Regulators and central banks have paid close attention in recent weeks to stablecoins as the emerging asset class hit a total market cap of more than $100 billion.
They’ve recognized the asset class, up fourfold this year alone, is far too big to ignore. While they’re right to take note, what should be considered is that stablecoin innovation can offer exactly that – stable coins. As such, the innovations coming from this space deserve attention.
Stablecoin development
The stablecoin space has evolved dramatically over the past year, introducing innovations that, counterintuitively, lend more rather than less stability to the emerging asset class.
Decentralized stablecoins, for example, are both more transparent and more stable. This is because some innovations stabilize the value of coins automatically.
The larger decentralized stablecoins become, the more stability and transparency they can provide within traditional financial systems. Central banks have a lot to learn from these innovations and if they, and nation-states, don’t embrace stablecoins and their innovations, they may simply fall behind.
But what exactly is a stablecoin and how does it work? Put simply, a stablecoin is a digital asset built on the blockchain. BY design, it maintains a price peg at a designated price, most often, $1.
This effectively removes holders from the swings of the market whilst providing a secure and stable way. This keeps funds on-chain to be more easily utilized across the growing DeFi sphere.
By providing a stable digital asset that investors can use as a mid-point between holding assets and withdrawing to the fiat system, the market is becoming much better suited for growth, longevity, and more stability.
Stablecoins come in a variety of forms: fully collateralized, overcollateralized, algorithmic stablecoins, and fractional-algorithmic stablecoins.
Fully collateralized stablecoins
The original and most common type of stablecoin is that which is fully collateralized.
In order to maintain their use and legitimacy as a payment method, stablecoins must have some backing in fiat cash, cryptocurrency, or on-chain tokens that can be redeemed or swapped against.
This backing is collateral. A notable example of a fully collateralized stablecoin is Tether or USDT. The more USDT tokens that Tether mints from the Tether Treasury, the more collateral backing it is required to hold.
The supply of Tether increases when the token price sways above the peg and it decreases when it is below the peg. The collateral can be bought and sold accordingly.
The collateralization component defines the backing that relates to each unit of supply. There are questions in the cryptocurrency investor community though, regarding the legitimacy of the collateral that these tokens claim to hold.
Tether, for example, claims to be backed by “Cash & Cash Equivalents & Other Short-Term Deposits & Commercial Paper.”
However, the “Cash” portion of this is in fact only 2.9%. This lack of real cash collateral has led to much disdain within the cryptocurrency community, which consequently led to court cases and fraud allegations. Despite this, Tether has maintained its position as the most utilized stablecoin.
USDC is backed by the US dollar, but they are centralized meaning you need to trust the third party has the corresponding dollars they issued.
Some of the most popular fully collateralized stablecoins include Tether (USDT) and USD Coin (USDC) at the time of writing.
Overcollateralized stablecoins
An over-collateralized stablecoin is one that has a larger number of cryptocurrency tokens maintained as a reserve for issuing a lower number of stablecoins. This offers a buffer against price fluctuations.
DAI is an example of an overcollateralized stablecoin loan and repayment process. It utilizes a collateralized debt position via MakerDAO to secure assets as collateral on-chain. Users will deposit ether or other cryptocurrencies accepted as collateral and can borrow against the value of their deposits to receive newly generated DAI.
For example, a user needs to deposit $150 worth of ETH to borrow up to 100 DAI. If the collateral value falls below the ratio, the loan can be automatically liquidated by smart contracts. If the value increases, additional DAI can be loaned.
Because DAI is on the blockchain, the asset is pegged to the US dollar allowing people to use Ethereum assets to generate DAI without the need for an intermediary.
Algorithmic stablecoins
As fully collateralized stablecoins gained interest, it soon became clear that as stablecoins grow in demand and adoption, collateralizing them will be a difficult task.
Not only is it difficult to amass and secure hundreds of billions of dollars, but it is also an inefficient use of capital. The collateral is sitting idle instead of being put to more productive use elsewhere.
Around the turn of the year, another form of stablecoin, algorithmic stablecoins, began to spring up. These came in the form of projects such as Basis Cash and Empty Set Dollar.
Algorithmic stablecoins utilize complex algorithms in their smart contracts to expand or contract the circulating supply of the stablecoin.
This will change the price of the stablecoin in reaction to the market conditions in order to help maintain the peg. In other words, an algorithmic stablecoin actually uses an algorithm underneath.
