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Decentralized Collateralized Stablecoins

April 22, 2022

Adam Wise

Decentralized Collateralized Stablecoins

Today, we take an example of how a collateral-backed stablecoin in DeFi can be issued by anyone and how the peg is maintained. We start with how they are issued, including context from traditional finance.

The two largest stablecoins in crypto by market cap (USDC and USDT) are backed by assets off chain. However, a range of stablecoins employ alternative methods to track a fiat currency, and most of them were created in the world of DeFi.

Issuance

In traditional finance, investors can borrow against securities. The securities are pledged in a separate brokerage account, with debt often issued at a variable rate, and there can be conditions to how the borrowed funds are used. Should the value of the collateralized securities fall below a certain value, they would be subject to liquidation.

In DeFi, the basic premise remains. However, stablecoins are ‘minted’ against a locked collateral token.

For example, an investor has a long-term bullish view on ETH but needs USD liquidity. ETH can be deposited into a smart contract, and a stablecoin can be minted from that collateral. For highly liquid tokens such as ETH, investors can mint stablecoins worth 60-80% of the collateral’s value.

The process is permissionless, and anyone with eligible collateral tokens can mint these stablecoins. They can also do anything they wish with them. Interest rates are charged whilst the stablecoin is in circulation, and an issuance charge may apply. The process is reversed to reclaim the locked collateral from the smart contract, which includes the repayment of accrued interest.

Liquidity

Deep liquidity on decentralized exchanges is essential to maintain the peg. The benefit to the stablecoin itself is the ability for investors to arbitrage any differences and bring the token’s valuation back in line. Investors are incentivized to provide this liquidity by the venue, often placing the stablecoin in a pool to swap against DAI, USDC, and USDT in return for a reward and share of trading fees.

The backbone for stablecoins in DeFi is Curve. Its automatic market maker pools offer around USD 20bn in liquidity on Ethereum across both stablecoins and non-stable tokens.

To dive deeper into Curve: https://resources.curve.fi/

Collateral

DeFi offers flexibility in the collateral used. An important development has been the use of tokenized strategies as collateral. Rather than depositing a 'static' token, investors can still receive a strategy's potential upside while borrowing against it.

An example of this would be tokenized staked ETH (e.g., stETH token) – rewards for the ETH being staked are still received, and stablecoins can be borrowed against it. As highlighted earlier, the issuance of these stablecoins is from a position of overcollateralization.

For further information on stETH: https://lido.fi/

Liquidations

If the collateral's value falls below the liquidation threshold, it will become eligible to open liquidations. Anyone can liquidate the position and receive a bonus, usually via a discount on the collateral's fair market value. These operations are automated on-chain via smart contracts. The stablecoin is used to perform any liquidation.

As with everything in DeFi, it is up to investors to manage their positions – there is no broker to call you!

Potential Issues

The obvious risk for any stablecoin is that it unpegs from the currency or asset it is trying to track.

Several factors could directly or indirectly lead to this scenario:

  • Liquidity – lack of liquidity to arbitrage price stability versus other stablecoins.
  • Collateral – Inability to liquidate the collateral backing the issuance.
  • Smart contract – Bugs or hacks. Example: bug that allows the minting of the stablecoins from low-quality or valueless tokens.
  • Oracle – Collateral incorrectly priced due to manipulation or error.
  • Sentiment – Lack of belief in the stablecoin's ability to remain pegged could create a vicious cycle of selling pressure.

This is a non-exhaustive list of risks. The design specificities of any stablecoin will also inherit specifically related risks.

Conclusion

Decentralized collateralized stablecoins are just one example of the exciting innovation occurring on-chain. DeFi remains the youngest and fastest-moving space within financial markets – with that comes risk.

The best way to learn is to get involved but only invest an amount you can afford to lose.


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