Written by: Aaron Guan
Though it is not crypto’s sexiest topic, stablecoins represent as one of the most important intermediaries that bridge the stability of traditional FIAT currency with expansive blockchain technologies. As cryptocurrencies are volatile, stablecoins allow individuals to interact with blockchain products, such as DeFi applications, with significantly reduced risks. Despite the widespread FUD generated from Terra Luna’s fall, the collapse was the product of its uncollateralized nature—relying on algorithms designed to keep the Terra USD (UST) peg through arbitrage with the Luna governance token. Consequently, most investors remain confident in collateralized stablecoins like USDT, USDC, and Dai. In this article, we will discuss the two primary types of collateralized stablecoins: off-chain and on-chain.
Off-chain collateralized stablecoins function exactly as its name implies—being backed by assets like cash and treasury bonds that exist outside of blockchains. Most issuers of off-chain collateralized stablecoins promise a 1:1 redemption of their tokens with respective real-world assets (e.g., redeem 1 USD for 1 Token and vice versa). Usually, these stablecoins peg to the USD through arbitrage, where market participants redeem and convert tokens according to exchange pricing. When the stablecoin’s market price goes above the 1:1 peg, individuals can profit by converting USD to stablecoins with the issuer and sell the stablecoins for a higher price on an exchange. If the price goes below 1:1, people can buy the stablecoin on an exchange at a discount and then redeem their tokens for USD with the issuer. For the arbitrage-stabilizing mechanism to be effective, the market needs to trust in the token’s ability to maintain its peg. If such trust is lost, stablecoin holders will rush to redeem their tokens for USD from the issuer—leading to a bank run-like situation. Moreover, if the issuer lacks liquidity for USD reserves, they may be forced to sell collateral assets at a discount. From there, the situation’s FUD will lead to a further devaluation of the stablecoin.
Therefore, to maintain the requisite trust, issuers which manage assets backing stablecoins must prioritize reserve transparency and liquidity. Currently, the two largest off-chain collateralized stablecoins are Tether’s USDT and Circle’s USDC. Though similar in structure, Tether’s earlier inception means that it remains as the more popular of the two in total value locked ($87.48 Billion vs $24.12 Billion)—making it more widespread on exchanges due to stronger liquidity. However, Tether has seen a fair share of controversy in the management of its collateral reserves. For instance, Tether was found to have used $850 million of reserve funds to fill a hole in their sister company Bitfinex’s balance sheet—resulting in fines totaling $42.5 million from the Commodity Futures Trading Commission (CFTC). Though Tether now offers assurance reports, some investors have since lost trust in its ability to effectively manage collateral assets.
Circle’s USDC is viewed as a trustworthy alternative to USDT as collateral reserves are made transparent through public declarations of banking partners (e.g., Blackrock, BNY Mellon), monthly attestations, and annual audits. However, despite its increased transparency, USDC remains exposed to risk factors. For instance, USDC lost its peg in March, falling to a value of less than 90 cents as holders rushed to redeem USDC for USD, when people realized that ~8% of Circle’s collateral reserves were held in the collapsing Silicon Valley Bank (SVB). Fortunately, USDC’s peg was able to recover when Circle confirmed that its deposits would be made whole. Nonetheless, both Tether and USDC’s controversies and depeg episodes demonstrate the underlying risk of a centralized model of collateral reserve management.
Thus, on-chain collateralized stablecoins represent as the decentralized alternative to Tether and USDC—allowing for a code-based, “trustless” management of collateral. The most popular on-chain collateralized stablecoin is Dai—the USD-valued token that powers the “Maker Protocol” built by the decentralized autonomous organization (DAO) MakerDAO. For context, a DAO is an on-chain organization governed by code, where holders of its governance token vote on various proposals. The MakerDAO’s governance token is the MKR, and MKR holders vote on the way that the Maker Protocol is run, with voting weight proportional to amount of MKR staked in a voting contract.
The Dai stablecoin is produced/minted on the Maker Protocol when users put up on-chain assets, such as Ethereum and USDC, as locked/vaulted collateral—making it akin to a traditional loan. To ensure that the MakerDAO’s collateral reserve could confidently back the Dai supply, the Maker Protocol utilizes a system of overcollateralization, where the value of the collateral assets exceed the value of Dai minted—enforcing a minimum collateral to Dai ratio of ~150% (e.g., $150 Eth can mint maximum of $100 Dai). Should the value of the collateral used to mint Dai depreciate and fall below a “Liquidation Ratio” determined by MKR voters (~110% collateral to Dai), the assets will be unlocked and auctioned off, with “auction keepers” using Dai to bid for the collateral. Then, Dai received from the auction will be used to cover outstanding obligations of the collateral’s previous owner. If there is enough Dai bid in the collateral auction to cover the outstanding obligations, the maker protocol will accordingly sell only the required amount of collateral—allowing for excess assets to be returned to the original owner.
To maintain Dai’s 1:1 USD peg, MakerDAO relies on both arbitrage and adjustments to the Dai Savings Rate (DSR). Like off-chain collateralized stablecoins, there are financial incentives for the market to push/pull Dai to its peg. When Dai trades above $1, individuals can mint Dai by putting up collateral and then selling the newly minted Dai on an exchange for profit. When Dai trades below $1, debtors with locked collateral would buy Dai at a discount to pay back their loan—driving Dai demand. As a secondary peg mechanism, the MKR governance token holders accordingly adjust the Dai Savings Rate (DSR) to balance Dai’s supply and demand. For context, the DSR is funded by the “stability fees” that debtors pay when they return/burn Dai to unlock collateral (e.g. avg stability fee of 3% can fund a DSR of 2%). Therefore, when Dai averages above $1, MKR holders can vote to decrease the DSR—reducing market demand and pulling Dai to $1. When Dai averages below $1, MKR holders can vote to raise the DSR—increasing market demand and pushing Dai to $1.
Combined, Dai’s overcollateralized nature and systems of ensuring the USD peg has propelled it into a premier stablecoin, with some regarding it as more trustworthy than USDT or USDC. Moreover, its protocol’s legitimacy means that the MakerDAO hosts the third largest DeFi platform—with a total value locked of $6.2 billion. Still, Dai remains exposed to centralized risk factors due to its reliance on USDC as collateral. For instance, when SVB went under, the resulting FUD meant that Dai briefly traded at 90 cents.
Overall, notwithstanding teething issues, collateralized stablecoins remain as the most risk-averse way to interact with DeFi. With the diversity offered by both on and off-chain collateralized stablecoins, participants can pick and choose the token they align with. Moreover, MakerDAO’s Dai is proof that decentralized autonomous organizations can effectively manage complex economic systems and vote on protocol changes. As the world of cryptocurrency and blockchain continues to evolve, collateralized stablecoins represent as the industry’s pillar of stability—acting as the middle ground that supports movement towards wider DeFi adoption.