Decentralized stablecoins refer to stablecoins issued and managed in a decentralized manner and do not require centralization Involvement of agencies/entities.

A stablecoin is a cryptocurrency whose price is anchored to a "stable" asset. Among them, "stable assets" can refer to currencies, a basket of currencies, other crypto-assets, commodities (such as gold), etc. For decentralization, please refer to the "What is DeFi" chapter; for stablecoins, please refer to the "What is a stablecoin" chapter.

Compared with other cryptocurrencies (e.g. BTC and ETH), stablecoins provide the market with a more stable pricing method and transaction medium, and are also closer to users’ traditional payment methods. Conducive to promoting the widespread use of cryptocurrency.

Classification of decentralized stablecoins

In general, decentralized stablecoins are divided into two categories, over-collateralized stablecoins and algorithmically stable coins currency.

Over-collateralized stablecoin

An over-collateralized stablecoin is a stablecoin whose value is backed by other cryptocurrencies as collateral (reserves). Usually the value of the collateral is greater than the value of the issued stablecoin, so it is called over-collateralization.

For example: a USD stablecoin with ETH as collateral. Every $1 worth of stablecoins is backed by $1.5 worth of ETH as collateral. Due to the large price fluctuations of crypto assets, this over-collateralization can effectively prevent the value of collateral from falling and being unable to support the value of stablecoins issued.

DAI is the earliest over-collateralized stablecoin issued and is currently the decentralized stablecoin with the largest market share. Other over-collateralized stablecoins include: LUSD, MIM, etc.

Algorithmic Stablecoin

The price stability of algorithmic stablecoin does not depend on the value of collateral, but adjusts the price by using automated algorithmic mechanisms to regulate the supply of stablecoins. When the stablecoin price is higher than the target price, the system will issue additional stablecoins to bring the price down, and vice versa.

Currently, there are two common stability maintenance mechanisms in the market: Rebase and Seigniorage. Rebase dynamically controls the supply of stablecoins by controlling the minting and destruction of stablecoins. On Ampleforth, the number of AMPL tokens in the user's wallet will be updated every 24 hours.

Seigniorage uses a dual-pass model, usually a stable currency and a governance pass. For example, Terra issued UST (now USTC) and LUNA (now LUNC). In the Terra market, UST is hard-pegged to the U.S. dollar (1 UST = $1), and users can arbitrage by exchanging UST and LUNA in the market. Users can mint 1 UST with 1 USD worth of LUNA at any time, or redeem UST as 1 USD back to LUNA.

For example:

When $UST is in short supply causing the price to rise above $1, say $1.05, then arbitrageurs can destroy $1 worth of $LUNA mints 1 UST and then buys back $1.05 worth of $LUNA, which is equivalent to a risk-free profit of $0.05. By continuously repeating such operations, the circulation of UST will increase and eventually stabilize at a balance between supply and demand, that is, 1 UST = $1. The continuous destruction of $LUNA leads to a reduction in circulation, which will eventually indirectly lead to an increase in price.

The Rebase mechanism regulates the supply of stablecoins by the protocol, while under the Seigniorage mechanism, the platform maintains the dynamic stability of stablecoin prices by encouraging users to actively arbitrage.

Decentralized stablecoins vs. centralized stablecoins

There are many differences between decentralized stablecoins and centralized stablecoins, mainly Includes: degree of decentralization, censorship resistance, transparency, reserves, and use cases.

Degree of decentralization

Different from centralized stablecoins, decentralized stablecoins are not controlled by centralized entities/institutions. Their issuance is controlled by smart contracts, and their governance is controlled by Decentralized users (usually DAOs) are responsible. For example, the decentralized stablecoin DAI is issued by the decentralized protocol MakerDAO and is managed by a DAO composed of MRK token holders. Because they do not rely on a single entity or institution, decentralized stablecoins will not be directly affected by the collapse of a certain entity or institution.

In 2023, Silicon Valley Bank, one of Circle’s six banking partners responsible for managing approximately 25% of $USDC’s cash reserves, collapsed. The reserve of USDC was therefore questioned, and the price of USDC fell to a low of around $0.8 on March 11.

Censorship Resistance

Decentralized stablecoins are censorship resistant. The transactions and funds of decentralized stablecoins are managed by decentralized networks and users, rather than centralized institutions or entities, so no central authority can unilaterally freeze or confiscate their transactions or funds. In addition, decentralized stablecoins run on a blockchain network, which is transparent and immutable, and all transactions are open, transparent and cannot be tampered with.

In 2022, Circle reported problems with BUSD’s reserves to the New York Department of Financial Services, and in January 2023 Binance admitted that BUSD had experienced reserve management deficiencies.

In February, BUSD issuer Paxos was investigated by the New York Department of Financial Services, and BUSD began to experience outflows. Subsequently, the SEC planned to sue Paxos, claiming that BUSD was an unregistered security. On the 13th, BUSD was announced to cease issuance.

On February 13, Binance CEO Changpeng Zhao stated that BUSD will no longer be the main trading currency on Binance

On February 28, Coinbase It was announced that BUSD trading would be stopped starting from March 13th. In March, AAVE DAO voted to remove BUSD from its lending platform.

Transparency

The reserves of centralized stablecoins are usually kept in the bank accounts of the issuing institutions. Users cannot know the actual reserves unless the institutions actively disclose them. Condition. The issuance and reserves of decentralized stablecoins are managed by smart contracts. The issuance, transaction and destruction records of stablecoins are all on the blockchain and are publicly available for inspection.

Reserves

The reserves of centralized stablecoins are legal tender and other real assets, while the reserves of decentralized stablecoins are mostly crypto assets, and algorithmic stablecoins do not even need Reserves. For example: 82.13% of USDT's reserves are cash and cash equivalents, 8.73% are secured loans, 5.14% are commercial bonds, funds and precious metals, and 4.01% are other investments. 63.8% of DAI's reserve assets are other stablecoins, 16.1% are ETH, 13.3% are RWA, 3.6% are LP, and the remaining 3.2% are other assets. (2023.3.29)

Due to the lack of sufficient reserve support for algorithmic stablecoins, the risk is high. Currently, the only well-known algorithmic stablecoin on the market is USDD. UST was once one of the decentralized stablecoins with the highest market capitalization. However, due to many reasons such as runs caused by market panic and excessive inflation of LUNA, UST began to rapidly unanchor on May 10, 2022, and has now basically returned to zero. FRAX used to adopt a hybrid mechanism of partial mortgage and partial algorithm balancing. But it has recently converted to a pure staking model through community proposals, abandoning algorithmic balance.

Use cases

Compared with centralized stablecoins, decentralized stablecoins have more single usage scenarios. USDT & USDC are not only used as centralized exchanges The standard currency is also widely used in decentralized protocols. However, the application scenarios of decentralized stablecoins are currently limited to on-chain applications. The role of some decentralized stablecoins like FRAX is mainly to cooperate with other products in the ecosystem and have specific application scenarios. Therefore, the composability is low and cannot be used. Widely adopted by third parties.

Related reading: "Status and Prospects of Stablecoin Market in 2023"