In order to provide a decentralized alternative to fiat-backed stablecoins, blockchain developers created alternative options backed by cryptocurrencies. Although crypto-backed stablecoins rely on crypto-assets as collateral, they retain the goal of maintaining a stable peg with a fiat currency, typically USD.
Crypto-backed stablecoins have a far smaller market share than their centralized equivalents, with the largest, DAI, reaching a peak market capitalization of just over $10 billion in early 2022. Although they face some challenging regulatory headwinds, crypto-backed stablecoins play an important role as a store of value in the decentralized financial ecosystem.
This article is part of a series of Nuant insights focusing on stablecoins. Part 1 introduces the asset class and a trilemma concerning their design goals, while Part 2 focuses on fiat-backed stablecoins, Part 3 on commodity-backed stablecoins and Part 4 delves deeper into algorithmic stablecoins.
The defining feature of a crypto-backed stablecoin is that it is minted using smart contracts on a blockchain, allowing users to deposit cryptocurrency as collateral and receive pegged tokens in return. Crypto-backed stablecoins aim to achieve the same characteristics as a blockchain itself – to offer permissionless access to decentralized infrastructure. At the same time, crypto-backed stablecoins also need to achieve the same peg stability as their fiat-backed counterparts. However, the degree to which any given crypto-backed stablecoin achieves these goals can vary.
Another feature of crypto-backed stablecoins is that many of them are subject to some degree of decentralized governance via a decentralized autonomous organization (DAO.) Under DAO governance, there is usually a second non-pegged token that empowers holders with voting rights over the stablecoin protocol. The existence of governance tokens or the presence of the term DAO does not imply that the project is subject to fully decentralized governance over all matters. In some cases, aspects of the stablecoin such as wallet key management may be governed centrally by the project’s founders or delegated to committees of elected representatives.
Governance tokens may or may not be linked to the economics of the stablecoin model, for instance, by playing a role in maintaining peg stability.
Crypto-backed stablecoins are subject to the tradeoffs detailed in the stablecoin trilemma outlined in Part 1 of this series. As such, while crypto-backed stablecoins are decentralized, there is a need to overcollateralize reserves due to the volatility of most cryptoassets. As a result, they are typically considered to be an inefficient use of capital.
As described in Part 2 of this series, the market for fiat-backed stablecoins is an oligopoly-like structure dominated by three players offering fundamentally identical products, albeit with some operational and regulatory differences. In contrast, the crypto-backed stablecoin segment has developed differently.
Maker, the project behind the DAI stablecoin, has maintained its first-mover advantage and remains the only crypto-backed stablecoin to achieve substantial market capitalization (not counting Terra’s now-defunct UST, which is handled in our article on algorithmic stablecoins). Other crypto-backed stablecoins focus on overcoming the key limitations of Maker’s protocol, but most are very new and have yet to prove they can reach the same level of adoption.
The idea for a crypto-backed stablecoin was proposed by Maker founder Rune Christensen within months of the first stablecoins emerging in 2014. The Maker Foundation subsequently launched the DAI stablecoin on the Ethereum blockchain in 2017. It introduced the concept of the Collateralized Debt Position (CDP), where users could deposit ETH as collateral to mint the DAI stablecoin, which is pegged to the US dollar.
In 2019, a protocol update enabled users to deposit any Ethereum-based asset that had been approved as collateral under MakerDAO governance, introducing the concept of “multi-collateral DAI.” The previous version of DAI was renamed to SAI, or single-asset DAI.
However, DAI was unfortunately still heavily collateralized by Ethereum when the crypto markets crashed in March 2020 at the onset of the pandemic. Plummeting ETH prices resulted in a mass liquidation event where DAI lost its dollar peg, followed by a huge drain on DAI liquidity.
Faced with an existential threat to DAI in the event of another market crash, MakerDAO members voted to begin accepting Circle’s fiat-backed USDC stablecoin as collateral as a way of stabilizing the project.
The intervention worked; however, the decision to integrate USDC came under criticism from decentralization advocates, who argued that there was now a central point of weakness. This argument was borne out in March 2023 when USDC depegged from the dollar amid the banking crisis in the US, resulting in a ripple effect where DAI also lost its peg. Maker governance quickly voted in several emergency measures designed to limit the extent of the damage. However, the depegging does not appear to have deterred DAI borrowers from collateralizing their loans with USDC, as the asset still accounts for around 35% of DAI collateral in late March 2023.
