Module 2.2: Understanding Stablecoins
This article explores the various types of stablecoins and their role in the world of cryptocurrencies and decentralized finance (DeFi). It describes fiat-collateralized, over-collateralized with cryptocurrency, commodity-backed, and algorithmic stablecoins, explaining how they maintain the stability of their value. Innovative approaches, such as income distribution to stablecoin holders and the use of futures to create stablecoins, are also discussed. The importance of stablecoins in DeFi is emphasized in the context of their role in providing liquidity, exchange, value preservation, and as collateral for borrowing and lending. Finally, the article briefly touches on the challenges and future prospects of stablecoin development.
Why are stablecoins so important to us? Imagine the world of cryptocurrencies as a sea where the prices of Bitcoin and other cryptocurrencies rise and fall like waves. These fluctuations can make using cryptocurrencies in everyday life quite unpredictable. For example, buying a coffee today might cost you $5 in Bitcoin, but tomorrow, suddenly, your purchase “costs” $10. This volatility can deter you from spending your crypto savings on anything.
For investors and traders, volatility also introduces its complications, as they often need to exchange cryptocurrencies for traditional money and vice versa to lock in profits or rebalance their investment portfolio. This is where stablecoins come into play, offering an oasis of stability in the turbulent sea of cryptocurrencies. Created to reflect the value of traditional currencies, such as the dollar or euro, stablecoins provide a way to avoid sharp exchange rate fluctuations, making them an ideal choice for those seeking stability in the world of DeFi.
The interest in stablecoins is significant, and for good reason. At their peak popularity in early 2022, the market value of stablecoins almost reached $200 billion, and it’s expected to continue growing. But how do they work? At the core of a stablecoin is a unique mechanism that allows it to track the price of another asset, ensuring its value remains stable and equal to that asset’s value. There are different types of stablecoins: some are pegged to fiat currencies like the dollar, others are backed by cryptocurrencies, commodity assets, or even operate on algorithms.
Let’s consider fiat-collateralized stablecoins. They hold fiat money, such as dollars, in reserve to maintain their value. Take USDC, for example, where for every token issued, one dollar is held in reserve. This allows users to freely exchange their dollars for USDC and vice versa, maintaining a one-to-one equivalence.
What if the price of USDC starts to deviate? The market itself regulates such situations. For instance, if USDC is worth more than a dollar, arbitrageurs quickly notice and start selling USDC to take advantage of the price difference. This increases the supply of USDC and helps bring its price back to the pegged rate. Conversely, if the price falls below a dollar, the mechanism similarly helps stabilize the value. Thus, thanks to these smart mechanisms, stablecoins remain a stable islet in the volatile world of cryptocurrencies.
Crypto-collateralized stablecoins are a truly fascinating topic. They use cryptocurrency as collateral, which may seem surprising given the well-known volatility of cryptocurrencies. Let’s delve into MakerDAO and their stablecoin DAI.
The MakerDAO mechanism is reminiscent of collateralized lending, but in the world of cryptocurrencies. You provide cryptocurrency as collateral and receive DAI in exchange. The entire process is managed by smart contracts, making it automated and secure. When you decide to return the DAI, your collateral is released, similar to getting your deposit back from a pawnshop.
This approach accounts for fluctuations in cryptocurrency prices, providing additional protection through over-collateralization. For instance, to obtain 100 DAI, you might need to collateralize crypto assets worth $150.
If the value of the collateral falls below a set threshold, it can be automatically sold to ensure DAI’s stability. MakerDAO charges fees for using the system, which helps regulate DAI’s supply and its value. Additionally, interest rates for holding DAI encourage users to keep it, even if the price fluctuates slightly. All these measures are aimed at ensuring stability in the fluctuating world of cryptocurrencies.
Nowadays, staked assets are increasingly used as collateral in the world of cryptocurrencies. This not only enhances capital efficiency but also allows for earning additional income. This approach is reminiscent of a modern pawnshop, where your collateral doesn’t just sit idly but works for you.
This has become especially popular in protocols such as CurveUSD and Lybra Finance on Ethereum, as well as Gravita Protocol. And let’s not forget about Aqua Protocol on the TON blockchain. These platforms transform the standard rules of the game, offering users not only security and stability but also additional opportunities to earn on their crypto assets.
Commodity-backed stablecoins tie their value to real assets, like gold or silver, acting similarly to fiat-collateralized stablecoins, but with commodities as collateral. A separate discussion is reserved for algorithmic stablecoins. They use smart algorithms to maintain stability without relying on fiat money or commodities. Typically, they aim to have their value equal to one dollar, automatically adjusting the supply based on market demand.
Imagine if the demand rises and the price of a stablecoin goes above one dollar, the system issues more coins to bring the price back to normal. Conversely, if the price falls, coins are removed from circulation. It’s like a seesaw trying to maintain balance.
In 2024, the financial innovation world is buzzing about yield-bearing stablecoins. Consider USDT: when they issue their digital dollars, they actually invest them in securities, thereby earning an incredible income. While stablecoin holders simply store their assets without any additional benefits, this has led to a new trend — sharing income with those holding stablecoins, distributing a portion of the profits. Lybra Finance is one of the pioneers of this approach, distributing income from staking in the form of additional stablecoins among all its users.
There are also protocols that create stablecoins based on futures and delta-neutral strategies, such as Etherna.fi. This method is particularly attractive because it does not require additional collateral, which is crucial for crypto-collateralized stablecoins.
Each stablecoin is unique and created by different teams, each with its strategy and approach. Some approaches are riskier, but it’s important to remember that all stablecoins carry a certain level of risk, especially algorithmic ones due to their complexity and the potential for a “death spiral,” where the price cannot recover after a fall.
In the world of DeFi, stablecoins perform critically important functions, providing stability and trust, serving as a medium of exchange and value preservation. They enhance liquidity, which is crucial for trading and participation in the ecosystem. They are used as collateral for borrowing, lending, and even in yield farming.
However, like everything in this world, stablecoins face challenges: from regulatory uncertainty to issues with centralization and transparency. Despite these obstacles, they remain an integral part of the cryptocurrency and DeFi ecosystem, and many projects tirelessly work on improving their resilience and reliability.
In the next module, we’ll move on to explore decentralized borrowing and lending — another vital element of the DeFi world.
All Educational modules list:
Module: 1.1 Differences between TradFi, DeFi and CeFi
Module 1.2: The History of DeFi
Module 1.3: Understanding Key DeFi Metrics
Module 2.1: Decentralized “Deposits” (Staking)
Module 2.2: Understanding Stablecoins
Module 2.3: Diving into Decentralized Borrowing and Lending
Module 2.4: Dive into Decentralized Exchanges (DEXes) and Swaps
Module 2.5: Decentralized Derivatives
Module 3.1: Providing Liquidity in DeFi
Module 3.2: Yield Farming in DeFi
This course was prepared by Julia Palamarchuk (co-founder of Aqua Protocol — the first CDP stablecoin on the TON blockchain, over-collateralized by liquid staking tokens).
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