Beginner’s Guide to DeFi: Stablecoins
The greatest trick cryptocurrency ever pulled was convincing the world it was all meant to be currency. Many have stumbled over this misconception. It is probably the most profitable misnomer in the history of speculation, especially since 2019 when DeFi began quietly snowballing into the juggernaut it is today.
When most people first get into crypto they find it through Bitcoin. Bitcoin makes sense to new entrants. It’s a digital currency. You can use it to buy goods or services. For much of the 2017/18 bull run prices rose on news of adoption as retailers started accepting crypto for payment. Subreddits were full of pictures of businesses accepting crypto or setting up Bitcoin ATMs, using this as proof mass adoption was coming.
Wading a bit deeper into the weeds got more confusing. Is someone really going to accept Sia as payment for a taco? Is Golem really going to be used as a currency? With over a thousand cryptocurrencies at the time it looked impossible to select the best one. There was, and still is, a fundamental misconception of the term cryptocurrency. One could argue every token is used as a ‘currency’ within their native ecosystem. But everyone intuitively knows any valuable currency is, in a way, Turing Complete, it can be used to buy ANYTHING, not just file storage space.
This shortsighted focus on digital assets being ‘currencies’ led many traditional minded investors to dismiss the space. Questions like ‘How many digital currencies are needed?’ and ‘If a new currency is created everyday is the space truly non-inflationary?’ were prominent but missed the bigger picture of what was to come: digital assets and decentralized finance. The cryptocurrency misnomer let retail front-run the suits and ‘smart’ money.
To capitalize on this misnomer it’s important to understand how we got here. This article focuses on the first foundation of DeFi: Stablecoins.
Fiat Collateralized Stablecoins
The early crypto space was widely viewed by mainstream participants as a place for anarchists, criminal endeavors, and money laundering for drugs. Early crypto exchanges were unable to obtain banking partnerships and therefore lacked access to government issued currencies like the dollar. With no reliable way to store users’ fiat, Crypto exchanges since Bitcoin’s inception through around 2017 were almost exclusively denominated in Bitcoin (e.g. ETH/BTC or LTC/BTC). This skirted the issue of banking agreements but left an unfilled need for those participants wanting to enter and exit the system.
In 2017 USDT, or Tether, rose to prominence as a way to reliably transact in US Dollars on-chain and on exchanges. Tether is a cryptocurrency guaranteed to be fully backed one-to-one by US dollars. The dollars are custodied by Tether Limited who manages the onchain minting of USDT when dollars are deposited with them and the onchain burning of USDT when Tethers are redeemed for cash. Tether earns fees by parking the custodied fiat in “risk-free” bonds and taking a fee when Tethers are minted or redeemed.
With USDT’s great success the crypto space saw several alternative fiat backed stablecoins emerge with similar minting and redemption mechanisms: USDC (managed by Circle), GUSD (managed by Gemini), BUSD (Binance), and others. Like USDT, all of these dollar-backed stablecoins are guaranteed by their issuer to be redeemable for the underlying fiat.
These fiat collateralized stablecoins fill many rolls: a stable means to transact across borders/exchanges/blockchains, a stable hedge when speculators expect price declines in crypto, a means to enter and exit the system, and a pristine collateral in DeFi endeavors.
Unfortunately this system relies on centralized entities to safely custody the fiat. Any hiccup by these centralized parties risks breaking the 1:1 peg. This threat is not just hypothetical, Tether briefly ran as a fractional reserve (not backed 1-to-1) after one of their vendors lost a significant amount of funds. For an unknown period of time 1 Tether was only backed by $0.74. Fortunately Tether remedied this and their auditors report USDT is now fully backed by US Dollars.
There are other threats too. Draconian regulation could hamper fiat collateralized stablecoins’ ability to be fully fungible. Currently Circle and other issuers are only allowed to mint and redeem coins with fully KYC/AML compliant wallets and, while unlikely, it’s not inconceivable that legislation could be passed where only KYC/AML compliant wallets are allowed to transact in fiat collateralized stablecoins at all. A trustless digital dollar was clearly needed.
