1. What is a stablecoin?

Stablecoins are a type of cryptocurrency. Due to the volatility of cryptocurrencies generated by algorithms or proof-of-stake mechanisms and their lack of value storage functions, they are often viewed as speculative assets rather than replacements for centralized currencies. The core idea of stablecoins is to create a decentralized ledger while maintaining a stable currency value mechanism.

Wikipedia. Stablecoin[EB/OL]. [2024.2.28].https://zh.wikipedia.org/wiki/%E7%A8%B3%E5%AE%9A%E5%B8%81.

The volatility of cryptocurrencies, both in the long and short term, makes these currencies mostly viewed as a speculative investment. Stablecoins supported by more traditional investments give the market greater confidence in their prices. Therefore, stablecoins are often the preferred option for institutional and retail users when making financial decisions involving cryptocurrencies.

2. Functions of Stablecoins

The price volatility of cryptocurrencies makes assets like Bitcoin too unstable for everyday use. There is a need for a decentralized but value-stable digital asset. The market requires an asset that can be used as a store of value for entering and exiting the decentralized financial ecosystem. This asset also needs to serve as a medium of exchange—its value should remain stable over time. Ideally, digital assets should have low inflation to maintain their purchasing power.

As a value-stable digital currency, stablecoins provide a value scale and hedging tools for the cryptocurrency market. In volatile markets, stablecoins can serve as a value anchor, helping investors mitigate risks. With stablecoins providing a stable value, volatile cryptocurrencies gain pivot points for mutual exchange, facilitating convenient asset exchanges in DeFi. Thus, stablecoins serve as a valuable value scale.

For traders, converting risky digital assets into stablecoins during bear markets can achieve hedging effects without leaving the entire cryptocurrency ecosystem.

3. Classification of Stablecoins

According to different stabilization mechanisms, the common stablecoins currently on the market can be roughly divided into four categories:

1. Fiat-Collateralized Stablecoins: Examples include USDC, USDT, and stablecoins issued by exchanges like BUSD.
2. Crypto-Collateralized Stablecoins: Examples include MakerDAO’s DAI and Synthetix’s sUSD.
3. Algorithmic Stablecoins: Examples include LUNA, AMPL, and Frax.
4. Commodity-Backed Stablecoins (Due to fewer existing solutions, this category is not extensively discussed here).

3.1 Fiat-Collateralized Stablecoins

Among them, fiat-collateralized stablecoins are the most popular type. These stablecoins are typically issued and managed by a centralized entity and are backed by real-world financial assets such as cash reserves denominated in US dollars. These centralized stablecoins serve as encrypted tokens with an “anchoring” property, aiming to anchor a certain on-chain asset and maintain the same value as it. To maintain price stability, centralized stablecoins are collateralized by off-chain assets. For instance, when issuing USDT, Tether Inc. prepares a reserve of one US dollar for each USDT issued. To ensure the stablecoin’s value is pegged to the supported asset quantity, centralized issuers usually engage independent accounting firms or audit agencies to regularly verify the supported assets in custody accounts. Due to the backing of real-world assets, the price fluctuation of such stablecoins is generally only influenced by short-term supply and demand, with relatively little volatility.

However, due to the high degree of centralization of such stablecoins, there are transparency issues concerning the issuer’s asset transparency. For example, despite Tether Inc.’s claim that USDT is backed by 100% reserves in USD assets, it has long been criticized as an opaque “unbacked printing machine.”

3.2 Crypto-Collateralized Stablecoins

Crypto-collateralized stablecoins are issued by staking digital assets such as BTC and ETH (often over-collateralized) on smart contracts to create digital currencies pegged to fiat currency prices. Representative examples of this model include DAI issued on the Ethereum blockchain by MakerDAO.

These over-collateralized stablecoins are generated through algorithms and code designs in smart contracts. They do not generate value out of thin air because over-collateralized stablecoins are typically minted by locking a certain amount of assets. If the locked assets need to be retrieved, the corresponding over-collateralized stablecoins must be burned.

