As envisioned by experts, cryptocurrency is an independent monetary system that can replace traditional finance. Stablecoins (cryptocurrencies linked to the U.S. dollar) are still widely circulated on the blockchain today. According to Coingecko, stablecoins usually account for more than 50% of the daily trading volume of cryptocurrencies. However, less than 10% of the total market value of cryptocurrencies is made up of stablecoins; they may be used more as a medium of exchange between assets than as a store of value.
Most of these tokens are issued by a single legal entity and have centralization risks that many DeFi users aim to avoid. But what if we can decentralize the stablecoin itself? easy to say, hard to do. Many agreements have proposed various innovative mechanisms to create such decentralized stablecoins, but few survive.
Staying anchored does not equal growth
The above chart depicts the supply of stablecoins that have a relatively stable anchor as of today. Even those stablecoins that have survived cannot be said to be successful, because price stability is only one of the pillars of growth. To be successful, the stablecoin protocol must achieve the three growth goals of liquidity, stability, and user adoption.
This research article delves into the data, details our elusive search for the perfect stablecoin model, and provides some lessons on how the protocol achieves the three goals of liquidity, stability, and user adoption.
Different stablecoin models
Although there have been many iterations of different stablecoin protocols, most of them have similar characteristics. This is my commonly used classification framework for thinking about the broad field of decentralized stablecoins. Please note that certain technical parameters and mechanisms differ between protocols of the same category.
Redeemability refers to the ability of users to exchange stablecoins for equivalent assets.
MakerDAO is a fully-reserve stable currency protocol linked to fiat currency. Someone deposits reserve assets (such as ETH) into Maker. He can then mint DAI based on the dollar valuation of the asset. Most cryptocurrency assets are unstable, so Maker only allows DAI to be issued based on a certain percentage of the asset’s value. Now, this ensures that DAI is almost always backed by corresponding assets worth $1.
Because of this, Maker is like a full reserve bank, guaranteeing that users of DAI can redeem its value. This guarantee means that fully-reserve stablecoins are over-collateralized and therefore capital efficiency is low. Compared with other loan agreements, Maker usually has a lower loan-to-value ratio and a higher interest rate. This means that people who mint DAI can usually borrow U.S. dollars at cheaper prices elsewhere.
The full reserve agreement also has a natural limit to growth: the supply of stablecoins is limited by the demand for leverage on crypto assets such as ETH. Think about it: Imagine if all USDT users in the world today want to convert to DAI, but no one wants to deposit ETH to mint them (for example, ETH may be locked in staking). There is simply not enough DAI available.
As the price of ETH falls, the supply of fully-reserve stablecoins declines
The algorithmic stablecoin protocol aims to circumvent these problems. The defining feature of the algorithmic stablecoin protocol is that it does not guarantee that users can exchange their stablecoins for basic assets with the same market value at any time. Algorithmic stablecoins usually have 3 ways to stay linked:
- Open market operations . Here, the agreement protects and anchors itself by exchanging reserve assets for the stablecoin itself through smart contracts, and vice versa. Fei Protocol does this by buying and selling directly on its Uniswap liquidity pool, while Float Protocol conducts Dutch auctions.
- rebasing . For Ampleforth, the supply of stablecoins will shrink and expand in proportion to the number of wallets. Suppose I have 10 $AMPL and the total circulating supply of $AMPL is 100. The price of $AMPL is $1. If $AMPL drops to US$0.90, only 9 $AMPL will be found in my wallet after rebasing, and the total circulating supply should be reduced to 90 $AMPL. (The actual mechanism is more refined than this).
- Secondary tokens . In the secondary token model, the risk of stable currency decoupling is continuously absorbed by secondary token holders. Let’s take Basis Cash as an example. When the stable currency transaction price is lower than the peg, users can exchange the stable currency into a bond at a discounted price, such as a bond of $0.70. Once relinked, bondholders can redeem their bonds at face value ($1). When stablecoin transactions are higher than the peg, new stablecoins are minted and issued to holders of stock tokens to reward shareholders who bear such risks.
Since 2021, a new kind of vertical stablecoin has emerged: those stablecoins that are not tied to the price of any legal currency at all. How does this work?
These agreements have variable target prices for stablecoins, which are less volatile and updated regularly. So how is this target price determined? As the agreement’s demand for ETH leverage increases and decreases, Reflexer’s target price (gradually) increases and decreases. Because of its redemption mechanism, it essentially faces the same capital efficiency challenges that plagued the early full-reserve stablecoin model.
The Float protocol can be classified as an algorithmic stable currency using a secondary token model. At a higher level, Float’s target price will (gradually) rise and fall as the overall price of its collateral rises and falls.
These models are ambitious but have not been tested on a large scale.
Designing a stablecoin protocol is difficult.
Whenever money is involved, it becomes a tricky thing. Stablecoin protocol design is usually verified in theory, but it becomes invalid in practice.
Because the interaction between users and the stablecoin protocol is very complex, protocols that are suitable for smaller scales may not be suitable for larger scale implementations, and vice versa. One reason is that as the user adoption rate increases, the proportion of participants who do not understand the protocol mechanism will also increase. As Vance from Framework Ventures pointed out, a death spiral is more likely due to panic selling by more participants.
The growth of the stablecoin protocol also depends on the path: anchoring losses may completely destroy confidence in a certain model, and once the governance tokens issued cannot be magically redistributed to the right people. In the early days of the agreement, it is important to cultivate a strong user community. They hope that the agreement can be maintained for a long time, so they are willing to bet on your stablecoin to remain pegged. This is an irreplaceable community “moat” that needs time to build.
In the end, participants cannot communicate with each other and do not know what other people think on the blockchain. Due to our aversion to losses and public psychology, users are actually more likely to sell stablecoins, causing it to be farther and farther away from the peg. Communication between teams is strong, and participants can agree to converge at a certain price point, which is important to a certain extent. After submitting a proposal that FEI holders can exchange ETH worth US$0.95 under any circumstances, the decoupling of FEI prices was quickly reversed. Even before the proposal was passed, the price of FEI jumped from US$0.71 to US$0.85.
As a further explanation of these two points, let us look at $FRAX and $IRON. The general mechanism of Iron Finance is no different from Frax Finance. But unlike $IRON, the stable currency $FRAX does not deviate significantly from the peg.
Frax’s implementation is more robust because it has the function of allowing users to lock Frax Shares ($FXS) and $FRAX liquidity pool tokens. Asking a group of supporters to lock up their capital to absorb the fluctuation of $FRAX can buffer the death spiral and send a signal to ordinary $FRAX users that they are not playing a prisoner’s dilemma game.
The supply of centralized stablecoins (USDT, USDC, BUSD) vs. all decentralized supplies.
It is no wonder that the ratio of the total circulation of centralized stablecoins to the market value of decentralized stablecoins today exceeds 10:1. For many people, the security of stablecoins issued by centralized custodians far exceeds the risks involved in decentralized stablecoins.
It is also questionable whether the user adoption rate is really increasing, as many people use these stablecoins as a temporary source of revenue. Except for DAI, since July, no other decentralized stablecoin has more than 3000 unique active senders! After NYAG and Tether reached a settlement this year, most of the concerns surrounding the lack of support for USDT have also dissipated to a certain extent. As consumers continue to join DeFi through entities such as Coinbase, the use of centralized stablecoins is still the de facto choice of many people.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/centralized-stable-currency-vs-decentralized-stable-currency-is-decentralized-stable-currency-a-utopia-does-this-road-work/
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