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Author’s note: this article continues Republic's and Byzantine Solutions' introductory series on everything an investor needs to know about decentralized finance. This series supplements Byzantine Solutions’ recently-issued report, Redefine 2020: A Primer, by breaking down individual groups of DeFi instruments. This article (and the rest of the series) is supplemental reading for attendees of our Blockchain 101 and Intro to Defi webinars.
Introduction
Fiat money and its digital representations are a great medium of exchange for everyday transactions. A very helpful property of fiat is that its purchasing power does not drop overnight, at least on most nights, because the sovereign nations or organizations that issue fiat currencies maintain monetary policies to counteract inflation and deflation .
This enables fiat to function as both a unit of account and a hedge against uncertainty. If you hold $5,000 or quote a client $5,000 payable in two months, you can be reasonably confident about the amount of goods and services that you'll be able to afford with that $5,000. You cannot place this same confidence in volatile crypto assets.
Having a stable currency is especially important for borrowing and lending, which was the topic of our previous article. Money markets—outside of loans for short-term speculative positions—need loans denominated in stable currencies and can only exist at scale when they're based on deposits in stable currencies, which allow low-risk, fixed-income mass-market investments.
The assets that serve this role in DeFi are called "stablecoins." The blockchain world offers two approaches to stablecoins:
1-to-1 USD-backed assets, largely centralized by their nature. USD-pegged coins are easy to design and produce, and ultimately rely on the reputation of registered companies and legal enforcement.
Algorithmically stabilized assets without central parties or links to anything off-chain. These are known as DeFi stablecoins, decentralized stablecoins, or algorithmic stablecoins.
Centralized stablecoins have a long-standing presence, both for their relative reliability and for historical reasons. Many centralized crypto exchanges do not exchange crypto into fiat, so stablecoins act as a proxy for fiat. Historically, only centralized stablecoins have been well-understood and available at scale.
Decentralized finance has to run on a different kind of stablecoin—crypto-native, decentralized, market-driven, and free from corporate control. Should one of the major centralized stablecoin projects lose its legal footing (or should the company behind it fail), it may spell the doom of any DeFi projects using its coins as collateral or means of liquidity provision. DeFi stablecoins would provide a more stable foundation. While stablecoins are not backed by the credit of a government and therefore may not be truly stable,considerable progress has been made.
Problem Statement and Mechanisms
Over the years, many attempts to implement a decentralized stablecoin have been made. The core concern is how to maintain the coin at a stable value, given that it is being traded on an open market. Stability is universally defined through a target currency (most often, the U.S. dollar), and the link in currency value is called the peg. When the stablecoin fluctuates below the peg, it needs a floor value and/or a mechanism that would contract the supply to compensate for the value drain.
Attempts at stable reserve cryptocurrencies run into a chicken-and-egg of problem: a given currency is either volatile, or stable because of centralized backing. Therefore, a DeFi stablecoin has to be un-backed, or collateralized by a volatile asset, with market mechanisms to shield the coin from the volatility of that asset. Reserve by a multi-currency basket is possible, but it will be as volatile as its constituent currencies, proportionate to their relative weights in the allocation.
There are three principal approaches to stabilization that have been explored to date: the collateralized debt model, seigniorage share, and profit/loss consumption.
Collateralized debt models
The collateralized debt approach, pioneered in practice by MakerDAO and its DAI stablecoin, uses oracles and overcollateralized debt positions. A user deposits collateral in ETH (other assets were added later on) and can mint some DAI stablecoin as debt, with a 150%+ ratio of collateralization. If a position goes under that target number, it can be liquidated by arbitrary market agents (with the DAI taken off the market and burned), thus regulating the supply. This mechanism covers both drops in collateral value and growth in the stablecoin value (to some extent).
Two more mechanisms that can be employed are stability rates and governance token auctions. Stability rate is the rate on the debt that DAI issuers owe to the system. Adjusting it (through governance votes) can drive position owners to open or close their positions, as they compare the rate they have to bear against the return they can make on the DAI, thus driving the supply of DAI in the corresponding direction.
Governance token auctions are a last-resort measure to recapitalize the system if it encounters a black swan event it cannot naturally recover from: if the governance chooses to mint and auction more governance token, it can increase collateral and decrease the stablecoin supply by making every governance token holder take a hit, enacting a bailout of sorts. Maker, in particular, has had several of these events, which were successful.
