Onomy Protocol
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Onomy Protocol

Exploring Collateral Systems for Stablecoins

Stablecoins are the new heartbeat of the crypto economy. As more of the world’s financial entities begin their march on-chain, the need for value-pegged crypto assets is becoming more vital. So far, stablecoins have captured over $110 billion in value, with the trend further growing, even more so in times of market-wide value dips.

Despite their sheer popularity, there’s a knowledge gap on how stablecoins are collateralized and how they manage to maintain their peg.

95% of all stablecoins are asset backed — whether that’s by the corresponding fiat currency, digital assets, or by other financial instruments such as gold, stocks or bonds. On the other hand, 5% of stablecoins have no collateral at all. Rather, they are governed by algorithms whose express purpose is to maintain a peg through the systematic minting and burning of tokens.

Faith in the underlying system that gives the token its value is the core tenet that allows it to be transacted freely and deployed effectively through the blockchain economies they exist in.

Let’s dive deeper into the main forms of collateral sustaining stablecoin protocols.

Asset-Backed Stablecoins: Tradition in the Digital Age

Currently, the most common form of collateralization is through the use of “off-chain” collateral, which is usually fiat currency like the US dollar. A central institution that issues the coin guarantees its value by holding a corresponding value of currency or other ‘real-world’ assets in reserve. The core idea is that should a blockchain economy fail and the market rejects the price of fiat-backed stablecoins either in part or as a whole, the institution issuing the currency will pay out on the value of the token. In theory, this gives token holders trust that the asset’s value will not be lost, as there is a real world currency backing every token issued.

Of course, this throws open the doors to some considerable issues of trust that emulate similar problems in the world of global finance. There is little regulation that demands minters of stablecoins to provide proof that their holdings correspond to the amount of their token in circulation. As such, there is a fear that much like the banks in the 2008 crisis that precipitated Satoshi Nakamoto to launch Bitcoin, these institutions can over-leverage their reserves and push more tokens into the crypto economy, exceeding their reasonable real world value.

However, for the most part, stablecoin issuers who offer fiat-pegged stablecoins do allow audits, and there is some control and restriction over the flow of their token into the blockchain economy — but as ultimate control over the token still rests in centralized hands, there is nothing to stop malfeasance of governance leading to black swan events. Legislative bills are being introduced to better control this emerging market, but regulation is often a double edged sword dependent on the crypto prowess of those in office.

It’s also important to note that other stablecoins use assets that may have a shifting real world value. Gold-backed stablecoins, for example, may well suffer in value if the price of the metal drops. A collapse in the value of the stock market could put tokens backed by stock holdings under pressure. However, as these tokens peg themselves to a set amount of the metal, such as one token for one gram of gold, then holders of the tokens know what they are getting. Even so, the question of ultimate redeemability in case of catastrophic failure remains.

Crypto-Collateralized Stablecoins: A New Paradigm

A more novel approach to collateralization is through the use of other cryptocurrencies to guarantee the value of a stablecoin.

The advantages are quite clear — it’s possible to sidestep the issues of trust and malfeasance as the smart contracts that organize the collateralization are publicly viewable and mostly unchangeable.

Crypto-collateralized stable assets also fully migrate the creation and storage of value on-chain. For those who believe that cryptocurrency is the future of money, and that ultimately, on-chain value will represent most value that exists, such stable assets represent the clear way forward. This decentralizes control over value, but bridges between off-chain and on-chain value realization are not necessarily burned. Before the new paradigm of on-chain value is fully established, on-ramps and off-ramps for those wishing to move their fiat into stablecoins and vice versa are necessary, and Onomy Protocol will provide this option.

Opting to bridge the gap between CeFi and DeFi, Onomy Protocol is building a stablecoin economy that allows users to easily mint stable assets pegged to the world’s major currencies. Instead of collateralizing stablecoins via a basket of volatile digital currencies, Onomy’s Denoms will be backed by our native NOM token. NOM is endowed as the perfect collateral, granted that its initial value is to be determined via the Bonding Curve, a deterministic pricing model that issues NOM into the market at prices proportional to the amount of NOM that has been minted. Given its malleability, scarcity, utility, and inherent fairness, NOM backing is built to properly maintain the value peg of Denoms, which aren’t only collateralized by NOM, but also act as a vessel of collateralization for the backing token as adoption rises. This drives a feedback loop that directly controls the collateralization ratio.

