:
- Fiat-collateralized stablecoins
- Crypto-collateralized stablecoins
- Algorithmic/non-collateralized stablecoins
Let’s take a look at each…
Fiat-collateralized stablecoins
Stablecoins that utilize fiat (i.e. government issued currency) as collateral achieve price stability through a “reserve” that contains real world assets to match the supply of the token. In other words, for every stablecoin in circulation, there is a real dollar held somewhere, which can theoretically be redeemed in exchange for the token. Tether, or USDT, is perhaps the best known example of this type.
Crypto-collateralized stablecoins
A variation on this same idea involves using a cryptocurrencies rather than a fiat as collateral. In this scenario, tokens are locked into a smart contract, which then issues a stablecoin based on the deposited collateral. The basic process in this case is quite similar to the lending and borrowing protocols discussed in the previous lesson. Dai (DAI), a stablecoin pegged to the U.S. dollar, is a well-known example based on this model.
Algorithmic/non-collateralized stablecoins
Still another variation does not depend on collateral at all to maintain its peg. Instead, it uses an algorithm to control the supply of the token in order to maintain a steady price. If the token price moves above its target, the algorithm will increase the supply, thereby reducing the price through inflation. Likewise, if the token price falls below its target, the supply will be reduced.
There are also some newer protocols that are experimenting with combining the second and third models. TerraUSD (UST) for example, maintains its peg in tandem with another token, Terra (LUNA), which can be burned or minted by holders to maintain the price of UST. In this instance, the token is considered “algorithmic” because it does not rely on collateral to maintain its peg.
Interestingly, since algorithmic stablecoins do not depend on collateral, they also introduce a novel possibility, which is an arbitrary value target rather than one based on a fiat currency. Think of it: the price can be set to any target, and the algorithm will work to maintain that price. This provides a model that is fully decoupled from traditional money.
What are the limitations of stablecoins?
The main risk for each type of stablecoin involves how it maintains its peg. For stablecoins collateralized with fiat currency, if the peg is based on a real world reserve, users are putting their faith in the centralized entity that the reserve is fully funded, which studies have revealed is often not the case.
For algorithmic stablecoins and/or stablecoins backed by cryptocurrencies, there are similar risks where a stablecoin can fall off its peg. Since these tokens maintain their value through collateral and user arbitrage provided by users of the token, some designs are vulnerable in events like “bank runs,” where everyone pulls their collateral at the same time can cause the price of the stablecoin to collapse or liquidity to run dry.
Stablecoins and Bridge Fragmentation
Another shortcoming of stablecoins is that they are generally issued on a single chain. This means that in order to use that token on another chain, it first has to be moved across a bridge and “wrapped” — meaning that the original token is locked on one chain, and a derivative is issued on another whose value is tied to the underlying locked token. For these wrapped tokens, the price peg is partially maintained through a price oracle, such as Chainlink, which relays the price of the token from its native chain.
Elk is currently developing on several products to address these fragmentation problems. One of these is a novel “proxy token” concept, which will create a virtual asset that can freely move between chains after it has been minted. As an example, users will be able to mint eDAI as a proxy token that utilizes DAI as collateral through the same process that crypto-backed stablecoins are issued. Once eDAI is minted, however, it can be moved across the ElkNet bridge, bypassing the need for wrapped tokens on each chain.
Taking this concept one step further, Elk is also preparing to release its own stablecoin, CHFT, whose price is pegged to the Swiss Franc. (One of the indirect risks of fiat-backed stablecoins, it should be mentioned, is that the underlying fiat currency itself may become devalued; the Swiss Franc was thus chosen for its unmatched track record of stability).
CHFT will be the first stablecoin that can be natively minted on multiple chains. Users will provide collateral by locking tokens on one chain to mint CHFT. Since it can be minted on any chain supported by the ElkNet bridge, users have the ability to transfer it onto any chain instantaneously through a burning and minting process, and they will be able to redeem it at any time based on the available collateral on that chain. In the unlikely event that there is no collateral, they can simply move it back onto a chain that holds collateral. Since all CHFT tokens will be overcollateralized, there will always be liquidity available for redemption.
Stablecoins are one of the greatest areas for innovation in cryptocurrency, but they also remain one of the main frontiers for technological problem solving. All stablecoins are not created equal, so it’s important to research their potentials and risks before choosing one to invest in.
