Demystifying DeFi

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Recently stablecoins have become an increasingly important topic in the crypto landscape. But what really is a stablecoin and why have we been seeing an explosion in their growth?

Well, as implied by the name, a stablecoin is supposed to be a “stable” asset i.e. has low price volatility and is typically backed by some sort of asset which ensures this low price volatility. The top 10 stablecoins by market cap can be seen below.

Let’s get a bit more specific… there are 4 different types of stablecoins: 1) Fiat-collateralized e.g. USDC 2) Crypto-backed e.g. Dai 3) Commodity-backed e.g. XAUT 4) Algorithmic e.g. UST

Let’s start with arguably the simplest fiat-collateralized. The logic here being you give a custodian $1 and so you get $1 worth of their stablecoin. They then hold your dollar and you can redeem your stablecoin for that $1 at any time. Simple!

The first stablecoins were fiat-collateralized due to this simplicity but there are some downsides: 1) the custodial risk, if you give someone a dollar to back a stablecoin they may run off with it 2) extremely centralised, the whole point of crypto is it is decentralised

The logical extension of fiat-collateralized is to use crypto as the collateral. In the simplest case rather than giving $1 to a custodian to receive $1 of stableoins I would give $1 of BTC. In practicality, BTC is far more risky than USD so a margin of safety is needed.

This results in overcollateralized. In our example above when giving $1 of BTC you may only get $0.70 of the given stablecoin. For example, when minting Dai using WBTC there is a min collateral ratio of 130%. This ratio varies depending on the collateral risk.

Relative to fiat-backed stablecoins crypto-backed stablecoins have the advantage of being more transparent as they are can be written in a smart contract.

However, they are less capital efficient. Why does capital efficiency matter? Well, the less capital efficient a stablecoin is the smaller the max supply that can be created for a given amount of collateral.

Why do I care about capital efficiency? Well because the more capital efficient a stablecoin is the less expensive it is to mint money which in turn results in lower lending rates more liquidity and better market efficiency.

Sam Kazemian has a great thread about just this about this

A 🧵 on algorithmic stablecoins & capital efficiency A lot of algo stablecoin critics continue to feel vindicated when a new project feils. But skeptics misunderstand nuances in how the space is evolving. Let me tell you why your life will be ruled by algo stables soon

What about commodity-backed stablecoins? Well as you might have guessed they are very similar to fiat-backed but collateralized with a commodity instead, for example XAUT is backed by gold.

However, rather than trying to track the price of say a dollar, these contracts will often track the price of the commodity they are backed by. So the stability of these stablecoins is somewhat debatable!

Commodity-backed stablecoins also have the same centralized risk as fiat-collateralised coins. The custodian ideally needs an inventory of the commodity or a product with delta 1 exposure to this commodity. Given these factors, this type of stablecoin isn’t very popular

Algorithmic stablecoins are quite unique in that they use a set of predefined algorithmic rules to try and maintain price stability.

Typically these algorithmic rules increase the supply of the stablecoin when it is trading above $1 to incentivise selling and decrease supply when it is trading below $1 to incentivise buying. Though the specifics of how this is done vary from coin to coin.

Algorithmic stablecoins are typically a lot more capital efficient and decentralised than the other stablecoin options. However, their ability to maintain stability can be questionable as they are susceptible to the dreaded “death spiral”.