Stable coins are backbone of the entire crypto industry , volatility in the crypto markets can lead to wealth decay easily , even blue chip coins like BTC, ETH experience huge volatile movements on a frequent basis . In such cases we need stable coin whose value is pegged to fiat (usually 1 USD) . Stable coins are safe haven as their prices don’t fluctuate much and can be used to store value . The demand of stable coins has only increased in the past couple of years as it is used for various DeFi applications such as lending borrowing with high APY and faster payments compared to traditional methods . Also Investors wanting to decrease their exposure to crypto use stable coin to store value instead of cashing out . There are various ways a stable coin can work , the major stable coins namely USDT , USDC are centralized , but given that crypto is based on the whole decentralization thesis there are various ways to decentralize them.
Below we will discuss how stable coins work and how they are pegged to dollar.
- Centralized (fiat backed) : USDT , USDC
- Mixed : DAI
- Decentralized — LUSD , SUSD
- Algorithmic : UST , AMPL
And lastly we will talk about a new type of stable coin that has been in discussion lately .
a) Centralized stablecoins maintain their peg as they are collateralized by same out of money in banks . USDT with market cap of over $60b claims that every USDT is backed by cash or cash equivalents . But these claims have been proved wrong over the past years as less than 5 percent of the supply is cash backed , rest are commercial papers and treasury bonds. Also there are rumors that tether is involved in price manipulation of crypto by minting USDT out of thin air for purchasing BTC and other crypto to inflate their prices . Also these coins are not immune to censorship and addresses can be blacklisted by freezing mechanism.
b) Maker DAO’s DAI stablecoin is a overcollaterlized stable coin backed by various crypto assets . Although it is censorship resistant but these are highly inefficient as it requires at least 150% collateral or your CDP (collateralized debt position)is liquidated . Users can deposit assets like ETH , USDC etc as a collateral to mint DAI to open a CDP which is burned when CDP is closed . 60 percent of DAI supply is backed by USDC so there is a suspicion on how decentralized DAI actually is . Over collateralization is a must because of price fluctuations in crypto . If it looses its peg arbitrageurs help maintain the peg by redeeming and minting .
c) Decentralized stables like LUSD and SUSD are completely backed only by ETH and are over collateralized . LUSD is stable coin of LIQUITY protocol which requires at least 110% collateral . Instant liquidations because of stable pools instead of auction based liquidations are reasons of low collateralization ratio . SUSD is collateralized by SNX the native token of Sythetix but is highly capital inefficient with 600% collateral ratio.
4)Algorithmic stables do not allow users to redeem the collateral to restore the peg as other stables do , instead contracts are designed to increase and decrease the supply based on price . In UST you have to burn 1 usd worth of LUNA to mint 1 UST . The pegs are restored by hard coded smart contract algorithms . Algorithm coins are considered to be holy grail because the expansion of crypto economy should not be dependent on amount of fiat backed for a stable coin. As algorithmic coins do not require any collateral and pegs are purely based on supply and demand they are considered the future of stable coins . AMPL stable coin by Ampleforth is also one such coin which trades price volatility with supply volatility meaning if 1 USD = 1.01 AMPL then it decreases the supply and vice versa .
Now we will discuss a new type of algorithmic stable coin (let’s say perpUSD), which will be backed by spot ETH and short ETH perp , which thus creates a delta neutral position.
A user can deposit 1 usd worth of eth and get 1 perpUSD the contract at the same time will open a short position on DEX like perpetual protocol with the spot ETH as collateral such that the PnL from fluctuation in ETH prices neutralizes PnL from short perp such that the perpUSD is always backed by required collateral . Use of perpetual swaps ,makes implementing this on a layer 1 DEX impossible but with new layer 2 scaling solutions rolling out it has made possible for such a stable coin to exist . The positions are automatically re balanced using smart contracts to avoid liquidations .
Although there are some concerns ,
- The funding rate payment is pooled together when longs pay the shorts i.e in a bullish trend , and these pooled capital is used to pay for the funding payments when shorts have to pay the longs in a bearish trend .
- The activity on perpetual DEXes is very little compared to CEXes , so expansion of the coin is totally dependent on the OI(open interest) of the DEXes .