Thus, it can issue more coins when its price increases and buy them off the market when the price falls. This algorithmic manipulation of supply to change the price removes the requirement of collateral backing.
Mainting the peg is key
A key concern, however, is that an algorithmic stablecoin is only effective if it can maintain its peg. Stablecoins maintain their peg through contraction or dilution of the total supply. The changes in the token supply will change the relative price of each token until it reaches the desired peg.
Collateralized stablecoins such as Tether and USDC will increase or decrease the supply manually. This is done by minting and burning when required.
Algorithmic stablecoins, however, will utilize smart contracts, or Algorithmic Markets Operations controllers (AMOs), to automatically control the supply.
Purely algorithmic stablecoins are difficult to bootstrap, are slow to grow, and experience extreme periods of volatility which counteracts the mission of being a stablecoin.
Without collateral backing that the stablecoins can theoretically be redeemed for, there is little to no financial incentive for users to contract or expand the supply and maintain the peg.
However, despite its flaws, an algorithmic stablecoin is a representation of what true decentralization may look like. It has no regulatory bodies to maintain or watch over the proceedings, as the code is what is responsible for both the supply as well as the demand, alongside the target price.
Another key benefit of algorithmic stability is the vast improvements to capital efficiency.
If a stablecoin does not require 100% (or 150% in the case of DAI) of its supply to be collateralized 1:1 for real dollars, then that capital which would otherwise be required to sit idle as collateral can instead be deployed elsewhere in a more efficient manner, such as in yield farms or used in lending.
Enter fractional stablecoins
The concept of algorithmic stablecoins inspired developers with the idea that a stablecoin could achieve mass adoption, yet require less than full collateralization.
The problem of maintaining peg, however, was plaguing the future of algorithmic stablecoins. If stablecoins were to become globally adopted, they must be able to scale. Scaling in this context means that the peg must be maintained as the coin grows, and providing collateral must be made more efficient.
Thus, the idea of fractional stablecoins was born. Fractional stablecoins are a new form of stablecoin and cryptocurrency. A fractional stablecoin is one that is backed in two ways: collaterally-backed and algorithmically modified. In other words, a fraction of the total supply is collaterally backed, not the full supply.
A fractional stablecoin has a collateralization ratio of less than or equal to 100%. This means the stablecoin can be backed by less real dollars or cryptocurrency — a fraction thereof — than its supposed total worth.
This method was devised due to its improvements to capital efficiency as fewer dollars are required to remain idle as collateral. For example, at the time of this writing, Frax’s collateral ratio has been hovering around 80-85 for several months. The other ~15% is backed by a non-stable seigniorage and governance token called FXS.
Mutliple variations on the model
There are many variations to the fractional stablecoin model. These include partially backing it with liquidity or partially allowing redemptions. However, the general idea is still the same, namely that the stablecoin protocol mints more tokens than collateral that is available.
In effect, this means that if users tried to redeem every single stablecoin token for real cash, at the same time, it would not be possible. There would simply not be the required collateral to give out real cash dollars.
Think of it another way: fractional stablecoins have a larger circulating supply of tokens than they do liquidity or collateral. They typically almost always have algorithmic mechanisms to prevent bank runs through economic incentives and game theory. These mechanisms are also called Algorithmic Market Operations controllers (AMOs).
If the price rises above $1, the AMO systems produce new stablecoins until the price returns to $1. If the stablecoin is overcollateralized, the process works in reverse and the available stablecoins or tokens will be burned. This is done in return for the redemption of collateral.
Since its conception, the AMO fractional stablecoin model is the only fractional stablecoin of its kind to maintain its $1 peg.
The AMOs also invest collateral in protocols such as Aave, Compound, and Yearn (as well as staking pools like StakeDAO and Convex), and can pull out invested collateral immediately with no waiting period.
This ensures the stablecoin can remain stable and enough USDC is available to forestall a “bank run” situation. By providing liquidity for the protocol, earning yield, and tightening the peg, AMOs are peripheral contracts that strengthen the protocol.
This is similar to the way that banks make money from loans and investments. However, instead it encourages users to collect admin fees for providing liquidity and helping the asset maintain its stability.
Understanding the power of AMOs
AMOs can be equivalised to those human entities that decide on monetary policy in the traditional financial system. The AMO, a programmed smart contract, decides how best to manipulate a stablecoin’s money supply in order to maintain peg during periods of growth or retraction.