3.3 Algorithmic Stablecoins

Algorithmic stablecoins have a unique mechanism. These stablecoins are not backed by any value but rather maintain their price stability through algorithmic adjustments of supply and demand, resembling central banks in the real world.

A typical example of this model is AMPL, introduced in 2018, which is also considered the pioneer of algorithmic stablecoins. Algorithmic stablecoins typically control supply through mechanisms like open market operations, rebasing, and issuing secondary tokens. Due to lacking other value foundations and relying solely on consensus, algorithmic stablecoins have limited resistance to price fluctuations caused by speculative behavior.

Below is a partial implementation of DAI, essentially an ERC-20 token.

Create a new stablecoin

Implementation of the function of stablecoin burning

4. Mechanism of Stablecoin

4.1 Mechanism of Centralized Stablecoins

Asset-Backed: The value of centralized stablecoins such as USDC and USDT is primarily maintained by pegging them 1:1 to fiat currencies like the US dollar. This means that for every stablecoin issued, an equivalent amount of one US dollar (or equivalent asset) is stored as backing. These backing assets are typically held by third-party custodial institutions.

Issuance and Redemption: Users can obtain an equivalent amount of USDC or USDT by depositing US dollars with the stablecoin issuing institution. Similarly, users can redeem these stablecoins for an equivalent value of US dollars. This process ensures that the supply of stablecoins remains consistent with the fiat currency they are backed by.

Compliance and Regulation: As centralized financial products, the issuing institutions of USDC and USDT must comply with relevant financial regulations and compliance requirements. This includes the enforcement of anti-money laundering (AML) and know your customer (KYC) policies.

Figure 1: Diagram illustrating the issuance and circulation of USDT.

Source: “Stability and Instability of Stablecoins” by Koda

In the issuance and circulation mechanism of off-chain stablecoins, there are three main parties involved: the issuing company, customers, and custodian banks. Taking USDT as an example, from the diagram, it can be observed that customers deposit a certain amount of US dollars into Tether Company’s bank account. After confirming receipt of the corresponding funds, Tether Company transfers an equivalent amount of USDT from its core wallet to the customer’s Tether wallet, which belongs to the customer. This process constitutes the issuance of USDT. On the monetary regulation level, Tether Company itself cannot intervene in the price of USDT through its daily issuance and redemption activities, nor are there external entities controlling the price of USDT.

Currently, in different countries, stablecoins anchored to their respective national fiat currencies have been introduced. For example, XSGD is a stablecoin anchored to the Singapore dollar (SGD) jointly launched by Zilliqa and Xfers. e-CNY is a digital version of the Chinese yuan issued by the People’s Bank of China and can be considered a nationally-backed stablecoin introduced by the central bank digital currency (CBDC). EURS, issued by STASIS, is a stablecoin anchored to the euro. Although there are no mainstream stablecoins pegged to the British pound yet, projects like GBPT are exploring this area. CADT is a stablecoin anchored to the Canadian dollar (CAD).

4.2 Over-collateralized Stablecoin Mechanism

For overcollateralized stablecoins, such as the Maker Protocol, the stablecoin mechanism generally operates as follows:

Minting and Burning Mechanism: Dai is created and burned through the overcollateralized loan and repayment process within the MakerDAO smart contracts. Users deposit collateral types (such as Ether) into the contract and mint new Dai as loans based on the value of their collateral.

To measure the relationship between collateral and borrowed stablecoins, we introduce the concept of collateralization ratio.

Collateralization Ratio: At any given time, the dollar value of the collateral divided by the amount of Dai borrowed represents the “collateralization ratio” of the loan. This is calculated based on the dollar prices of collateral assets reported periodically to the contract by a set of decentralized oracles. Each type of loan has a fixed minimum collateralization ratio, typically ranging from 110% to 200%.

As the value of the collateral currency fluctuates, causing fluctuations in the collateralization ratio, when the ratio falls below the specified minimum collateralization ratio, it often triggers the liquidation phase.

Liquidation Mechanism:

If the collateralization ratio of the loan falls below the minimum ratio, anyone can invoke a function of the contract, causing a portion of the collateral to be sold on decentralized exchanges in exchange for Dai. The Dai obtained is then used to repay the debt and pay a reward to the account that invoked the function.