By integrating lessons learnt from arbitrage trading and algorithmic stablecoins, NOM is minted and burned constantly to maintain the Denom pegs, with sufficient liquidity playing an essential role in maintaining the Denom peg. By building liquidity-backed bridges, the quality of the peg is enhanced, which creates a solid means of migrating the Forex market on-chain.

Another example of this system is having crypto, like Ethereum, placed into the pool in order to gain access to a stablecoin pegged to a notional value like the dollar in the form of a loan. Over-collateralization is required, and the loan withdrawn is frequently under the actual price of the asset, as this gives a buffer to the natural fluctuations of the market. There are fallback procedures in place too, with one being the creation of extra governance tokens that rule the asset pool managing the loans (which themselves have value) to back any shortfall. A final measure would be the liquidation of various stablecoins to stop any further minting of tokens until the collateral pool can match the value of the stablecoin out in circulation.

In Onomy Protocol’s case, token burns rather than liquidations will be implemented. The reasoning here is simple — in times of great market volatility, selling the underlying volatile asset can produce what is known as the ‘death spiral’, a black swan event that causes liquidation cascades, drastically reducing or even eliminating the asset’s value.

Another system used is asking users to buy the cryptocurrency that governs the protocol in order to then use it to produce another corresponding currency with the asset peg required, be that gold, Euros or US Dollars. In this way, users seeking to produce a cryptographic token of an asset are swelling the asset pool by their purchase of the token, and that asset pool then stands as a reserve of value to enable the crypto asset to be created and its value backed and stable. To maintain stability in the face of volatility, extreme over-collateralization is required — often upward of 10x. However, should the price of the governance token rise, then holders of it who have locked it away will be able to mint yet more pegged-assets. It can create an evolving economy due to the frictionless trade then possible between various pegged-assets, but it is restricted by the extreme disparity needed at first between value that is locked and value that is operable on the blockchain, potentially hindering the exponential growth made possible by on-chain migration.

Finally, there have been movements towards hybridised stablecoins that are backed through a combination of real-world assets and cryptocurrencies. Although initially bootstrapped using capital reserves and assets like government bonds and securities, over time — as on-chain transactions become the norm — more and more of the collateral will shift to crypto. The ultimate goal would be to “unpeg” this coin from the notional value of the dollar and allow it to exist at its own value peg based upon the overall assets accumulated in the pool.

Algorithmic Stablecoins: Novel Pursuits

A third and final way of denominating the value of stablecoins is through a purely mathematical method, where the protocol fights to keep its peg to a notional value through interaction with the open market. These algorithmic stablecoins have no collateral backing it whatsoever, so how do they keep their value?

One of the classic ways to do this is through Seigniorage Shares. First, the protocol establishes a baseline of shareholders. Then, once the stablecoin is above its peg, it mints new tokens and gives them to holders of these shares, increasing the supply until the peg is restored. If the coin is below its peg, it begins to sell off bonds in exchange for its own currency — effectively going into debt but, by burning the coins it receives in exchange for the bonds, it helps bring the peg back up to its desired value. To pay off the debt, bondholders outrank shareholders when it comes to distribution of new coins until the peg is restored. This creates a stable system, but there is one key flaw. The system needs to continue growing in order to keep the peg stable. If faith in the protocol breaks, either on an individual level or in the whole economy, the peg is easily broken and confidence in the coin fails.

Another way of doing this is by wider interaction with various parts of the market, buying and selling in a similar way to arbitrage bots or other high frequency traders to ensure the peg is maintained. If the coin goes above peg, the algorithm sells off assets it has in reserve to reclaim the coin until the peg is restored. If it’s too low, the algorithm mints new coins and uses them to restock the asset reserve to counteract the next time the peg fails. In this way, it functions a lot like a central bank by battling to keep the peg in place, with the difference that governance is orchestrated by holders of a governance token rather than a central institution.

So far, algorithmic stablecoins have had mixed success. The primary issue is that because they are directly interacting with the market and are relying on it to fight for their peg — and they do not have the colossal reserves or institutional power of central banks engaging in the same scope — then they are particularly fraught with danger from the seesawing of the market. Several have so far broken their peg, while other recent coins have had more success.

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Onomy Protocol

Onomy Protocol

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Offering the infrastructure necessary to converge traditional finance with decentralized finance.