Cryptographic Proofs: Oracles and Stablecoins

Explore the role of decentralized oracles in securing data outside the blockchain and maintaining stablecoin price pegs.

content

  • Decentralized Web3: Crypto Truth and Transparency
  • Stablecoin Issuance: DeFi vs. CeFi
  • Reserve Auditing and Proof of Repositioning Algorithmic Stablecoins Using Decentralized Oracles
  • Web3 Composability: Oracles Critical to Stability
  • references

Defining the Web3 term stablecoin in its broadest sense is fairly straightforward. Stablecoins are cryptographic assets that maintain a stable spot price, pegged to the spot price of a given non-crypto asset. USDC tracks spot prices in U.S. dollars, for example, the price of Paxos Gold (PAXG) is pegged to the price of an ounce of gold. As a result, investors are able to gain exposure to both assets while benefiting from the liquidity of cryptocurrency exchanges and blockchain technology.

Since stablecoins constitute a large amount of value circulating in DeFi applications, they need to provide the same security guarantees to the blockchain and the dApps that use them. The interconnectivity or composability of Web3 requires stablecoins to be as powerful as any component of the ecosystem.

In practice, this means that oracles must be decentralized and have multiple layers of cryptographic security. This provides transparency and trust to users of these stablecoins, as they can be sure that their wealth is being held digitally, rather than double-spending, i.e. through fractional reserve issuance or loan inflation or otherwise being held by the stablecoin issuer abuse. With SupraOracles, price pegs can be kept to the highest degree of certainty, as the refresh rate happens within seconds.

At a deeper level, stablecoins are mainly divided into two categories: direct collateral and algorithmic. Directly collateralized stablecoins tend to be held by a centralized third party that backs their stablecoins at a 1:1 ratio of stablecoins to peg assets.

Algorithmic stablecoins, on the other hand, are dynamically minted or destroyed in real-time to adjust the circulating supply of issued stablecoins based on demand, thereby adjusting prices up or down to maintain a stable price peg to a given asset.

Decentralized Web3: Crypto Truth and Transparency

Blockchain technology and Web3 have changed expectations for financial transparency and accountability more broadly. That is, with a transparent and immutable shared ledger in the form of a blockchain, users want to know that they can trust the solvency of the entity responsible for their assets.

Bitcoin was of course the supernova that exploded in 2009, introducing immutability, transparency, decentralization, and strict rules governing the issuance of new bitcoins on the blockchain.

Of course, it is important to note that transactions made on the blockchain cannot be reversed, even if an accidental payment or funds are sent to the wrong address. Therefore, greater care and responsibility must be exercised as one cannot call a bank and ask them to step in and correct such mistakes.

Since blockchain transactions are irreversible and there is no central custodian responsible for users’ assets, there is no room for error. For fiat banks, fraud can occur, but the presence of infrastructure can recover or freeze stolen funds and reintegrate the defrauded user.

“Without tamper-proof and robust oracles, the entire blockchain ecosystem could be compromised, causing transactions to be executed based on fake or stale price data.”

Banks are trusted entities that can step in to manipulate their ledgers when needed. This cannot be done on a blockchain because the ledger is shared by all nodes on the network and therefore immutable, as the ledger history cannot be rewritten without the consensus of network participants.

Regardless of which stablecoin is examined, accurate pricing data from decentralized oracles is required. The oracle needs to continuously capture the spot price of various commodities and currencies and update the on-chain price accordingly to maintain its price peg, even for stablecoins that are simply backed 1:1 by fiat paper deposits.

Without tamper-proof and robust oracles, the entire blockchain ecosystem could be compromised, causing transactions to be executed based on fake or stale price data. After all, the value of fiat currencies fluctuates all the time in relation to each other and to other commodities.

As such, Web3 is an internet of decentralization, accountability, network consensus, and cryptographic proofs. That said, online financial protocols and transactions must strictly adhere to cryptographic primitives, on-chain transparency, and blockchain immutability. SupraOracles will play an important role in securing these characteristics, especially in auditing tokenized assets and stablecoins.

Stablecoin Issuance: DeFi and CeFi

Stablecoins can be issued by centralized custodians holding collateralized assets in off-chain accounts, or by decentralized protocols, and provide collateral for assets held on the blockchain ledger. Each option has unique advantages and disadvantages, and requires different auditing methods to verify that stablecoins are indeed backed by the collateral value they claim to represent.

For example, centralized custodians holding fiat dollars in bank accounts must utilize oracles to provide transparency through proof-of-reserve audits. Issuers of such stablecoins require a certain level of trust in a given custodian, thus requiring a third party to increase the transparency of custodians and issuers.

That is, the oracle must periodically search for USD deposits in a given custodian’s account and ensure that the amount matches the number of stablecoins issued and in circulation. A notable example is Coinbase’s USDC pegging its value to the U.S. dollar and backing it 1:1.

Cryptographic Proofs: Oracles and Stablecoins

If stablecoins are to represent real and verifiable value on the blockchain, they must be backed by off-chain assets.

Alternatively, decentralized stablecoin issuers are overcollateralized with cryptoassets that can be audited on-chain. This is possible because all assets on the public blockchain are transparently verifiable, providing ongoing accountability in the form of on-chain audits. This removes the need for depositors to “trust” a third party to honestly report and maintain proper collateral for issued stablecoins, hence the term “trustless” that has become associated with decentralized protocols.

