Decentralized Stablecoins: A Critical component of the cryptocurrency ecosystem 1/3
Part 1: Overcollateralized USD stablecoins
Stablecoin Market Overview
Stablecoins hold a significant position in the cryptocurrency field. As of December 2023, the total market capitalization of stablecoins is approximately $130.2 billion, accounting for 8.1% of the total cryptocurrency market capitalization. In terms of market ranking, USDT, USDC, and Dai are ranked 3rd, 7th, and 20th, respectively, highlighting the importance of stablecoins in the cryptocurrency ecosystem. From a macro perspective, the market capitalization of stablecoins is primarily driven by market liquidity. Despite the impact of the Federal Reserve’s interest rate policy in 2022, stablecoin market capitalization has continued to grow significantly compared to 2021. In 2023, there was a slight decrease in market capitalization, but overall stability, with a rebound towards the end of the year.
Issues Addressed by Stablecoins
Stablecoins primarily address the following issues:
- Market Liquidity: Stablecoins provide a convenient liquidity pathway for cryptocurrency transactions, especially during market downturns, allowing traders to quickly settle assets and re-enter the market after stability is restored.
- Cross-Platform and Cross-Border Transfers: Unlike highly volatile cryptocurrencies, stablecoins are usually pegged to the US dollar, enabling cross-platform or cross-border transfers without relying on fiat currencies, reducing dependence on traditional financial systems.
- Core of the DeFi Ecosystem: Stablecoins are essential for the operation of decentralized finance (DeFi) and are commonly used in DeFi protocols to facilitate transactions or serve as collateral for lending.
Risks of Fiat-Collateralized Stablecoins
While fiat-collateralized stablecoins offer convenience, they also come with risks:
- Centralization: Contrary to the decentralized ideology, these stablecoins are typically connected to third-party custodians (such as banks) and subject to national regulations.
- Trust Issues: Investors need to trust the issuer of the stablecoin, including the risk of asset freezes and the requirement for financial transparency.
- Reserve Transparency: Issues with the reserves of stablecoins, as seen with Tether, have garnered public and regulatory attention. Under pressure, the asset reserve quality of USDT has improved, with cash and cash equivalents accounting for nearly 86% of the reserves.
- Regulatory Risks: Centralized stablecoins are subject to stricter regulatory policies. In August 2022, the U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) sanctioned the crypto mixer Tornado Cash, leading Circle to freeze USDC assets in Tornado Cash wallet addresses. This event highlighted the potential threats that centralized stablecoins pose to the DeFi ecosystem. Tether and Circle, backed by U.S. regulation and significant interests, can blacklist DeFi protocols on anti-money laundering and national security grounds, freezing user assets.
This article will focus on decentralized stablecoins, characterized by complete transparency, non-custodial nature, limited or no third-party control, which have become more attractive as centralized stablecoins face stricter regulation.
Classification of Decentralized Stablecoins
- Overcollateralized USD Stablecoins: Examples include MakerDAO’s Dai and Liquity’s LUSD. These stablecoins are backed by other cryptocurrencies and require overcollateralization to maintain stability.
- Other Stablecoins: These include non-overcollateralized USD stablecoins (e.g., Synthetix’s sUSD) and non-USD pegged stablecoins (e.g., Reflexer Finance’s RAI).
Overcollateralized USD Stablecoins
Let’s first explore USD stablecoins that are overcollateralized. These stablecoins are backed by other cryptocurrencies. In this case, the underlying assets are also cryptocurrencies, which can be highly volatile. Therefore, such stablecoins require overcollateralization to maintain stability. Stablecoins collateralized by cryptocurrencies are one of the most competitive areas in the blockchain industry.
1. MakerDao Dai
MakerDAO is a decentralized autonomous organization and smart contract system based on Ethereum, designed to create a decentralized stablecoin known as DAI. DAI is a stablecoin pegged 1:1 to the US dollar, generated through the over-collateralization of crypto assets, primarily ETH. Currently, DAI is the leading decentralized stablecoin (excluding centralized stablecoins like USDC and USDT), ranking 20th in market capitalization among all cryptocurrencies, with a circulation exceeding 5 billion.
Mechanism of DAI Generation
Within MakerDAO, users can mint DAI by locking crypto assets (such as ETH) in smart contracts, at a value exceeding their worth. This process involves a contract known as a “Collateralized Debt Position” (CDP). For example, if a user locks ETH worth $1,000, they can mint up to $666 in DAI, equating to a 150% over-collateralization rate.
If the value of the collateral in a CDP falls, causing the collateralization rate to drop below the minimum requirement, the CDP faces liquidation. In such a case, the collateral is automatically sold to repay the DAI debt and cover the associated liquidation penalty.
Each CDP must also pay a Stability Fee (akin to loan interest) on the minted DAI, set by DAO governance.
As the DeFi ecosystem grows, driving up DAI demand, newer versions of MakerDAO have introduced more collateral types, with collateralization rates and Stability Fees determined by the asset’s risk profile and MKR governors.
