Stablecoins were developed as a digital alternative to conventional currencies, which are frequently backed by governments and central banks and are linked to physical assets like cash or commodities (such as gold or silver).

Because of this, a lot of stablecoins have a 1:1 relation with fiat money like the US dollar or the euro. Then all stablecoins are decentralized, right? No, most remain centrally located.

Stablecoins were introduced so that traders could store money in an asset that would retain its value and remain available for trading.

Before the development of stablecoins, anytime traders found it extremely unpleasant to sell coins because they had to convert their proceeds back into fiat money or, in some cases, remove their funds entirely from the cryptocurrency exchange.

Due to the ability to temporarily move money into a stablecoin until they were ready to return to the cryptocurrency market, stablecoins have helped traders cope with moments of volatility.

What is a decentralized stablecoin?

Decentralized stablecoins are being created to increase the security and transparency of stablecoins or other stablecoin types, decentralized stablecoins are digital assets with a value tied to a specific external asset, either a national fiat currency like the US dollar or a commodity. Theoretically, being anchored to a physical asset reduces volatility.

Decentralized stablecoins are completely transparent and non-custodial, which means that no one organization or centralized entity has control over them. This distinguishes them from centralized stablecoins. Users are aware that the stablecoin is backed by collateral because it is transparent to them.

Decentralization enables a trustworthy and secure system in which a centralized party cannot manipulate the coin supply or falsely claim to have assets to back the token. Instead, the coin's supply is managed automatically by smart contracts and algorithms.

How decentralized stablecoins work?

Decentralized stablecoins all operate under several control points rather than a single authority, as is the case with centralized stablecoins. Centralized stablecoins are issued and distributed under the supervision of a single entity, and their pegs are kept at the value of actual fiat money or other assets like gold, oil, and real estate.

The governance and pegging systems of decentralized stablecoins are different. Because the governance structures of the various types of decentralized stablecoins are comparable, they are categorized according to their methods for minting and maintaining their pegs. The four most common decentralized stablecoin types at the moment are as follows.

4 types of decentralized stablecoins

Overcollateralized stablecoins

As the name implies, these stablecoins are frequently collateralized by sums that are substantially more than the value of the newly issued stablecoin. For instance, you need to mortgage $2 to mint $1 in stablecoin.

Algorithmic stablecoins

The working of algorithm stablecoins

The working of algorithm stablecoins (Source: Bybit learn)

Instead of solely depending on collateral, algorithmic stablecoins typically maintain value by automatically adjusting the supply through mints and ongoing token burning. To maintain a predetermined peg, algorithmic stablecoins are designed to react to the dominant forces of supply and demand.

The majority of algorithmic stablecoin initiatives use a dual token system: a stablecoin and a volatile asset that upholds the demand and supply dynamics that maintain the stablecoin's value.

Fractional Algorithmic stablecoin

These stablecoins can be thought of as a cross between algorithmic and collateral-backed stablecoins. For example, by collateralizing a sum and simultaneously having the algorithmic stablecoin model hold its price, the semi-algorithmic stablecoin can be created.

Algorithms and collateral provide a portion of the backing for fractional algorithmic stablecoins. Depending on the state of the market, the collateral to stablecoins ratio changes. The collateral ratio is larger during bad market conditions than during more favorable ones. This makes it possible for the protocol to satisfy the presiding conditions.

Non-pegged stablecoin

Unlike the aforementioned stablecoins, the price of this stablecoin will be set by the project's own supply and demand model rather than attempting to maintain a value of one US dollar. This model has not yet gained popularity or been applied broadly for a variety of reasons.

Discussion around decentralized stablecoins

Pros of decentralized stablecoins

Crypto users are gradually losing faith in centralized stablecoins as the company behind it could experience issues at any time in light of Paxos' recent SEC lawsuit, which prevented the stablecoin BUSD from being issued.

Because of their openness and strong security, stablecoin projects that are moving towards decentralization are receiving a lot of attention. This gives decentralized stablecoins a foundation on which to grow and later establish trends.

Decentralized stablecoins, in my opinion, have not been successful in starting a significant trend. In part, there are many issues with decentralized stablecoins and the story of this development is yet unknown.

Most people are now familiar with stablecoin types including algorithmic stablecoins, crypto-collateralized stablecoins, and stablecoins backed by cash. Although there are more kinds of stablecoins, like commodity-backed and seigniorage, these three are the most widely used.

Users may favor one type of stablecoin over another for various reasons. Some people, for instance, favor using algorithmic stablecoins due to their decentralized nature. Others would choose centralized fiat-backed cryptocurrencies like Tether USDT and USD Coin over decentralized alternatives since private companies keep the corresponding fiat reserves of each token created. The fact that a real asset is used to underpin fiat-backed currencies is still a benefit.

