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Algorithmic vs 1:1 Backed vs Collateralised Stablecoins

Dezy Team

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Published on 25.05.2022
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What’s the difference, and why is this important?

Recently, stablecoins have come into the mainstream media, particularly after the collapse of an algorithmic stablecoin, UST lost its peg, and caused billions of dollars of losses. 

Before we dive into what happened, it’s important to start with the base understanding of what is a stablecoin, and why it’s important. 

Simply put, stablecoin often refers to a tokenized form of currency, most often the USD.

The idea of a stablecoin is to have a stable asset that does not fluctuate with the whims of the market. 

In 2018, USDC issued by Circle, came into existence and was the first mainstream adopted stablecoin backed by USD. The concept was fairly straightforward, every $1 of USDC could be redeemed by USDC’s parent company for $1 in fiat USD. 

There have been numerous design iterations of the stablecoin architecture, both centralized and decentralized, which aim to solve two problems:

  • a stable asset onchain (meaning, on specific blockchains) and/or
  • censorship resistant access to a stablecoin pegged to the worlds safe haven currency, USD. 

Solving for the second problem is where things start getting a bit complicated. 

As a result, there are 3 broad categories of stablecoins which exist today. Here is an easy summary:

Fiat backed stablecoins

The first problem above is often solved by 1:1 redeemable USD against an on-chain equivalent, of which the 2 major players are USDT and USDC. 

Each of these companies is regulated and are all backed by liquid fiat or commercial paper such as US Treasuries.

Take USDC for example, USDC is a store of value, an electronic money instrument. One can create or redeem these through Circle. They can go through our partners like Coinbase or FTX, or others, and it doesn't do anything else. It's held in cash and short-term government bonds.

This in design is quite simple.

For most users, this might be the preferred design as they are most interested in the stability and redeemability factors of this solution. Users want to know that at any time their USDC can be redeemed for real greenbacks.

However, what users give up is censorship resistance, where the parent company of these types of coins can freeze the movement of these coins and wallets. 

Overcollateralized Stablecoins

This category was the first major shift towards censorship-resistant stablecoins, by using a mechanism known as over-collateralization.

Simply put, a user will take in volatile assets, most often more mainstream ones such as Ether or Bitcoin and put that in a vault.

With this vault, the user can now mint a stablecoin, which is pegged to $1 against the collateral of your vault.

For this, the user locks up their Bitcoin or Ether and mints dollars against that. The vault then tracks the dollar value of the vault (i.e. the dollar value of Ether or Bitcoin, and calculates the collateral value). 

Because the assets in the vault are volatile, a user typically needs to put in (more than)>$1 of assets to mint $1 worth of assets. It’s not uncommon to require $2 of vault assets to mint $1 of stablecoins. 

The protocol then charges a fee to mint these assets, usually a couple % p.a. of interest, in order to pay the protocol for this service. 

There are some key risks with this method of minting a stablecoin.

The obvious one would be, what if the collateral value of my vault (which remember is made up of volatile Ether and Bitcoin), drops dramatically if the market sells off aggressively? 

This is where the concept of liquidation comes in, but that’s an in depth article for another day. Sign up for our newsletter to read it first.

We can think of it very similarly to how a home loan would work. 

To receive a home loan, a homeowner puts up their house as a collateral for the mortgage. 

If you miss mortgage payments, your home could be repossessed by the bank and sold off on the open market so that the bank can recuperate the capital from the loan. 

Similarly, these are how overcollateralized vaults work.

If you’re unable to pay back the minted stablecoin when the market value of your vault is dropping, the protocol will take your collateral and sell it on the open market to recover the loan.

The key difference here is that with the housing market, it’s unlikely you would see large swings in pricing on a daily basis, vs in crypto markets, hence why you don’t get your house repossessed due to a housing market dip.

The natural next question is, why would people do this? 

There are a few reasons, but primarily many crypto investors are holding positions like Ether and Bitcoin for the long run, and don’t want to sell their assets for dollars today, but rather borrow against their Ether or Bitcoin and use the dollars for a variety of activities, including participating in other DeFi protocols or even just offramping to pay for real-world things while they wait for the value of their collateral to appreciate overtime.

It’s almost like taking your equity portfolio and borrowing against that because you believe the equities will appreciate over time and you don’t want to sell the stocks today.

However, this solution is capital inefficient since we have to lock up to $2 of assets to mint  $1 of stablecoins. The almost opposite version of this would be back to our home loan example.

You only need to put 10%-20% of the home value to get a loan, which is far more capital efficient.

Overcollateralization it’s not necessarily the ideal solution to solve problem #2 above. 

Most common overcollateralized stablecoin: DAI

Algorithmic Stablecoins

Now for the fancy and as we have seen, risky stuff. This is where things start getting a bit complicated.

Algorithmic stablecoins aim to use code to maintain a peg against the USD and have 0 collateral requirements.

There are various experiments in this space, but the most common one which we have heard about recently is Luna/UST. 

At a high level, UST is minted when you convert the equivalent dollar amount of Luna and UST is always redeemable for the equivalent dollar amount of Luna. 

The system is designed so that $1 of UST is pegged to $1 worth of Luna at any time.

When UST < $1 then Luna is minted and when UST > $1 then Luna is burned. This works well if the price of Luna is stable or generally moving upward in price. If the price of Luna starts going down dramatically, then we could run into a “death spiral” scenario (one which we just witnessed two weeks ago), where the Luna price keeps going down, and as people rush to swap their UST to Luna.

If the sell pressure continues, and there is a loss of confidence, the system breaks and a peg cannot be maintained and there is a rush for an exit. In Luna’s case, a loss in confidence killed the system and created a catastrophic knock-on effect which was not recoverable, even after billions of stimulus was injected into the protocol.

Closing Thoughts

There are many ways to create stablecoins as we’ve seen, and the tradeoffs are clear between the various ways we can have stable assets on-chain.

Ultimately, demand will drive the development of how stablecoins evolve and the amount of risk appetite in the underlying infrastructure they want to take. 

Here is the summary again to reiterate everything we’ve covered:

Stablecoins are a massive opportunity for the crypto market to solve. Aside from just holding value for trading and DeFi, having stablecoins allows the world to use the highly efficient payment rails created by blockchain technology to move funds around.

In saying all of this, you do not need to directly hold stablecoins to reap the benefits of decentralised finance and the higher yields available in this system.

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About the Author

Dhruv Sahgal

Dhruv Sahgal is a crypto investor, advisor and NFT collector. Sahgal is passionate to see the wider adoption of blockchain. technology. Connect with him on Twitter, or LinkedIn.


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