DeFi Friday - Decentralized Stablecoins

What you should know about them

Feb 17, 2023

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Current State of DeFi

Total Value Locked (TVL) across all of DeFi: $49.11 Billion (+4.82%)

Chains with notable TVL growth past 7 days:

Cardano (+29.91%)
Astar (+25.05%)
Arbitrum (+16.75%)

Chains with notable TVL decline past 7 days:

Aptos (-7.68%)
Kava (-3.83%)
Moonriver (-2.44%)

(Source DefiLlama.com)

What you should know about decentralized stablecoins

There’s been a ton of fear and hysteria this past week regarding BUSD, Paxos, Binance, and others. Are stablecoins securities? Is USDC going to get banned?

Some of the fear is justified, and some of it seems to be false rumors spreading.

Here’s what we know so far:

Circle (issuers of USDC) have not received a Wells Notice and have not been charged with anything
Paxos is currently dealing with two issues (maybe related, maybe not).
The SEC intends to sue Paxos over its BUSD issuing, alleging that BUSD is an unregistered security
Paxos will stop minting new BUSD but will still support redemptions of BUSD
Paxos is also under investigation from NYDFS, there’s limited info on the scope and details of this investigation

At least for now, it seems like the SEC is going after BUSD issued by Paxos specifically because of the unique operations and design of BUSD and will not be going after USDC (Circle) and USDT (Tether),

Centralized stablecoins are often seen as convenient and have some of the largest on-chain liquidity but they do come with some significant risks. One of the main risks is that they are subject to the same vulnerabilities as traditional fiat currencies, including inflation, counterparty risk, and market volatility. Additionally, centralized stablecoins are often issued by private companies, which means that they may be vulnerable to external pressures, financial difficulties, or general organization mismanagement.

Another significant risk associated with centralized stablecoins is the potential for government intervention. Unlike decentralized stablecoins, which are designed to be outside of the control of any central authority, centralized stablecoins are often subject to government regulations and restrictions. Governments may impose restrictions on the use or exchange of stablecoins, or they may require that the issuer of the stablecoin comply with certain regulatory requirements.

Centralized stablecoins are also vulnerable to censorship and blacklisting. For example, Circle, the issuer of the USD Coin (USDC) stablecoin, announced that it had blacklisted several Ethereum addresses associated with the privacy-focused mixer service Tornado Cash. This move effectively froze the funds held in those addresses, preventing their owners from using them. While Circle claimed that the blacklisting was done in response to regulatory requirements, it raised concerns about the potential for centralized stablecoins to be censored or restricted in this way.

Furthermore, the level of transparency and accountability provided by centralized stablecoins can be limited, as users may not have full visibility into the underlying assets that back the stablecoin. This lack of transparency can make it difficult for users to assess the level of risk associated with holding the stablecoin, and it may also make it easier for the centralized authority to manipulate the stablecoin's value.

In contrast, decentralized stablecoins are often designed to be more transparent, with users able to view the underlying assets that back the stablecoin and participate in governance decisions. They are designed to be trustless and their value is maintained through the use of smart contracts and/or algorithmic mechanisms. Decentralized stablecoins have become a crucial component of the decentralized finance (DeFi) ecosystem, enabling users to transact in a stable currency without relying on centralized intermediaries. The benefits of decentralized stablecoins include transparency, trustlessness, and resistance to censorship and regulatory interference.

Let's explore some examples of decentralized stablecoins in the DeFi space, including DAI, MAI, FRAX, crvUSD, and GHO. By no means are these the only decentralized stablecoins and by no means are we recommending these vs not recommended others that we left off this list. We just wanted to cover a good sampling to give a sense of just how different and unique each stablecoin design and functionality can really be.

DAI

DAI is the most popular decentralized stablecoin in the DeFi ecosystem. It is issued by MakerDAO, a decentralized autonomous organization (DAO) that operates on the Ethereum blockchain (though the DAI stablecoin can be bridged to many other chains and has pretty substantive liquidity). DAI is designed to maintain a stable value of $1.00 US dollar and is backed by a collateralized debt position consisting of other cryptocurrencies, primarily other stablecoins. The MakerDAO protocol enables users to lock up their crypto assets as collateral in exchange for DAI. These loans are all over collateralized which means that more has to be deposited than what is borrowed.

The stability of DAI is heavily reliant on the value of the collateral assets, which can be volatile. Therefore, the MakerDAO protocol has a mechanism in place to maintain the collateralization ratio and ensure the stability of DAI. If the value of the collateral assets drops below a certain threshold, the protocol automatically liquidates some collateral to maintain the collateralization ratio.

