5 Decentralized stablecoins; the risks and benefits

Introduction

The past period has been turbulent for the financial industry. One notable example was the inability of Silicon Valley Bank (SVB) to meet withdrawal demands led to widespread panic, which quickly extended to the crypto market. Circle, the company behind the stablecoin USDC, had a portion of its capital backing the stablecoin held at the faltering SVB. This caused USDC to de-peg from the US dollar.

While the USDC situation is resolved, it's worth considering the benefits of decentralized stablecoins as a potential solution to mitigate similar risks in the future. Decentralized stablecoins are not reliant on centralized institutions, which can be vulnerable to crises, as seen with SVB and Circle. These alternatives offer stability, transparency, and reduced counterparty risk, making them increasingly appealing to investors. We recently saw this when the United States Securities and Exchange Commission (SEC) issued a wells notice to Paxos, alleging that BUSD is unregistered security.

This goes to show that centralized stablecoins are still at the mercy of regulatory scrutiny and traditional financial systems. By adopting decentralized stablecoins, the market can potentially achieve greater resilience and independence from such vulnerabilities. As the financial landscape continues to evolve, it's essential for investors and market participants to explore and adopt innovative solutions, such as decentralized stablecoins, which can provide increased stability and reliability in times of uncertainty.

This article will look closely at five decentralized stablecoins, exploring their unique features, risks, and benefits. By understanding these alternatives, investors can make better-informed decisions and navigate this complex space.

Liquity, the real decentralized stablecoin

Liquity is a decentralized borrowing platform on the Ethereum network. It allows users to use Ethereum as collateral to borrow LUSD, a stablecoin, without interest. The platform requires a collateralization ratio of 110%, making it efficient for users. For instance, if someone wants to borrow $1,000 in LUSD, they need to deposit an amount of ETH worth $1,100 into their Trove. A Trove is a particular account used to manage LUSD loans.

Liquity uses a unique system called a stability pool to keep the value of its LUSD stablecoin at $1 and ensure the platform stays solvent. Stability pools provide liquidity to pay off the debt from liquidated Troves, ensuring that the total LUSD supply is always backed by collateral. When the collateral value falls below the required 110% collateralization ratio, Liquity's stability mechanism is activated. The platform automatically sells some of the borrower's collateral to repay the LUSD debt. Users can then buy the liquidated collateral at a discounted price to pay off the loan. This process helps keep LUSD overcollateralized by ETH and the platform solvent.

Curve, the stable swap stablecoin

Curve, a major decentralized exchange on the Ethereum network, has published a whitepaper about its upcoming overcollateralized USD-pegged stablecoin called crvUSD. What sets crvUSD apart is its innovative Lending-Liquidating AMM Algorithm (LLAMMA), designed to protect borrowers when the value of their collateral drops below the liquidation price.

Initially, Curve will use ETH as collateral, but there are plans to expand collateral options to include liquidity pool (LP) positions.

For example, if the price of ETH falls close to the liquidation point, the protocol will automatically convert ETH into USD. Conversely, when ETH costs increase, the USD will be converted back into ETH. This innovative process smooths out the liquidation process, which used to be an "all-at-once" event, leading to significant slippage and potentially worsening losses, particularly during volatile market periods.

The introduction of Curve's crvUSD could generate increased revenue for the CRV token and improve its competitiveness against other tokens in the market. There has yet to be an official launch date for Curve's crvUSD, but rumours suggest it might be released soon.

AAVE, the money market stablecoin

AAVE is one the biggest decentralized lending platforms. The protocol enables users to lend crypto while earning fees in return and borrow crypto assets in an overcollateralized manner while paying borrowing fees to lenders.

AAVE plans to introduce its own overcollateralized USD stablecoin called GHO, which will be backed by various cryptocurrencies that users can currently deposit on the platform. GHO's oracle price on AAVE will be fixed at $1, unlike many other stablecoins on the platform. In addition, AAVE token stakers participating in the platform's safety module can mint GHO at a discounted price, which adds further utility to the AAVE token.

GHO is fully decentralized and secured by an over-collateralization mechanism, just like Aave's crypto loans. Aave mints GHO tokens when users of its loan service deposit cryptocurrency as collateral to borrow GHO tokens. When the loan is repaid, Aave burns the GHO tokens issued in connection with the loan. In this way, the number of tokens in the protocol is reduced. Only assets in the Aave protocol can be used as collateral against GHO tokens.