MakerDAO and Crypto Collateralized Stablecoins
USDT’s loss of the 1–1 fiat peg raised an important question, if Cryptocurrency is supposed to be trustless and decentralized, how do we create digital dollars with no 3rd party risk? Enter MakeDAO, the first project to solve the problem of decentralized stablecoins.
MakerDAO is arguably the first successful DeFi project. While other DeFi projects preceded Maker (TheDAO of 2016, some 2017 ICOs) the majority of them are irrelevant today. Maker is a DeFi protocol that trustlessly issues Dai, a stablecoin pegged at $1. Dai distinguished itself from USDT, USDC, and others by its stabilization mechanism. While USDT is a fiat-collateralized stablecoin, Dai is a crypto-collateralized stablecoin.
With USDT a user deposits fiat into Tether Limited and in return receives USDT. With Dai a user deposits cryptocurrency, like Ether, into the MakerDAO smart contract and receives Dai in return. This is what makes Dai a crypto-collateralized stablecoin: it’s backed by onchain crypto assets instead of offchain assets.
Whereas with fiat backed stablecoins the liability of maintaining the peg rests entirely on the issuer (Tether Unlimited, Circle, etc) with Dai this liability falls on effective design of the Maker protocol. With a fiat backed coin maintaining peg is fairly straightforward: only issue coins if you’ve been given dollars, only burn coins if dollars have been redeemed, and don’t lose the fiat. When the collateral backing the stablecoin is highly volatile, as with Dai, maintaining the peg requires some engineering.
traditional loans use banks to lend money to borrowers who promise to pay back the money with interest. Generally there is some sort of collateral such as a car, home, or future earnings offered by the borrower that the bank can seize should the borrower fail to repay their loan. In a mortgage loan, for example, the property being bought with the loan is the collateral. If the home-buyer fails to pay their loans the bank takes ownership of the home from the borrower and sells the home to recoup their losses. Crypto collateralized loans are no different.
To mint (aka borrow) Dai users deposit cryptocurrency (i.e. collateral) worth more than the amount of Dai they wish to borrow into the smart contract. For instance, if a user has 1 Eth worth $1,000 they can take a loan of 500 Dai worth $500. This makes the loan over-collateralized, the value of the collateral (Eth) is worth more than the value of Dai borrowed. This over-collateralization is essential for maintaining peg.
In order to keep Dai pegged at $1 there are a number of stability mechanisms used by the Maker protocol. As discussed with Tether, if there is less collateral in the reserves backing the stablecoin than there are stablecoins issued then the system is not acting as promised; it is no longer a solvent, full reserve asset. For Maker this means the value of the collateral in the smart contract must ALWAYS be worth more than the amount of Dai outstanding.
Maker avoids becoming under-collateralized by liquidating loans that get close to being under-collateralized. So if the Ether backing that 1 Eth loan for $500 starts to drop in dollar value users must take action to avoid having their Ether sold by the protocol by either repaying the loan or depositing more collateral. Just like how cars will get repossessed if borrowers don’t pay their car loans, Maker borrowers can have their cryptocurrency sold for Dai at auction if they don’t maintain enough collateral in their loan.
In addition to liquidations, other mechanisms are used to insure Dai maintains its $1 peg such as variable interest rates on loans (rates go higher when Dai is above $1 and lower when Dai is less than $1), MKR dilution to backstop the system in crisis, and mechanisms involving arbitrage and use of MakerDAO fees.
Over 3+ years the MakerDAO and Dai system have been wildly successful, surviving numerous market crashes including Black Thursday March 12, 2020. With its success have come numerous copycats and re-imaginings like Unit Protocol (USDP), Vesper (Vai), Liquity (LUSD), Waves (USDN), Terra (UST), and others. These protocols offer slight variations on the crypto-collateralized stablecoin offered by Dai. Some have lower liquidation levels while others have mechanisms that do not require over-collateralization (USDN and UST).