As long as there are verifiable holdings of such fiat reserves, its peg will continue to be stable. The most obvious danger here is still a bank run, which for Tether might be problematic given how heavily it is dependent on commercial paper. Large firms issue commercial papers, which are unsecured debts with maturities of up to 270 days or more. Tether's holdings of commercial paper have been drastically reduced over the past six months because a significant number of redemptions could cause it to become insolvent.

On the other side, crypto-collateralized stablecoins like Dai are supported by a surplus of another cryptocurrency, in this case, Ether ETH. Dai mandates a collateralization ratio of at least 150%, which means that the amount of ETH deposited in a smart contract must be at least 1.5 times greater than the amount of Dai being borrowed. For instance, a user must lock in $1,500 worth of Ether to borrow $1,000 worth of Dai. The collateral is automatically repaid into the smart contract to close the position if the market price of Ether falls below the threshold at which the minimum collateralization ratio is no longer met.

Cons of decentralized stablecoins

Decentralized stablecoins can have some drawbacks, though. Currently, a lot of users are also worried about these things:

Unstablility

How stable are decentralized stablecoins? The majority of stablecoins tied to the US dollar have a track record of deviating noticeably from the dollar peg. Several decentralized stablecoin initiatives have completely lost their peg and fallen apart. Decentralized stablecoins are a high-risk investment because they are constantly de-pegged from centralized stablecoins. The purpose of a reliable store of value is wholly defeated in this.

While there are quite a few of these occurrences, the most well-known and terrifying example of stablecoin de-pegging is the collapse of Luna and UST. An event that is thought to have made the cryptocurrency winter harsher. An infamous exploitation that rocked the USTC pegging algorithm (already discussed) set off a chain reaction of subsequent dishonest incidents. The rest of the market reportedly collapsed as a result of efforts to save the peg via the Treasury system.

Other de-pegging events were hampered by the USTC incident. During this time, a significant number of decentralized stablecoins lost their pegs. While some have now bounced back and taken back their pegs, others have not.

Risk of fraud or hacks

Many decentralized stablecoin initiatives have shut down with the teams allegedly taking customers' money (such as Acala USD, BeanStalk, and Easily Finance). Due to fraud allegations made by the community or the projects' creators, a few decentralized stablecoin projects currently in existence are under constant watch. Decentralized stablecoin initiatives are viewed as the wild west, much like the volatile and uncontrolled cryptocurrencies, and cryptocurrency aficionados are currently more at ease with centralized stablecoins like USDT and USDC, as evidenced by their commanding market capitalization.

Short lifespan

Many decentralized stablecoin projects have failed just a few months after debuting due to a lack of interest and issues with the operating concept. The stablecoin USN produced by NEAR is the most prevalent. After only six months in operation, this stablecoin was "killed" for a variety of reasons.

The degree of decentralization in decentralized stablecoin projects has also been the subject of numerous inquiries. The community can decide the project's future thanks to the DAO mechanism. But despite the community's wishes, this structure is still vulnerable to change. Additionally, it has been claimed that project teams are coming up with strategies to rig community votes in their favor. Projects are not fully decentralized in situations like this.

Examples of decentralized stablecoin

MakerDAO DAI

The MakerDAO loan system for DAI is set up to let users borrow less than the value of the provided collateral. A 150% collateral system is required by the lending procedure. In other words, users can create DAI by locking 150% of the DAI's value that they want to borrow. For example, $150 of ETH or other authorized assets must be locked to manufacture $100 worth of DAI.

Amounts of DAI are minted as loans when a user locks an asset. Like other cryptocurrencies, the newly created DAI can be utilized. Every DAI in circulation is supported by a surplus of assets thanks to the excess collateral scheme. The minted/borrowed DAI accumulates interest over time. The collateral is released to the user while the DAI is burned after the minted DAI and the interest are paid back.

The MakerDAO is in charge of the Maker protocol. On suggestions put forth by community members, Maker token owners can vote via the governance portal. The Maker protocol and the DAI are both completely controlled by the DAO.

Frax Finance FRAX

The concept of fractional algorithmic stablecoins was first proposed by Frax Finance. FRAX, a stablecoin tied to the US dollar, and FPI, a stablecoin tied to the US Consumer Price Index, are both operated by Frax. Additionally, two distinct DAOs led by FXS (Frax share) and FPIS (FPI share), respectively, maintain the FRAX and FPI stablecoins. The two stablecoins, a native AMM (Fraxswap), and a lending facility (Fraxlend) make up the bulk of the Frax Finance ecosystem.

The FRAX stablecoins' peg is maintained through the minting and redemption algorithm. A user offers USDC and FXS as collateral to mint FRAX. The ratio of the two tokens offered for the minting is specified by the FRAX collateral ratio. There are more FXS provided throughout the minting procedure when the collateral ratio is higher.