DAI Stability Mechanism
The stability of DAI, central to the MakerDAO system, relies on a series of complex mechanisms and strategies to maintain its 1:1 value correlation with the US dollar.
- Over-Collateralization: DAI issuance is based on crypto assets locked in CDPs. To mitigate market volatility risks, the required collateralization rate is significantly higher than the debt value, ensuring each DAI is over-backed by assets.
- Stability Fee: Similar to interest, this fee is paid by CDP holders on minted DAI. Set by MakerDAO governance, it adjusts based on market conditions to incentivize or dampen DAI creation.
- DAI Savings Rate (DSR): An incentive mechanism allowing DAI holders to earn interest by depositing into a specific smart contract. Adjusting the DSR influences DAI’s market supply and demand, aiding price stability.
- Automated Price Adjustment Mechanisms: If DAI’s market price deviates from $1, MakerDAO adjusts the Stability Fee and DSR to steer the price back to its peg. For instance, reducing DSR to decrease demand if DAI’s price exceeds $1, or increasing it to boost demand if below $1.
- Liquidation Mechanism: Automatic liquidation occurs when a CDP’s collateral value falls below the required margin. During liquidation, collateral is auctioned off to cover the DAI debt and liquidation penalty.
- Peg Stability Module (PSM): A newer mechanism allowing near-costless swaps between certain centralized stablecoins (like USDC) and DAI, strengthening its peg to the dollar. Arbitrageurs exploit price differences between DAI and other stablecoins for profit.
These mechanisms enable MakerDAO to maintain DAI’s stability under various market conditions, offering flexibility to address sudden market fluctuations.
DAI Liquidation Mechanism
The liquidation mechanism is a critical part of the MakerDAO system, ensuring its stability and healthy operation. Designed to protect the system from individual CDP failures, it reduces overall risk by timely liquidating depreciated collaterals. Here are the details:
- Liquidation Triggers: A CDP faces liquidation when its collateral value falls to a certain proportion relative to the borrowed DAI, dropping below the minimum collateralization rate.
- Liquidation Process: During liquidation, CDP collateral is auctioned. Bidders use DAI to purchase these assets, and the auction proceeds repay the CDP’s debt, including the original DAI debt and Stability Fee.
- Liquidation Penalty: Additionally, CDP liquidation incurs a penalty, an extra fee added to the debtor’s obligations as a penalty for poor risk management.
- Auction Mechanism: If the auction raises enough DAI to cover the CDP’s debt and penalty, any remaining collateral is returned to the original CDP holder. If not, the shortfall becomes a debt of the Maker protocol, paid from the Maker Buffer in DAI.
- System Deficit Handling: When the system faces a deficit, i.e., the Maker Buffer in DAI is insufficient for debt repayment, MakerDAO raises funds by issuing MKR tokens to cover these losses. This mechanism ensures overall system health and stability, although it may increase MKR supply.
MakerDAO’s Peg Stability Module (PSM)
PSM is a key component in the MakerDAO system, specifically designed to enhance the value peg between DAI and the US dollar. Introduced in late 2020, it mainly allows users to swap certain centralized stablecoins (like USDC) directly with DAI at minimal cost.
- PSM Operation: PSM permits direct conversion between USDC and other centralized stablecoins and DAI. This direct exchange mechanism differs from the traditional over-collateralization method. PSM aims to strengthen the 1:1 peg between DAI and the dollar by exploiting arbitrage opportunities. For example, when DAI’s market price slightly exceeds $1, arbitrageurs can profit by converting USDC to DAI at $1 and selling it at a higher market price.
- PSM Impact: The introduction of PSM significantly impacts DAI’s stability, attracting substantial capital inflows to support DAI’s stability. For instance, in Q3 2022, the DAI generated through PSM constituted a significant portion of the total issuance, reflecting its importance in maintaining DAI’s stability.
- Risks and Challenges: While PSM supports DAI’s stability, it introduces certain risks. Relying mainly on centralized stablecoins like USDC increases MakerDAO’s dependence on these centralized assets. When Tornado Cash was sanctioned and Circle froze related USDC assets, this dependence raised concerns within the Maker community about PSM strategy and reliance on a single asset. Therefore, the community began exploring diversified PSM portfolios to reduce dependency on a single centralized asset.
Future Development of MakerDAO
In August 2022, following the sanctioning of Tornado Cash by the U.S. Treasury Department (OFAC) and the subsequent freezing of Tornado Cash wallet addresses by centralized stablecoin issuers like USDC, the Maker community, concerned about Circle’s actions to block user addresses, began seeking various solutions to adjust the composition of funds in the PSM pool, reducing dependence on the single asset USDC. This led to the introduction of real-world assets (RWA) as a solution, increasing investment in them to improve income structure.
In March 2023, the protocol’s founder proposed a new blueprint, the “Endgame Plan,” aiming to achieve reorganization and decentralization over the next decade through five stages. This includes creating multiple independent governance communities (subDAOs), introducing EtherDAI staking derivatives, and integrating real-world assets (RWA).
