Over-Collateralized Stablecoins: A More Than Ever Safe Haven?
After the Terra’s UST debacle the market is experiencing a large demand for over-collateralized stablecoins such as DAI. We take an analytic look at the stability of these stablecoins.
The recent UST value loss from $1 to practically $0 is raising questions about how the disaster could have been prevented. Understanding all the intricacies and inner workings of the different stablecoins might be daunting, but can help to understand which are those that pose an increased risk of peg loss compared to others.
Stablecoins can essentially be backed by cash (or cash equivalents) by centralized entities such as USDT or USDC or be backed by crypto assets, such as UST, DAI, MIM, FRAX and many others. While the risk in centralized stablecoins is a product of the solvency of the stablecoin issuer, in the second model the risk stands mostly on the intrinsic economical model that stabilizes the system. Regardless of the methodology used to stabilize its price, all of them trade openly and their parity to the dollar fluctuates constantly:
In this article we are focusing on this second group, those collateralized by crypto assets. The economical models stabilizing these coins to its parity differ greatly from coin to coin, but can be simplified in two main categories:
Collateralized Debt vs Algorithmic
The minting system of coins such as DAI, LUSD, or agEUR is based in creating collateralized debt positions (CDP). In these cases the stablecoins are created as an exchange of locking some of the allowed crypto assets as collateral. Minting a stablecoin pegged to the USD against an asset such as ETH is equal to take a long position on the price of ETH against the dollar, since the value of the debt can decrease if the price of ETH falls, and the position could end up with the value of our borrow superior to the value our collateral. That situation could turn our debt from over-collateralized to under-collateralized, potentially making the protocol insolvent. That is why all of these CDP protocols have liquidation mechanisms that incentivize and prevent these situations.
Due to this mechanism, it is common that the supply of these stablecoins is largely reduced after large market downturns, due to both liquidations and a reduction in demand to open leveraged positions.
Although most stablecoin have a part of their mechanism creating supply algorithmically, Algorithmic stablecoins or Algo-Stables are referred to those such as FRAX or UST are minted by miting or burning their seigniorage tokens (FXS, LUNA respectively) when the price of their stablecoins are off-peg. We covered this mechanism in another of our blog posts. Henceforth we will cover how the stablecoins based on collateralized debt differ: which collateral and how much they use.
Collateralization Ratio
The collateralization ratio of a stablecoin is the value of the crypto assets that are locked as collateral divided by the total value of the circulating supply of the stablecoin. For example, Dai currently has over 165% collateralization ratio, which means that the assets that are locked as collateral (USDC, WBTC, ETH…) exceed 165% in value respect to the value of circulating DAI:
Knowing both this ratio and the composition we can quickly make a comparison of all CDP stablecoins:
All of these stablecoins have almost close to two times their market value locked in their protocols. High collateralization ratios have tradeoffs as well, the higher collateralized that a stablecoin is, the more stable its value is but the less capital efficient is the protocol. Capital efficiency attracts usage, since lower collateralization ratio allows users to have access to larger leverage. The stablecoin with the highest collateralization ratio is LUSD, this is a need due to being collateralized just by ETH, which is a very volatile asset. This brings us to the next key property, collateral quality.
Collateral Quality
Volatility is the worst enemy for these stablecoins. Since minting stablecoins is equivalent to being long in the asset deposited as collateral, when the collateral experiences large price moves, many of the CDP created are at risk of liquidation, and if not liquidated properly the stablecoin can become unbacked. This is exactly what happened to DAI in the March 2020 crisis, that ended up deciding to add a large part of USDC as collateral. Since USDC does not oscillate in value when ETH or BTC fall due to a centralized redeemability system to exchange USD for USDC, from a stability point of view it makes sense that these kinds of assets back many stablecoins (for example, 89% of FRAX is currently USDC). Although we know that BTC and ETH are volatile, it is helpful to compare them with something that seems less volatile like precious metals:
Sometimes the volatility of BTC or ETH is 2 or 3 times higher than these assets. The intrinsic nature of Cryptocurrencies makes them consistently more volatile than other asset classes like stocks, ETFs or precious metals. As a word of caution and exercise to the reader, one could imagine what could happen if a stablecoin would be collateralized with illiquid crypto assets with an insane volatility, such as NFTs.
Closing thoughts
After reviewing these key properties it is easier to understand that In the case of UST, the risk was double: it was only collateralized by LUNA, a highly volatile cryptocurrency that grew from nothing to $40bn market capitalization in just 1 year. The BTC backing did not enter into effect, and it appears that was used to market buy UST when it lost peg. Secondly, the collateralization ratio of UST depended solely on the market capitalization of LUNA. Before LUNA lost $50, there was a point where the market capitalization of UST was larger than LUNA, which would mean that UST is undercollateralized and will not be able to be fully redeemed by LUNA tokens.
It was not strictly necessary to dig deeper into the algorithmic mechanism that LUNA-UST offers and the potential death spirals that could happen, to at least hint at some potential instability risk on UST. Next time that you are contemplating on holding a new decentralized stablecoin, you will be able to hint at their stability by just checking both their collateralization ratio and collateral quality.