Despite being heavily collateralized by a stable asset, DAI reserves still represent 165% of the issued value. While this helps to maintain stability, it means that DAI does not represent an efficient use of capital.
Following the depegging event in 2020, MakerDAO also implemented a measure whereby MKR governance tokens may be sold on the open market to raise funds to protect the peg in the event of any future crash that could result in mass liquidations.
DAI users incur a stability fee of 3.5% when they settle their position and redeem their collateral. The fee rate is determined by MakerDAO governance. Users can also generate interest at a rate on their DAI holdings by depositing them in DAI Savings Rate (DSR) smart contracts. The rate of interest paid on DAI Savings Rate is adjusted weekly by MakerDAO governance according to the performance of DAI against its dollar price peg. The DSR is used as a way of managing the supply and demand of DAI, thus supporting peg stability.
The term “collateralized debt position” to describe smart contracts handling crypto-backed stablecoins has now become a somewhat generic term in DeFi. Since 2019, MakerDAO has used the term “Vaults” for its own CDPs.
DAI only operates on Ethereum, but its popularity has led to many rivals that are effectively clones of the Maker protocol operating on other blockchains. For instance, Kava which is part of the Cosmos network, and JustStable, which runs on Tron, both operate a very similar model.
More innovative competitors attempt to solve the capital efficiency challenge by reducing the high collateral requirements without compromising on stability. One example is Frax, which issues its native stablecoin FRAX on the Ethereum blockchain. FRAX was originally conceived as a hybrid coin, partly collateralized by cryptocurrencies and partly managed through an algorithm. This mechanism aimed to reduce the high collateralization requirements.
However, following the regulatory intervention in BUSD in February 2023 (see Part 2 of this series), Frax governance voted for FRAX to become a fully collateralized stablecoin. The project will use its revenues to build up reserves to 100% over time. The algorithm will remain as a means of ensuring that there is enough liquidity during times of volatility. It is worth noting that FRAX was also affected by the USDC depegging in March 2023, suffering volatility after a depeg.
Frax operates six Algorithmic Market Operators (AMOs) which automate the management of platform revenues to keep liquidity flowing. Each AMO plays a specific role, including supporting price stability, lending FRAX to DeFi protocols, and staking collateral on DeFi protocols to generate returns.
Frax launched in 2019 and as of February 2023, it was the fifth-largest stablecoin by market capitalization – some way behind DAI but outranking lower-cap fiat-backed options such as Paxos’ USDP and TrustToken’s TrueUSD.
Another competitor to DAI is Liquity, which launched on Ethereum in 2021. Liquidity allows users to mint its LUSD stablecoin using ETH as collateral. With a one-time fee and a collateralization ratio of 110%, Liquidity aims to be more efficient than DAI.
The project has developed so-called “Stability Pools”, which exist to offset the risk of depegging in the event of market volatility. Stability Pools are staking pools for LUSD, which is used to liquidate Liquity’s CDPs in the event of a crash in ETH prices. The collateral for the loans is distributed to stakers in the Stability Pools, creating an incentive to stake as liquidations typically result in some profit. Furthermore, stakers earn Liquidty’s LQTY token, which is an additional incentive since LQTY can also be staked to earn a share of fees paid by Liquity borrowers.
Liquidity’s innovations have led to a stablecoin with a greater degree of decentralization; however, the project has struggled to maintain the LUSD peg during times of volatility. Furthermore, there are reports that large amounts of LUSD supply are held by single entities, creating a substantial risk of market manipulation – a common problem with low-liquidity crypto projects (see more under “Risks”).
Two new stablecoins are expected to launch in the first half of 2023. They are notable for the fact that they will be issued by two of the largest projects in the decentralized finance sector – lending protocol Aave and decentralized trading platform Curve Finance.
Aave’s GHO token is comparable to Maker’s DAI in many ways, with the major distinction that its collateral will be generated from deposits made to lending pools on the Aave lending platform. This mechanism means that users will continue earning yield on their collateral for the duration of the time they hold GHO. Furthermore, anyone who stakes the protocol’s native AAVE token can mint GHO at a discounted rate, creating an incentive to become an AAVE staker. GHO creation will be limited to “facilitators” – addresses that Aave has whitelisted for minting and burning GHO, up to a pre-agreed limit set by the Aave DAO.