The collateralization ratio required for generating DAI can vary from ~101% - 150% depending on which asset is used as collateral. If an asset has a collateral ratio of 150% it means users need to deposit $150 worth of ETH for every $100 worth of DAI generated. If the collateral ratio ever goes below that amount, the user would get liquidated and the assets would begin to be sold off to pay back the loan.

MAI

The MAI stablecoin is the primary product of the Mai Finance protocol. It is designed to be backed by a basket of assets, which includes USDT, USDC, DAI, ETH, wBTC, and other tokens. This part of the protocol is somewhat similar to Maker. By using a basket of assets, Mai Finance aims to create a more stable and flexible stablecoin.

Three methods are used to maintain the peg:

1. Interest-Bearing Stable Collateral Vaults: When the MAI peg is over $1.00, Mai Finance increases the debt ceilings for interest-bearing stable vaults. Due to the low risk and high LTV ratio of stable collaterals, stable vaults are very attractive for high leveraging and their vaults are quickly depleted. This leveraging applies a lot of sell pressure on MAI helping bring the peg back down to $1.00.

2. Liquidation Ratio: The liquidation ratio (minimum collateral to debt ratio) ensures that every MAI is always backed by the collateral value in their vaults. When vaults fall below the liquidation ratio, they can be partially liquidated. This means that some of the vault's debt is repaid by a liquidator, and in return, the liquidator will receive some of the vault's collateral. The initial liquidation ratio will be set at 150%, which is subject to change by community proposals/voting.

3. Collateral Token Fluctuations: Vaults are overcollateralized (by 130-150%, depending on the asset) to ensure that there is always collateral value to back the stablecoins minted. As the value of the collateral rises, more stablecoins can be issued as a rise in collateral price will increase the collateral-to-debt ratio. Conversely, as the value of the collateral falls, fewer stablecoins can be issued. This is implemented to maintain the minimum collateral-to-debt ratio of each vault type.

If the collateral market price falls, the collateral-to-debt ratio will decrease, prompting users to either deposit more collateral or repay their MAI debt
If the collateral market price increases, the collateral-to-debt ratio will increase, allowing users to either borrow more MAI or withdraw some of their collateral

FRAX

FRAX is a decentralized, partially algorithmic stablecoin. FRAX is backed by a combination of stablecoins, other cryptocurrencies, and FXS. Its peg is maintained through a combination of algorithmic supply and demand mechanisms. FRAX also has a unique dual token system, consisting of a stablecoin token (FRAX) and a governance token (FXS), which enables holders to participate in governance and earn rewards for maintaining the stability of the stablecoin.

As of Feb 16th, FRAX is 92% backed by collateral and 8% algorithmic.

The governance token (FXS) serves as a stabilizing force for the FRAX stablecoin. When the value of FRAX falls below $1.00 US dollar, the protocol automatically mints new FXS tokens, Conversely, when the value of FRAX rises above $1.00 US dollar, the protocol burns FXS tokens and mints new FRAX tokens, thus increasing the supply of FRAX and reducing its value.

This example from the FRAX Docs is the best way of explaining the price stability mechanics:

“FRAX can be minted and redeemed from the system for $1 of value, allowing arbitragers to balance the demand and supply of FRAX in the open market. At all times in order to mint new FRAX a user must place $1 worth of value into the system. If the market price is above the price target of $1, then there is an arbitrage opportunity to mint tokens by placing $1 of value into the system per FRAX and sell the minted FRAX for above $1 in the open market. The difference is simply the proportion of FXS and collateral comprising the $1 of value. When FRAX is in the 100% collateral phase, all of the value that is used to mint FRAX is collateral. As the protocol moves into the fractional state, some of the value that enters into the system during minting becomes FXS (which is then burned). For example, in a 96% collateral ratio, every FRAX minted requires $.96 of collateral and burning $.04 of FXS. In a 95% collateral ratio, every FRAX minted requires $.95 of collateral and burning $.05 of FXS, and so on.
If the market price of FRAX is below the price range of $1, then there is an arbitrage opportunity to redeem FRAX tokens by purchasing cheaply on the open market and redeeming FRAX for $1 of value from the system. At all times, a user is able to redeem FRAX for $1 worth of value from the system. The difference is simply what proportion of the collateral and FXS is returned to the redeemer. When FRAX is in the 100% collateral phase, 100% of the value returned from redeeming FRAX is collateral. As the protocol moves into the fractional phase, part of the value that leaves the system during redemption becomes FXS (which is minted to give to the redeeming user). For example, in a 98% collateral ratio, every FRAX can be redeemed for $.98 of collateral and $.02 of minted FXS. In a 97% collateral ratio, every FRAX can be redeemed for $.97 of collateral and $.03 of minted FXS.”