The official launch date for AAVE's GHO has yet to be announced, but it is rumored to be coming soon.

sUSD, a synthetic stablecoin

sUSD is a synthetic stablecoin on the Synthetix platform designed to track the US dollar's value. Users can create sUSD tokens by staking SNX tokens in a smart contract. Once minted, sUSD tokens can be used on the Synthetix platform to trade against other synthetic assets.

In the Synthetix ecosystem, sUSD functions as a "debt obligation." Users who mint sUSD receive a portion of the total debt pool for all synthetic assets created on the platform. As a result, the demand for minting and holding sUSD depends on the demand for generating and owning synthetic assets on Synthetix.

The sUSD token maintains its stable value through arbitrage opportunities with other synthetic assets in the debt pool. For example, if the price of sUSD drops to $0.98 on secondary markets, a user can purchase 100 sUSD for $98 and then redeem the sUSD tokens for $100 worth of sBTC or any other synthetic assets on the Synthetix platform. This process helps to keep the sUSD token's value stable and close to the US Dollar.

Reflexer, the stablecoin with the reflex index

Reflexer Finance (RAI) offers a unique stablecoin system that relies on a reflex index rather than traditional pegging mechanisms used by other decentralized stablecoins. The reflex index adjusts based on prevailing supply and demand conditions, allowing for a more flexible and adaptive system.

Two key parties interact within the RAI ecosystem: SAFE users who mint RAI using their Ethereum and RAI holders. These parties are incentivized to either mint RAI or redeem their assets based on supply and demand, maintaining the system's stability.

A lending protocol guided by the redemption rate encourages users to repay their debts or borrow from the pool. Users lock their assets in the system to access funds from the RAI protocol and mint or borrow a stablecoin.

The value of RAI is determined by the redemption rate, which adjusts according to the current supply and demand conditions rather than being pegged to another asset like DAI. RAI's system connects to a price feed technology that updates the redemption price whenever price updates are received for approved collateral assets.

The Advantages of Decentralized Stablecoins

Decentralized stablecoins have emerged as an innovation in cryptocurrencies, offering unique benefits to users looking for stability, security, and autonomy. One of the main benefits of decentralized stablecoins is the decentralization aspect itself. By removing the need for central authorities, such as banks or governments, decentralized stablecoins reduce the risk of debanking, censorship, manipulation, and the influence of political agendas. This allows for a more transparent and open financial system where users can trust the underlying protocol rather than relying on centralized entities that may prioritize their interests.

Decentralized stablecoins provide improved security by distributing the responsibility for maintaining the system across a network of nodes. This distributed nature reduces the likelihood of a single point of failure, making it less vulnerable to attacks or manipulation. Additionally, decentralized stablecoins are typically backed by various cryptocurrencies or smart contracts, reducing the risk of a central authority's mismanagement or failure.

The Risks of Decentralized stablecoins

Decentralized stablecoins also come with certain risks that need to be considered.

One risk associated with decentralized stablecoins is the collateral volatility used to back them. These stablecoins are often overcollateralized with cryptocurrencies, which can experience significant price fluctuations. A sudden drop in the value of the collateral can result in liquidations, potentially destabilizing the stablecoin's value and affecting its users. Overcollateralization also leads to capital inefficiencies as for every $1 of stablecoin, more than $1 is locked into a smart contract.

Another concern is the potential vulnerability of smart contracts that underpin decentralized stablecoins. These contracts can have bugs or security flaws that hackers can exploit, compromising the stablecoin's integrity and potentially leading to the loss of funds for users or affecting the stablecoin's stability. Their design can also be fundamentally flawed like Terra’s UST stablecoin that collapsed in 2022. Due to the complex design of stablecoins, very few market participants can actually signal these flaws.

Finally, Decentralized stablecoins rely on external price feeds or oracles to determine collateral value. Oracle risk arises when these price feeds are manipulated or provide incorrect data, which could impact the stablecoin's stability, leading to forced liquidations or other issues.

A final thought

Decentralized stablecoins represent the next evolutionary step in the world of digital currencies. As an alternative to the more traditional centralized stablecoins, they offer a transparent and open system, built on public ledgers with open-source code. It's intriguing that decentralized stablecoin projects face scrutiny similar to their centralized counterparts, despite their inherent transparency.

These innovative stablecoins have immense potential, but it's important to acknowledge the risks that come with their development. The growing pains of these emerging systems only serve to highlight the early stage of their evolution. With each failed decentralized stablecoin project, valuable lessons are learned, paving the way for new iterations that address past shortcomings. This cycle of continuous improvement could eventually lead to the creation of a flawless decentralized stablecoin system, offering stability and resilience in the ever-changing financial landscape.