Interest Rates and Repayment:

Once the loan and its accumulated interest are repaid, the returned Dai is automatically burned, and the collateral is available for withdrawal. Thus, the dollar value of Dai can be said to be supported by the dollar value of the underlying collateral held by the MakerDAO smart contracts.

Controlling Dai’s Value:

By controlling the accepted types of collateral, minimum collateralization ratios, and the interest rates for borrowing or storing Dai, MakerDAO can control the quantity of Dai in circulation, thereby controlling its value.

Governance and MKR Token:

The power to propose and implement such variable changes is granted to holders of MKR tokens through code. Owners of governance tokens can vote on proposed changes proportionally to the amount of tokens they hold. MKR tokens also serve as an investment in the MakerDAO system. Additional interest paid by borrowers is used to purchase MKR tokens from the market and burn them, permanently removing them from circulation. This mechanism aims to link MKR to the income from borrowing Dai and create deflationary pressures.

This mechanism ensures the stability of Dai as a stablecoin while maintaining its value in a decentralized manner.

Figure 2: Illustration of Dai Issuance, Circulation, and Regulation

Source: “Stability and Instability of Stablecoins” by Koda

As shown in the figure above, in the issuance, circulation, and regulation mechanism of chain-based stablecoins like DAI, two main types of participants are involved: customers and holders of “related tokens” (such as MKR). The specific process is as follows: customers first deposit Ether (ETH) into a “Collateralized Debt Position” (CDP) established by MakerDAO specifically for them. After confirming the amount of ETH, the CDP locks it and issues a corresponding amount of DAI to the customer’s digital wallet based on a proportion lower than the market value of ETH. If a customer wants to redeem their collateralized ETH, they need to return the corresponding amount of DAI to the CDP and pay the required “stability fee.” Afterward, the CDP will burn the recovered DAI and release the collateralized ETH. In this system, holders of MKR tokens decide critical economic parameters such as collateralization ratios, liquidation ratios, and stability fees through voting. These decisions affect the costs and incentives for customers to issue or redeem DAI, thereby influencing the market value of DAI. When the market price of ETH falls triggering the preset liquidation ratio and the related DAI debt is not repaid in time, the system will automatically initiate a forced auction process to handle the ETH collateralized in the CDP.

Summary

Bitcoin and other early cryptocurrencies were born out of skepticism about the credit of fiat currencies, aiming to achieve openness, democracy, and stability in currency issuance. However, due to factors such as the lack of intrinsic value, most early cryptocurrencies experienced significant price volatility. In this context, stablecoins targeting stable currency prices began to emerge.

Compared to early cryptocurrencies like Bitcoin, off-chain stablecoins anchored to fiat currencies have the most stable prices, followed by on-chain stablecoins anchored to other cryptocurrencies, while algorithmic stablecoins without intrinsic value and only controlled by private entities exhibit the strongest price volatility. In the process of achieving price stability, stablecoins have also given rise to credit risks and “trust” risks, falling into a logical dilemma between “breaking away from fiat currencies” and “achieving price stability.” The operation mechanism of stablecoins, whether decentralized or even completely centralized, fundamentally contradicts the original intention of private digital currency issuance.

Many blockchain optimists believe that in the future, most offline physical assets will be tokenized, becoming digital assets on the blockchain. Each digital asset can be divided into a certain number of tokens for circulation worldwide, which will greatly promote the optimization of resource allocation. As offline assets are tokenized, there arises a need for a price-stable digital currency to effectively facilitate transactions between digital currencies and tokens through smart contracts, thereby fulfilling the functions of a medium of exchange, a unit of account, and a store of value.

In the author’s view, as a foundational infrastructure with financial attributes, we, as ordinary people, can focus on the opportunities presented by decentralized stablecoins. Currently, there are many mechanisms that have been operating for years as overcollateralized stablecoins, such as MakerDAO, DAI, sDAI, Aave, GHO, PRISMA, etc. Perhaps in the future, we will discover even better stablecoin solutions.

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