The dual token system provides incentives for users to maintain the stability of the stablecoin and participate in governance. The FXS token holders also have the power to vote on changes to the protocol and earn rewards for participating in governance.

crvUSD

crvUSD is an upcoming (not live yet) decentralized stablecoin that will be issued by the Curve Finance protocol, which is a decentralized exchange (DEX) that specializes in stablecoins and “like-assets” (ie ETH, stETH). crvUSD is designed to maintain a stable value of $1.00 US dollar and is backed by a basket of other crypto assets as collateral.

crvUSD will use something they’re calling “LLAMA” or a lending-liquidating automated market maker algorithm, which helps protect collateral depositors. In very very simple terms, if you deposit ETH and mint crvUSD, if the value of your ETH starts to dip below your collateral requirements, your ETH will slowly start to be converted into crvUSD, but vice versa is also true. If your ETH starts to raise back up in value, you will get some of it back.

This is a great quote from foobar:

“This transforms liquidations from a jagged, all-at-once, all-or-nothing affair with huge slippage losses, into a smooth transitioning that could even earn the collateral holder swap fees if they weather the volatility.”

GHO

GHO is a new decentralized stablecoin launched by the Aave, which is the largest borrowing and lending protocol in all of DeFi. GHO is not currently live on mainnet yet, however, it is live on testnet and it’s expected to go live on mainnet fairly soon.

You can view more and learn about GHO here.

Like some of the other stablecoins we’ve covered, GHO will be a stablecoin pegged to $1.00 US Dollar and will be fully backed by crypto assets.

Individuals can mint GHO by depositing crypto assets as collateral (unclear which assets will be allowed to be collateral yet). Then new GHO is minted and loaned out to that individual at a fixed interest rate.

An interesting component of this design is that stAave holders will be allowed to borrow a limited amount of GHO at a discounted interest rate.

To help keep the price pegged to $1.00, GHO will rely on similar arbitrage mechanics as other decentralized protocols. Aave will always treat 1 GHO = 1 USD. If the price of GHO is $0.90 on-chain, you could buy GHO on a DEX and pay back your loan at a “discount”. If the price of GHO is above the peg on-chain, then you could mint GHO from the protocol and then sell it on a DEX for a profit.

Another interesting component of GHO is the concept of “facilitators” and “buckets”.

From their docs:

“GHO introduces the concept of Facilitators. A Facilitator can trustlessly mint and burn GHO tokens through various strategies. These strategies can be enacted by different entities that may employ varying strategies for integrating GHO (each entity, a Facilitator). The Aave DAO assigns each Facilitator a Bucket with a specified capacity, where a Bucket represents the upward limit of GHO that a specific Facilitator can mint. This limit is defined by Aave Governance.”

What does this mean? The “facilitator” of a bucket will be Aave, but in the future other protocols may be accepted as facilitators and be able to run their own “bucket” (ability to lend out minted GHO). These new buckets will be independent sizes, interest rates, etc all determined by Aave governance.

That’s only the tip of the iceberg regarding decentralized stablecoins. There are MANY others.

YUSD from Yeti Finance
MIM from Abracadabra
VTS from VestaFinance
mUSD from Mstable
LUSD from Liquity

It’s important to remember though, that decentralized stablecoins come with their own set of risks. A perfect example of this is USP from Platypus Finance. As I’m writing this piece (Feb 16th), Platypus just suffered a smart contract exploit. A flash loan that exploited a logic error was used and $8.5 million was drained from the main liquidity pool. USP is currently trading at $0.47.

What’s interesting about this situation is that Tehter has already frozen all of the stolen USDT and the Platypus team has contacted Circle to do the same with USDC.

Conclusion:

In DeFi, you may hear the term, “Stablecoin Trilemma”. It’s the idea that there are three main characteristics of stablecoins. Good stablecoins can successfully achieve two out of the three characteristics, but we have yet to see a stablecoin design capable of all three.

Each of the decentralized stablecoins mentioned has its unique features and mechanisms for maintaining stability. Ultimately, the choice of stablecoin will depend on your specific needs and preferences, your comfort will vary depending on your level of risk, the liquidity of each stablecoin on different chains, as well as the current market conditions.

Decentralized stablecoins provide users with greater transparency, control, and security over their funds compared to centralized stablecoins. As the DeFi ecosystem continues to evolve, decentralized stablecoins are likely to play an increasingly important role in facilitating financial transactions and providing access to a more inclusive and decentralized financial system.

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