Seigniorage share
The second approach is reminiscent of how some central banks manage national currencies. It uses one or more “I owe you” (IOU) assets that represent future issuance (not unlike a Treasury bond) and tries to manage the peg of the stablecoin by expanding and contracting the stablecoin supply with IOU (bond) auctions.
For instance, if the stablecoin depreciates too much, the system may issue and sell off some IOUs, collecting the stablecoin as payment and burning it, thus contracting the money supply and boosting the stablecoin's value. Conversely, if the stablecoin goes above the peg, the system increases its supply by minting new stablecoins and distributing them between the holders of the IOU asset.
There are three issues that seigniorage share projects may run into:
Regulatory positioning
It could be argued that the IOU asset is very reminiscent of a security, so its regulatory status is rather unclear. In a traditional finance setting, the best-case scenario is that this would limit the size of the potential audience— unregistered securities ownership has to be tied to known persons or institutions, with non-accredited individuals shut out of trading in novel/risky securities. However, introducing KYC checks to implement the legally-required restrictions would defeat the purpose of DeFi, so this may be a deal breaker. One of the best-known projects using this model—Basis—could not launch because of the SEC classifying their bond tokens as securities.Fallback value
A “pure” seigniorage share model that doesn’t use any kind of collateral may not survive a flash crash. The stablecoin may go below the peg for any number of reasons—e.g. if someone buys a lot of Bitcoin with it on an open exchange. In cases like this, the stablecoin's ability to recover depends solely on the belief of potential IOU buyers that it would recover and that the IOUs have positive NPV. If that fails, the stablecoin value will undergo a positive feedback loop that can drive it to 0.Correction size
Since the key systemic action here is issuing an appropriate amount of IOUs, the system has to make a very good estimate of the required adjustment to the money supply to recover the peg. The other two approaches to stabilization have shorter iterative loops, so they don’t have to rely on theory. The seigniorage share model, on the other hand, needs to make an informed decision that will have decisive economic consequences.
Due to these reasons (with #2 arguably being the most serious), pure seigniorage share model stablecoins haven't had much traction as of late. There are, however, hybrid models. For instance, Frax starts off fully collateralized with other stablecoins, with a planned reduction in reserves as the money supply grows and its stability becomes progressively more assured.
Profit/loss consumption
PL consumption has two types of coins: the stablecoin itself and a number of volatile coins that capture and isolate volatility from the stablecoin. Both types are collateralized with the same volatile asset. The trick is in the continuous reallocation of collateral between stable and volatile coins in order to maintain a constant reserve for the former.
The simplest example would only consist of two coins: a stable one and a volatile one. The stablecoin is always redeemable for its target peg value, and the collateral can always be drawn from the volatile coin. The corollary of that is that the peg on secondary markets is maintained through arbitrage—when the price is higher than the peg, it is profitable to buy the stablecoin on secondary markets and redeem it in the system, and vice-versa.
A reference project for profit/loss consumption is Money-on-Chain: it uses BTC as the volatile collateral and has three types of assets in the system:
The stablecoin itself, always collateralized as described
The volatile coin, representing a 2x leveraged position in BTC (and therefore bearing the risks that recollateralize the stablecoin if BTC loses value)
And the collateral token that offers yield on BTC and, in exchange, extends the collateral base of the system without introducing leveraged exposure
Stablecoin projects based on profit/loss consumption are somewhat simpler than the other two designs. However, they target multiple audiences at the same time, and need traction with each of them in order for the system to be able to afford the target supply of stablecoins.
Conclusion
As of this time of writing, the market cap of decentralized stablecoins is quite modest—around 5% of the overall stablecoin market. But it is there, and the biggest DeFi stablecoin holds the first place in Total Value Locked among the on-chain DeFi protocols, with almost $7 billion in collateral.
DeFi stablecoins are a vital component of the decentralized financial ecosystem. Being of reliable stable value, they can be safely used as an everyday payment vehicle or а retail-grade investment medium. Moreover, stablecoins are ideal collateral for other, more complicated financial instruments, since they do not introduce additional exposure.
A long history of algorithmic stablecoins has been amazingly fruitful in fuelling tokenomics research and mechanism design, giving rise to many great concepts and projects. This is an ongoing, sector-wide evolution, so we expect many more interesting innovations on the road to a stably-valued backbone for the DeFi ecosystem.
This educational article is provided by Republic to help its users understand this area of the market, it should not be construed as investment advice as it is impersonal, disinterested and was produced by Republic's users, without remuneration received or expected.