Minting and Redeeming process via Frax Finance (Source: Frax Finance)

With a 50% collateral ratio, a user would need to contribute $0.5 in USDC and $0.5 in FXS to mint $1 in FRAX. For each FRAX submitted, the user will receive 0.5$ USDC and 0.5$ FXS; the provided FXS is burned when redeeming at the same ratio. The given FRAX is burned while redeeming FXS and USDC.

In February 2023, it was decided that FRAX will gradually lose its algorithmic support and be entirely collateralized by USDC.

Liquity LUSD

Another decentralized borrowing protocol on Ethereum is called Liquity, which allows users to borrow LUSD interest-free with simply ETH as collateral and a capital-efficient collateralization ratio of 110%.

For instance, to borrow $1,000 worth of LUSD, a user must deposit $1,000 worth of ETH into their Trove account, which serves as a credit account for handling LUSD loans.

Liquity uses a novel stability pool technique to guarantee that the LUSD stablecoin's value stays at $1 and that the protocol is financially sound. Stability pools serve as a source of liquidity to pay off debt from liquidated Troves, making sure that the entire quantity of LUSD is always backed.

The stability mechanism of Liquity kicks in if the collateral value is less than the 110% collateralization ratio. To settle the LUSD loan, the system automatically sells some of the borrower's collateral. Users who can repay the loan can bid on the liquidated collateral at a discount auction. This contributes to maintaining the protocol's financial stability and the over-collateralization of LUSD by ETH.

Stability Providers gradually lose a pro rata portion of their LUSD deposits while accruing a pro rata portion of the liquidated collateral. However, because Troves are probably liquidated at collateral ratios just under 110%, it is anticipated that Stability Providers would receive more money in terms of collateral compared to the debt they settle.

Users can borrow interest-free loans against their ETH collateral thanks to Liquity's distinctive stability mechanism, which sets it apart from other stablecoin protocols.

The protocol has made great progress in the decentralized finance (DeFi) community, and DeFi investors and traders are growing more and more accustomed to using its LUSD stablecoin. even had its governance token, LQTY, published on Binance.

Reflexer Finance RAI

Unlike previously decentralized stablecoins, RAI's stablecoin system runs on a reflex index rather than a pegging mechanism. Prevalent demand and supply conditions serve as the Reflex Index's guiding principles. It isn't backed by a vault or pegged like other stablecoins.

The RAI system involves two parties. By leveraging their Ethereum and RAI holders, SAFE users create RAI. Both parties are motivated to mint RAI or redeem their assets depending on the supply and demand conditions. Thus, the system remains stable.

Users are encouraged to repay their obligations or borrow from the pool thanks to a lending procedure that is driven by the redemption rate. Users will need to lock their assets in the RAI protocol and mint/borrow a stablecoin to borrow from the RAI protocol.

The redemption rate determines the RAI's worth. Instead of being pegged like the DAI, the RAI is exactly in line with the current supply and demand situations. Every time a price update is received for the approved collaterals, the RAI system interfaces with a price feed technology and changes the redemption price.

According to RAI, MakerDAO initially suggested the DAI use this system. The RAI system offers users a larger variety of rewards.

Bottom lines

Stable cryptocurrency development has advanced to the stage of decentralized stablecoins. They offer a more open stablecoin system as an alternative to the somewhat more established centralized stablecoins. Ironically, efforts for decentralized stablecoins have experienced the same level of scrutiny as those for centralized stablecoins.

The fact that these systems are still in their infancy confirms their brilliance and does not diminish their genius. Every unsuccessful decentralized stablecoin gives birth to a new one with suggested fixes for the last. This idea may (hopefully) become a fully functional decentralized stablecoin system as a result of ongoing advancements.

There are several benefits to using a perfect decentralized stablecoin system over centralized ones. a mathematically-based system that is impervious to outside intervention. This might provide a stablecoin system that is truly sovereign and has a long-term peg. a political and financial dual utility.

A well-running decentralized stablecoin gives cryptocurrency aficionados a potent financial weapon in the financial department. one created using technologies they comprehend. It offers a reliable focal point for adoration and a way to hold worth.

Decentralized stablecoins are sufficiently transparent from a political standpoint, and regulatory agencies may simply confirm their legitimacy. Their resistance to censorship gives holders and traders additional peace of mind.

Having said that, it's critical to recognize that cutting-edge systems like decentralized stablecoins still have a risk of malfunctioning. This is evident in the case of USTC and other decentralized stablecoins, which have had their systems abused or lost their pegs in the past, severely harming users. To avoid or reduce losses, it is crucial to take into account the safety levels of these systems and proceed cautiously.

Disclaimer:
This article is intended for and only to be used for reference purposes only. No such information provided constitutes advice or a recommendation that any investment or trading strategy is suitable for any specific name.

Decrypting decentralized stablecoins theory