Over-Collateralized Stablecoins: The Crypto Potential “Safe Haven” the Market Needs
Disclaimer: Although we use the terminology “stablecoin,” 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.
Following the catastrophe of Terra’s UST, the market is seeing a surge in demand for over-collateralized stablecoins such as DAI. With a new over-collateralized USD stable asset launching on the Sikka protocol powered by Polygon, the DeFi market is about to enter a new era.
The sudden fall of UST value from $1 to almost $0 raises concerns about how the crisis may have been avoided. Understanding all of the nuances and inner workings of the many stablecoins might be difficult, but it can assist in understanding which ones face a higher risk of peg loss than others.
Stablecoins may be backed by cash (or currency equivalents) by centralized protocols like USDT or USDC or by crypto assets like DAI, MIM, FRAX, etc. Regardless of the methods employed to fix their price, they all trade publicly, and their parity to the dollar swings slightly constantly. In contrast, the risk in centralized stablecoins results from the stablecoins issuer’s solvency related to the fundamental economic model that stabilizes the system.
Algorithmic versus Collateralized Debt
The formation of collateralized debt holdings is the basis for the minting procedure for currencies such as DAI, LUSD, and agEUR (CDP). Stablecoins are created in these situations by locking a portion of the permitted crypto assets as security. Creating a stablecoins that is linked to the US dollar versus an asset like ETH is equivalent to taking a long position on the price of ETH against the dollar because the value of the debt can fall. If the price of Ethereum declines, the position might be worth less than the amount borrowed being greater than the value of the collateral. This circumstance might cause the debt to become under-collateralized, thus bankrupting the protocol. As a result, all of these CDP protocols have liquidation mechanisms to both reward and avoid such occurrences.
Because of this process, it is usual for the supply of these stablecoins to be significantly decreased during big market downturns due to both liquidations and a decrease in desire to establish leveraged positions.
Although most stablecoins contain an algorithm that creates supply, Algorithmic stablecoins or Algo-Stables are created by minting or burning their seigniorage tokens (FXS, LUNA,e.g.) when the price of their stablecoins is off-peg.
Ratio of Collateralization
The collateralization ratio of a stablecoin is the value of the crypto assets locked as collateral divided by the entire value of the stablecoin’s circulating supply. For example, Dai now has a collateralization ratio of more than 165%, which indicates that the assets locked as collateral (USDC, WBTC, ETH…) are worth more than 165 percent of the value of circulating DAI.
These stablecoins have almost doubled their market value locked within their protocols. High collateralization ratios have downsides as well; the more collateralized a stablecoins is, the more stable its value is, but the protocol is less capital efficient. Capital efficiency encourages utilization since a lower collateralization ratio enables consumers to access more leverage. LUSD has the highest collateralization ratio, which is required since it is collateralized only by ETH, which is a very volatile asset. This takes us to the second important characteristic, collateral quality.
Quality of Collateral
Volatility is the worst enemy of these stablecoins. Because minting stablecoins is comparable to being long on the asset used as collateral, many of the CDP minted are at risk of being liquidated. If the stablecoins is not properly liquidated, it may become unbacked. DAI experienced exactly this in March 2020.
Regardless of the breakneck speed of growth, the crypto and stablecoins markets are still in their infancy. Adaptation and innovation, like anything new, are required to address flaws and improve systems to make them more sustainable and secure. Through MATIC over-collateralization, Sikka intends to bring such innovations to the market in order to re-establish trust in stablecoins as a viable transaction and savings instrument.