Spark Protocol, the first subDao of MakerDao’s “Endgame Plan,” will issue its token in the future. Forking AAVE V3’s code, it positions itself as a lending platform within the Dai ecosystem, with functions and mechanisms similar to Aave, primarily focused on over-collateralized lending around Dai. Its initial goal is to help expand Dai’s usability and market penetration. Before Spark Protocol’s launch, MakerDao lacked a native front-end interface for users to generate Dai.
With Spark’s launch, users can deposit Dai into Spark to receive sDai, a certificate for interest-earning Dai obtained after depositing into Maker’s DSR (Dai Saving Rate).
Furthermore, Spark Protocol is integrated with Maker’s D3M (Direct Deposit Module), a facility allowing Maker to inject Dai liquidity directly into third-party lending platform pools. Due to Maker’s direct liquidity provision, Dai’s borrowing costs on Spark Protocol are highly competitive in the market.
2. Liquity LUSD
Liquity is a decentralized, immutable, and governance-free lending protocol that allows users to obtain interest-free loans using Ethereum as the sole collateral. Loans are issued in LUSD, a stablecoin pegged to the US dollar, requiring a minimum collateralization ratio of 110%. In addition to the collateral, the loans are collectively backed by a Stability Pool containing LUSD and by other borrowers acting as guarantors to maintain the peg to the dollar. Currently, LUSD has a circulation exceeding 180 million, and the Total Value Locked (TVL) maintains over 700 million, not large in total but relatively stable.
LUSD and LQTY
LUSD is a stablecoin pegged to the US dollar. It can be redeemed at face value against the underlying collateral, ETH, at any time.
LQTY is a token issued by Liquity. It captures the system’s fee revenue and incentivizes early adopters and projects providing front-end UI.
Liquity is the a DeFi project that does not provide its front-end UI. Through profit-sharing incentives, it attracts other projects to provide front-end UIs based on Liquity’s contracts, charging a specific service fee (set by the front-end provider) and allowing users to choose their preferred UI based on user-friendliness and fee ratio.
Trove
Similar to MakerDao’s CDP, Trove is where Liquity users manage and maintain their loans. Each Trove is linked to an Ethereum address, with only one Trove allowed per address.
Troves maintain two balances: one for the collateral asset (ETH) and another for debt denominated in LUSD. Users can change these amounts by adding more collateral or repaying the debt. As these balances change, so does the collateralization ratio of the Trove, and users can close their respective Trove at any time by fully repaying the debt.
Stability Pool
The Stability Pool is the first line of defense in maintaining the system’s solvency, composed entirely of LUSD provided by independent Stability Providers. When a Trove is liquidated, LUSD corresponding to the remaining debt of the Trove is burned from the Stability Pool’s balance to cover its debt. In exchange, the entire collateral of that Trove is transferred to the Stability Pool, distributed proportionally to the Stability Providers.
Over time, Stability Providers proportionally lose their deposited LUSD in the Stability Pool but gain the collateral from liquidated positions. Additionally, since the collateral is priced at a discount during liquidation, Stability Providers effectively acquire ETH at a discount.
Stability Mechanism
- Hard Peg Mechanism: One of Liquity’s core innovations is that LUSD holders can redeem the underlying collateral ETH from borrowers at any time. During redemption, the system uses LUSD to repay the currently lowest collateralized Trove, transferring the corresponding amount of ETH from the affected position to the redeemer.
A one-time fee, known as the redemption fee, is charged for this process. Starting at 0%, the fee increases with each redemption and decays back to 0% if no redemptions occur for a while. This fee ensures that redemptions do not occur too frequently from a price stability perspective. - Soft Peg Mechanism: The price of LUSD influences borrowing and repayment behavior, thereby regulating the total supply of LUSD. The supply of LUSD is closely linked to its value against the US dollar.
Key Advantages of Liquity
- 0% Interest Rate: As a borrower, there’s no concern about accumulating debt.
- Fee Structure: Unlike MakerDAO’s ongoing Stability Fee for loans, Liquity charges a one-time borrowing fee. This different fee structure makes Liquity more cost-effective for long-term loans.
- Minimum Collateralization Ratio of 110%: More efficient use of deposited ETH, enhancing capital efficiency.
- No Governance: All operations in Liquity are preset and fully automated, with protocol parameters set at contract deployment and unchangeable. Governance plays a significant role in MakerDAO, where protocol parameters, such as debt ceilings and minimum collateralization ratios, are determined by voting.
- Direct Redemption: LUSD can be redeemed at any time at face value for the corresponding collateral.
- Complete Decentralization: Liquity contracts have no admin keys and are accessed through multiple interfaces hosted by different front-end operators, granting censorship resistance.
Liquity’s stability mechanism has been thoroughly validated. During bear market phases, the Stability Pool has effectively resolved liquidation issues. By establishing a liquidation pool, the liquidation capability is shifted from professional market makers to LP providers. It also proves that there’s always a market demand for purchasing liquidated ETH at a lower price. With around 50% of LUSD consistently in the Stability Pool, it has helped maintain the LUSD peg, effectively creating an additional use case.
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