Central banks around the world are also starting to issue their own stablecoins, also known as digital currencies (CBDCs), backed by sovereign governments and their local fiat currencies, each with their own collateral and auditing requirements. Depending on the local situation and the nature of its financial reporting and regulators, these may or may not be as transparent as decentralized or private stablecoin issuers.

After all, collateral levels for fiat debt issuance by central banks and commercial banks do not match the levels of over 150% of their crypto counterparts. In the United States, fractional-reserve loans allow fiat banks with less than $16.3 million in assets to issue bonds without any reserve requirements. Larger banks with more assets only need to hold 3%-10% of the statutory reserve debt they issue.

Proof of Reserve Audit and Repositioning Algorithmic Stablecoins Using Decentralized Oracles

As mentioned earlier, stablecoins maintain their peg to commodities or fiat currencies using an elastic supply that is burned or minted on-chain through the use of direct collateral or algorithms. In order to convince depositors that stablecoins are indeed backed by equivalent assets, decentralized oracles must constantly monitor stablecoin issuers’ reserves to provide verifiable and transparent on-chain proof of their reserves and the supply of stablecoins in circulation is in order.

The mechanism for verifying the reserves of stablecoins or other crypto assets is called a proof-of-reserve (PoR) audit. Oracles capture the data stablecoin issuers need to maintain a highly accurate view of the true collateralization of the stablecoins they have issued into circulation.

The PoR reference feed can be autonomously operated by a decentralized oracle network. Because transparent auditing of collateral is always happening in real-time, user funds are protected from fraudulent activity, black swan security breaches, fractional reserve fraud or other misuse of deposits from stablecoin issuers.

Cryptographic Proofs: Oracles and Stablecoins

Stablecoin reserve audits showing levels of overcollateralized reserves both increase investor confidence and promote sound decision-making incentives for stablecoin issuers and custodians.

Paxos uses an oracle-based PoR auditing system for its USD stablecoin Paxos Standard (PAX) and its gold-backed token PAX Gold (PAXG). However, if the dollar or gold spot prices experience wild swings, their oracle price updates may not be fast enough.

As mentioned earlier, some algorithmic stablecoins maintain their pegs by burning or minting currencies tied to the collateral that backs them, relying on oracles to continuously pass the spot price back to the stablecoin issuer to keep the peg as close to the spot price as possible. Horizontal. MakerDAO is an example of a decentralized protocol that uses oracles and adjustable interest rates to issue a USD stablecoin with the ticker DAI.

MakerDAO is a decentralized stablecoin protocol that maintains its peg by letting users lock collateral in smart contracts through overcollateralized debt positions. The smart contract allows users to borrow the minted stablecoin, called DAI, at a fixed rate, depending on the overcollateralization tier selected by the user. For example, higher rates come with 130% over-collateralized Ethereum deposits borrowed in DAI, providing better rates for deposits that reach 170% over-collateralized.

Protocols that use oracles to provide real-time PoR auditing provide users with transparency as they demonstrate the true backing of the tokens they hold. These oracle-based audits also provide collateral data on pegged assets, increasing the transparency of stablecoins. This also encourages healthy incentives for lenders and borrowers of these tokens, as the Web3 overcollateralization standard increases the liability of all participants.

Web3 Composability: Oracles Critical to Stability

Oracles are absolutely necessary for acquiring and validating external data for stablecoin issuers, smart contract platforms, NFT markets, etc. Without high-throughput oracles to keep data faucets running at full speed, DeFi’s usefulness and slippage risk will be negatively impacted without paying exorbitant gas fees, pushing up like on other blockchains operating costs and causing further network congestion. Therefore, oracles have a responsibility to promote trust in cryptoassets by adding a layer of verifiable cryptographic randomness and decentralization to the Web3 ecosystem.

Perhaps due to the novelty of digital assets and DeFi, the legitimacy necessary for stablecoin issuers to gain further adoption will inevitably boil down to gaining the trust of depositors through transparency and proof of healthy reserves. Therefore, as global adoption in the next few years and traditional assets find themselves moving back and forth in the Web3 protocol, oracles will increase the stability of the entire digital asset ecosystem.

Given the composability of blockchains, dApps and crypto assets, SupraOracles strictly adhere to the principles of decentralization and verifiable randomness to ensure liquidity between digital and traditional assets and Web3 assets. For stablecoin issuers maintaining off-chain fiat or commodity reserves, SupraOracles’ regular PoR audits will provide issuers with transparency and accountability, as well as broader monitoring of the health of their reserves and the Web3 protocol.

Related Reading

CB Insights Research Report. (2022, 25 Jan.). What are stablecoins? CB Insights.

GeoEconomics Center. (2021, 20 Apr.) The rise of central bank digital currencies. Atlantic Council.

Maxwell, A. (2021, 19 Oct.). The world of cryptographic proof. World Magazine.

Prathap, M. (2021, 24 Dec.). Top 6 stablecoins in the crypto market — what are they, how they work and why they have governments worried. Business Insider India.

Robinson, D. (2021). Stablecoins and oracles [Lecture 9 PDF]. Stanford Computer Science: 251.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/cryptographic-proofs-oracles-and-stablecoins/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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