How Do Stablecoins Maintain Sufficient Collateralization?

The Mechanics of Crypto-Collateralized Stablecoins

Are we escaping the grips of a long and dark crypto winter? With significant cryptocurrencies like Ethereum seeing a major bounceback, many of us are hopeful of a bull market and want to start investing again.

Furthermore, given that cryptocurrencies are incredibly volatile selling assets in a bear market can be difficult due to requiring liquidity. After all, no one enjoys needing to sell during a bear market to pay for immediate expenses only to miss out on the bull turn.

Additionally, moving assets between established banking systems and the novel DeFi protocols can be intricate and costly.

Luckily, stablecoins address both of these problems.

How Stablecoins Function

Since stablecoins provide stability by pegging to the most secure fiat currencies like the USD & EURO, they have the potential to be the foundational way to store value in crypto amidst a volatile environment. With stablecoin, you can have the best of DeFi, without being exposed to its immense volatility.

Sure, the buying power of the USD may vary over time, but nowhere close to how much Ethereum will. Similarly, fiat and commodity-backed (with gold) stablecoins are the most popular.

Overcollateralization: A Beginner’s Explanation

Stablecoin pegs rely on the fact that the reserve is an equal or greater value than the stablecoin in circulation. To keep all funds native to the blockchain, developers created an ingenious solution — over-collateralization. In short, a vault of cryptocurrencies always maintains a higher asset value due to smart contracts rules.

Whereas fiat-backed stablecoin organizations pledge to maintain $1 federal bank account reserves, it’s not always easy to know whether this is the case. There’s always the possibility that the stablecoin issuer lacks the adequate reserve to keep the peg. Government authorities do their best to audit and regulate fiat-backed stablecoins and crack down on firms that aren’t holding up their promises by misrepresenting asset allocation. Still, the audits are 100% perfect, and we’d recommend you do your research on top of audits.

Crypto over-collateralized stable assets solve this problem by storing all reserves on the fully transparent blockchain, so anyone can see how much crypto is locked in the organization’s smart contract vaults at any time. For this reason, crypto-backed stablecoins like DAI have a durable risk prevention architecture.

Stablecoin Use Cases

The primary use case for stablecoins is a personal store of value, like a bank account. It’s comparable to parking cash in a traditional investment account as you await an opportunity to invest. Or even to store your money until you need it in the future.

Although, if you’re looking for a low-risk, low-return option for storing your money, you could deposit your stablecoins into crypto lending and borrowing platforms like Aave or Compound and receive a decent yield (1–4% APY). These protocols are a popular choice among many in DeFi and one of the most prevalent use cases for the crypto-interested.

Since there are a seemingly infinite amount of high-risk investments in DeFi, the primary value proposition of most users for stablecoins is to control some of the risks amongst their whole portfolio.

Financial Opportunities of Stablecoins

The primary opportunity is to engage with the crypto wild west in the least risky way. Stablecoins could be the innovation that bridged the TradFi-DeFi gap for those looking to get started with crypto.

Suppose you’re contemplating getting into the DeFi space with stablecoins. In that case, you should know that risk is still involved, just considerably less than high volatility coins like Bitcoin, Ethereum & BNB.

If we had to summarize the riskiest stablecoins to avoid, it would be algorithmic stablecoins like MIM. We all experienced the tragedy of the UST crash and the number of people that lost their life savings in a stablecoin that wasn’t backed. The lesson to be learned is to ensure sufficient reserves back the stablecoin. If it’s not, then simply don’t invest in it!

Disclaimer: Although we reference “stablecoins,” we don’t claim that these assets will always hold their peg. We call SIKKA a stable asset, reflecting that it’s over-collateralization price stability has a few days lag time.

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