As of March 2023, GHO was live on an Ethereum testnet.
The second is Curve's stablecoin, crvUSD. It proposes a new collateral liquidation mechanism called LLAMMA, which stands for Lending-Liquidating Automatic Market Making Algorithm. It aims to mitigate the volatility risk of relying on cryptocurrency-based reserves by using the collateral underpinning a stablecoin loan to mint a Liquidity Provider (LP) token. LP tokens are a common feature in DeFi protocols, generated automatically by the underlying smart contract as a kind of redemption voucher when a liquidity provider stakes tokens in a pool on a decentralized exchange or lending protocol.
A typical crypto-backed stablecoin requires the user to monitor their position at all times to avoid liquidation due to volatility. By making the collateral into an LP token, LLAMMA offsets this need by converting ETH into crvUSD gradually as it approaches the liquidation point, automatically rebalancing the position. crvUSD introduces an algorithmic element to managing the reserve. However, unlike algorithmic stablecoins which aim to reduce the collateral requirements, it remains overcollateralized by cryptocurrencies.
As of March 2023, crvUSD creation was in the Curve DAO governance process and seems set to launch at some point later this year.
In our algorithmic stablecoins article, we provide some examples of hybrid options. Hybrid stablecoins aim to reduce the need for high collateral requirements by introducing an algorithm to enable fractional reserves.
For institutional participants, regulatory risk is likely to prove the biggest deterrent. The upcoming EU Markets in Crypto Assets (MiCA) regulation introduces stringent requirements for so-called “asset-referenced tokens”, which applies to stablecoins like DAI backed by a basket of other assets. There are also limitations on the extent to which such a token can be used as a medium of exchange within the bloc. Meanwhile, across the Atlantic, US lawmakers have tabled the Stablecoin TRUST Act, which would put all stablecoins under the purview of the Office of the Comptroller of the Currency.
Whether or not DAI or other crypto-backed stablecoins will be able to continue to operate when new regulations come fully into force remains to be seen. However, Maker founder Rune Christensen has already told reporters that the industry should be “ready for the worst,” and MakerDAO members recently passed a vote to establish a legal defense fund for project members worth $5 million. Christensen has also previously floated the idea of depegging DAI from the US dollar as a means of avoiding regulation.
The fact that DAI is backed by USDC, another stablecoin also facing regulatory headwinds, creates an additional level of risk. Should USDC become the next target of regulatory intervention in a similar way to BUSD, it will inevitably have an impact on DAI.
The DAI depegging events in 2020 and 2023 demonstrate that overcollateralization, even with other stable assets, is not necessarily a hedge against extreme volatility. For its part, MakerDAO has implemented several measures designed to protect the peg in the event of future instability. However, as it is difficult to accurately simulate a crash, how well these measures will hold up during a real-world mass liquidation event remains to be seen. Holding USDC in reserve mitigates some of the risk, but as outlined above, USDC’s ongoing existence is in the gift of lawmakers and regulators and it is not immune to losing its peg. If it loses the ability to restore confidence and thus its peg, then it will become useless as a reserve asset.
Stablecoins with a low market capitalization can also suffer from the problem of “whale dominance” where a wealthy entity acquires a majority of tokens and potentially destabilizes the entire market. Considering that crypto-backed stablecoins are also run by DAOs, where membership is represented by tokens, governance risks could also become an issue. DAOs can become subject to hostile takeovers by parties acquiring large quantities of tokens, or polls can become corrupted by practices such as vote buying.
Finally, there is also a risk that the smart contracts underpinning crypto-backed stablecoins or their governance could become compromised. In the worst case, this could see reserves drained, but for a stablecoin dependent on investor faith to maintain a peg, even a minor attack could be enough to create instability.
Crypto-backed stablecoins represent an innovative segment of the asset class, offering DeFi participants a more decentralized and transparent alternative to fiat-backed stablecoins. However, given the extensive risks, they should be approached with considerable caution and the knowledge that their regulatory status is precarious. Nevertheless, the development of this segment is likely to be of interest to all observers of financial innovation in the digital asset space.
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