In the world of stablecoins, fiat-collateralized coins are like egirls. They’re the best digital representations of a physical girl allowing for value creation in the metaverse. Crypto-collateralized coins are like waifus. Wholesome and versatile, ethereal but real, completely existent in the metaverse with no physical version of themselves. Then there’s algorithmic stablecoins which are the catfishing Tinder girls who are actually balding men using elaborate filters to appear as though they are the real thing. They violate the spirit of money in nearly every way imaginable.
Examples of Algorithmic stablecoins include Ampleforth, Dynamic Set Dollar, DIGG (Badger’s algorithmic stablecoin tracking Bitcoin), and Fei Protocol (which is actually partially collateralized).
Whereas the previous stablecoin systems use collateral to peg coins to $1, algorithmic stablecoins change their supply in an attempt to peg to $1. The idea is that arbitrageurs will buy and sell the algorithmic stablecoins to maintain the peg. If the price is trading over $1 then arbitrageurs will sell the coin until it reaches the $1 peg. If the price is below $1 then arbitrageurs will buy the coin until price is $1. However If these mechanisms fail to maintain the peg then the protocol alters the supply of the coin to match demand. If the price is above $1 more coins are created in every holders’ wallet and if price is below $1 coins are destroyed from every holders’ wallet.
The key here is that the created and destroyed coins come straight out of holders’ wallets. So if a user holds 100 Ampleforth and the coin is trading at $1.01 each when a rebase occurs, after the rebase the user will have 101 coins worth $1 each. Alternatively, if a user has 100 coins trading at $0.99 each, after the rebase the user will have 99 coins theoretically valued at $1 each.
Unfortunately this mechanism has failed to provide price stability. AMPLE, DSD, ESD, FEI and others have all lost peg to the downside resulting in significant losses for holders. Inducing demand is very difficult for a brand new asset. The market so far has shown that it does not trust algorithmic, unbacked stablecoins to hold peg. Banks can run as a fractional reserve because they have the trust of their depositors and the backing of the federal government (FDIC deposit insurance acts as a type of peg in this case). Algorithmic stablecoins have no such trust and no such guarantees.
The book is not finished on algorithmic stablecoins however. Fei and others have introduced partial reserve and coupon systems in an attempt to backstop the $1 peg. Most likely, these changes to the design will make algo-stablecoins just like crypto-collateralized coins but with extra steps.
Thoughts on system liability and auditability
As a parting thought on stablecoins it’s interesting to consider who is liable for maintaining peg and if they can be audited. With fiat backed stablecoins like Tether the liability for maintaining peg lies solely with the issuer of the stablecoin. Issuers are obligated to faithfully custody the fiat backing the coins they mint. Auditing these third party custodians has proven quite difficult and requires a high degree of trust by users.
With collateral backed stablecoins like Dai the liability for maintaining peg is far more complicated but the transparency of the backing is far superior. The Maker Protocol in aggregate oversees maintenance of the peg but this protocol is composed of many moving parts such as smart contracts, oracles, keepers, auctions, and the Ethereum blockchain itself. While Maker survived the 2020 Black Thursday crash it was not without hiccups. Several loans were liquidated with keepers paying 0 Eth for the collateral at auction. Maker made whole the liquidated CDP owners by minting and selling MKR (the protocol coin). This makes MKR holders the ultimate backstop of the system. Maker has since patched the bug.
Transparency on Maker collateral, however, is instantly auditable in real time. Numerous sites offer real time health metrics for the entire Maker system. The real time auditability of crypto collateralized stablecoins help make them strong competitors to their less auditable, more centralized counterpart.
Algorithmic stablecoins have nothing to audit and essentially no one to hold liable. An argument could be made that the code and devs who wrote it are liable but in general the code is not the reason why algo-stables can’t hold peg, they can’t maintain peg because of a lack of trust and adoption in a fugazi asset.
This was part one of a multipart series on understanding DeFi. In the next article I will discuss lending platforms as a vital pillar of the DeFi landscape.