DeFi Alternatives to Centralized Stablecoins

Current alternatives to centralized stablecoins are lacking.

The Ideal Decentralized Stablecoin

When considering the essential features of an ideal stablecoin, three key characteristics stand out:

1. Stability: The primary objective of a stablecoin is to maintain a consistent peg to a non-cryptocurrency asset, such as the US Dollar. If a stablecoin experiences significant fluctuations above or below this peg, it undermines its utility and reliability.

2. Decentralization: It is important that the issuance, trading, and circulation of the stablecoin are not reliant on any centralized authority. The ability to mint and redeem the stablecoin should be decentralized and permissionless.

3. Capital Efficiency: Ideally, anyone should be able to mint $1 worth of stablecoin with minimal assets, as low as $1. Requiring a higher amount is inefficient and limits broader adoption, as users suffer opportunity cost on the overcollateral.

Current Decentralized Stablecoins

Unlike centralized stablecoins, which are issued and managed by a single entity or organization, decentralized stablecoins operate on decentralized blockchain, where transactions are verified and recorded. DeFi Alternatives to Fiat-backed Centralized Stablecoins usually falls into two main types, categorized by their collateral:

Overcollateralized Stablecoins

In an overcollateralized stablecoin protocols, users can mint stablecoins by depositing a certain amount of collateral, typically in the form of other cryptocurrencies. The collateral is then locked up in a smart contract, and stablecoins are minted and issued to the user based on a predefined collateralization ratio. This ratio ensures that there is always more collateral backing the stablecoins than their total value in circulation.

The overcollateralization mechanism helps to mitigate the risk of default and ensures that the stablecoin maintains its peg to the desired asset, such as the US dollar or another fiat currency. If the value of the collateral falls below a certain threshold due to market fluctuations, users may be required to either add more collateral or have their collateral liquidated to maintain the stability of the stablecoin.

The biggest issue with overcollateralized stablecoins is their lack of capital efficiency. Although over-collateralization can effectively maintain a 1:1 peg, the amount of resources necessary to safeguard the stablecoins' prices is significantly greater compared to traditional financial arrangements. This additional locked up capital incurs substantial opportunity costs for users.

Algorithmic Stablecoins

Algorithmic stablecoins typically employ a combination of supply and demand management techniques, algorithmic rebalancing, and incentive mechanisms to regulate the stablecoin's supply and stabilize its price. For example, when the price of the stablecoin exceeds its target value, the algorithm may increase the coin's supply to bring the price back down. Conversely, if the price falls below the target value, the algorithm may decrease the coin's supply to increase demand and raise the price.

Most algorithmic stablecoin protocols use a dual-token system: a stablecoin with a fixed face value, and an investment token with a floating value. The algorithm allows users to convert the investment token into the stablecoin at the investment token's market price. When the stablecoin depegs, arbitrageurs can buy the stablecoin token at the lower price and burn them to redeem the relatively higher-valued investment token. This increases the stablecoin demand, thus its price, and prevents the stablecoin from depegging. The reverse is also true.

The biggest issue with algorithmic stablecoins is their lack of stability. The dual-token algorithmic stablecoin system relies on the value of the investment token to maintain the value of the stablecoin token. However, when the stablecoin depegs, the investment token's market value is also likely to be impaired as the confidence in the whole stablecoin arrangement erodes. This results in the investment token not being able to support the arbitrage, making the stablecoin stray farther from the peg and creating a 'dead spiral' for the whole system.