An AMO is a decentralized and autonomous instrument that decides on monetary policy for a currency. AMOs are beneficial because they provide scalability for the algorithmic model alongside decentralization and transparency for the collateralization model.
By providing a stablecoin solution that doesn’t require full collateralization, the stablecoin is more likely to achieve the size and growth large enough for full adoption. Therefore, the growth is sustainable.
If full collateralization is required, a stablecoin’s growth would be capped by the protocol team’s ability to source funding.
An AMO that can achieve the function of supply-side control reliably is a viable alternative to a centralized team that decides on monetary policy as we have in global governments today.
This would free the process of monetary policy from politics, human error, or manipulation. These are three common issues with the traditional finance structure.
The mechanics of AMOs
How does an AMO work? With centralized stablecoins such as Tether and USDC, these supply-side decisions are made in-house by the protocol’s team.
Yet, the goal of decentralization requires this role to be given to a smart contract. The AMO will change the circulating supply of the stablecoin so that the price remains at the target peg.
To allow for decentralized control of the peg and circulating supply, there must be some form of external incentive to entice other people to sell and burn the stablecoin, lowering the price, or to purchase it, raising the price.
This external incentive comes in the form of a seigniorage token. Seigniorage-style stablecoins are designed to have flexible money supplies governed by AMOs that programmatically buy and sell a stablecoin’s tokens.
They often issue a redeemable bond or coupon to incentivize buyers when the stablecoin declines below par value, in order to maintain the token price near the intended peg. This redeemable token is referred to as a seigniorage token.
On top of being used to expand and contract the supply, and in turn balance the price around the peg, seigniorage tokens also act as a governance token for the decisions put to a protocol’s DAO governance structure.
The seigniorage token will act as a ‘vote’ in the DAO’s governance. It gives users of the protocol an element of control over the future decisions that guide the fractional-algorithmic stablecoins.
AMOs have four key functions that it performs depending on the collateralization ratio. This ratio refers to the amount of collateral there is per stablecoin unit.
For example, a stablecoin that has $0.50 collateral for every $1 unit will have a ratio of 50%. The collateralization ratio is adjusted by the AMO to provide an arbitrage opportunity for token holders.
Let’s consider this practically
In the following example:
- The stablecoin is labelled X
- The associated seigniorage token is labelled Y
- ‘Collateralization ratio’ is shortened to CR
1. Decollateralize: Lowers the CR if the price of X is above $1
This is achieved by offering excess collateral to Y holders, which they then redeem for and the AMO burns Y. This improves value-accrual to Y holders.
2. Equilibrium: Maintains CR as the price of X is equal to $1
This is the ideal state.
3. Recollateralize: Increases the CR if the price of X is below $
This is achieved by offering users a .20% bonus rate on the minting of a seigniorage token, to provide an incentive for the provision of more collateral.
4. Deploy idle collateral usefully
Idle collateral is invested in numerous protocols to earn interest/yield. The profits are reinvested back into the protocol.
What’s the draw of fractional algorithmic stablecoins?
Stablecoins are a safe haven in the choppy waters of the cryptocurrency market when it is volatile and uncertain. Instead, holding funds in these assets creates a more stable and secure alternative.
They’ve also secured greater interest because of their ability to generate more yield. This is thanks to decentralized finance applications. Traders can access incredibly high APY in return for staking their cryptocurrency assets and putting these assets to work rather than sitting idle.
This has changed the way many investors and traders think about deploying capital in cryptocurrency. AMOs have introduced the concept of decentralized market stabilizers that can act as an algorithm-controlled central bank.
They are opening the doors to a new strategy of financial stability that brings a formalized framework for increasing and decreasing money supply in a stable way.
We will see the build of more of these capital-efficient stability mechanisms that can be programmed into any kind of market operation like lending markets. Users can now hold a large amount in a stablecoin and stake it for yield. Thus, removing themselves from the volatility of the wider market, while remaining on-chain.
Previously, traders were forced to sell assets into a fiat currency to remain stable in times of volatility. Remaining on-chain means more flexible and rapid transfers, lower fees, and lower regulatory barriers.
Decentralized stablecoins will help create more stability in financial systems. This is because they are an answer to the volatility impacting crypto markets, enabling it to be a truly stable payment method.
Capable of all the above yet decentralized, truly stable, and scalable, fractional algorithmic stablecoins will be the future of decentralized finance.
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