Stablecoins. How are they tied and why they don't untie!?

Hi everyone, I'm going to talk about what steblecoins are, what categories they can be divided into, what models of binding preservation are used and at the end I'll show a tutorial implementation. This should be interesting for both techies and those just interested in the world of decentralized finance!

Stablecoin is a type of cryptocurrency whose value is tied to some asset (fiat money, other cryptocurrencies, precious metals, etc.) and remains stable relative to other market assets. Stable value is achieved by holding reserve assets or applying algorithms that manage the supply and demand of the stablecoin.

Important! Stablecoins help users hedge against the volatility of cryptocurrencies and are a reliable medium of exchange.

At the time of writing, according to the CoinGecko service, there are 85 stablecoins. This includes the newly launched PYUSD from PayPal. I read one article where the guys were predicting a #4 spot for PYUSD in a year's time. ??

All stablecoins can be divided into two groups:

• Centralized. A prominent representative: . The asset is issued by a centralized organization, often after receiving fiat funds. Characterized by a lack of transparency in the actual amount of reserve funds that should provide the necessary binding.
• Decentralized. A prominent representative: the . Managed almost entirely by predefined smart contract rules. It is characterized by the transparency of the holding of reserves to preserve the attachment to the asset.

Among other things, a stablecoin is a digital asset and is always linked to another asset (e.g. dollar). Therefore, in order to maintain legitimacy and utility as a payment method, it must have some "backing" in the form of another valuable asset for which it can always be exchanged. This "backing" is called collateral

Stablecoin Categories

1) Relative stability

(By attachment type)

• (Stable binding). Example: USDT, DAI, USDC. All of these stablecoins are pegged to the dollar. This effectively means that 1 USDC = $1 and the bank physically holds $1 for each USDC token.
• Floating pegging (Floating attachment). There is no peg to market assets. The stability of the peg is achieved algorithmically by adjusting supply and demand. Example: RAI

2) Stability method 

(By type of binding retention mechanism)

Any pegging mechanism is based on the ability to control the amount of token in the market by creating (mint) and burning (burn).

• Governed (Managed). Governed centrally by an organization or company with human participation in the process of minting and burning a stablecoin. Example: USDT, USC, TUSD.
• Algorithmic. The stability of the peg is ensured by a transparent algorithm with mathematical calculations or organization of the code for minting and burning without external intervention. Example: DAI, RAI, FRAX, UST, LUNA.

3) Collateral amount 

(By quantity of collateral)

• Partially-collateralized. For example, a UST that was secured by a LUNA token, but had an algorithmic component that supported the binding without the involvement of collateral.
• Fully-collateralized. For example, USDT, USDC, BUSD, which are fully secured. With these stablecoins, each token is backed by one U.S. dollar in a bank account.
• Over-collateralized. For example DAI, for its creation the collateral exceeds its face value. Such collateral guarantees additional stability and reduces the risk of losing the peg.

Collateral type

(By type of collateral)

• Exogenous collateral. Such collateral is formed off-chain outside the protocol. For example, ETH is the collateral for DAI. If something bad happens to DAI (ugh, ugh, ugh, ugh, ugh, don't jinx it), will the same thing happen to ETH? The answer is no, ETH will still be used outside the DAI. Hence, the provision of DAI in the form of ETH is exogenous
• Endogenous collateral. Such collateral is formed on-chain within the protocol. For example, the LUNA token was the collateral of the UST stablecoin. To create UST, LUNA had to be burned, and vice versa. They were created together inside the same protocol. If something happens to UST, LUNA will be in trouble as well. This has already been proven in practice by the collapse of LUNA. Therefore, provisioning in the form of LUNA for UST is endogenous.

Let's break down the most interesting categories of stablecoins below.

Overcollateralized Stablecoins

Overcollateralized stablecoins are stablecoins that require excess collateral to maintain a value peg to a particular asset. Such a reserve is often referred to as overcollateralization.

MakerDAO's DAI stablcoin is the first overcollateralized stablcoin. is pegged to the dollar at a 1:1 ratio. The creation of the DAI and the maintenance of the peg are managed by the Maker protocol's crediting system.

protocol is designed for lending to users. Lending DAI requires overcollateralization with a collateralized asset. The lending protocol specifies a 150 percent collateral system. That is, users can create DAI for themselves by locking 150% of the value of the DAI they want to borrow into a smart contract.

At first glance, this may seem pointless and less capital efficient. To borrow an asset, you need to provide the protocol with 150% of the value of that asset. However, there are several reasons for this approach:

1) Resilience to volatility. Cryptocurrencies are often subject to high volatility. In this case, overcollateralization ensures that the stablecoin will be maintained even if the value of the pledged asset fluctuates significantly. In case of extreme market situations (black swan), overcollateralization acts as an additional protection.

2) Increased user confidence. Overcollateralization increases the level of trust in the stablecoin. Users can be assured that every Stablecoin that comes into their hands is backed by collateral that far exceeds its value.

3) Interest rates and financial instruments. On platforms with overcollateralization, and MakerDAO is no exception, users can earn additional rewards for pledging assets as collateral. It can also open up other opportunities to participate in financial instruments: mining, staking, voting, and the like.

Example. To purchase a $100 DAI, you must provide a pledge of ETH equivalent to $150 or other assets allowed by the protocol to be used as collateral.

The resulting DAI can be used like any other cryptocurrency. Overcollateralization ensures that each DAI in circulation is backed by a surplus stock of assets. Interest accrues over time on the borrowed DAI. When the DAI received and the interest for use is returned to the protocol, the user has the option to take the collateral back. In doing so, the DAIs will be burned.

In case the market value of the collateral drops, the protocol has a liquidation mechanism. This automatically puts the user's loan into a collateral auction to cancel the user's debt. In the first version of the protocol it was an English auction, in the second version it is a Dutch auction.

Note that loan protocols work on a similar principle. A borrower can take out a loan, but to do so, the borrower needs to secure the loan by transferring some amount of a specified asset to the protocol. Examples of credit protocols are Aave, Compound, and Liquity.

Important! Stablecoin DAI provides for the ability to change interest rates via the protocol's DAO. This means that it is partially . However, its binding stability is managed by smart contracts, so it is still algorithmic

Algorithmic Stablecoins

The smart contracts of algorithmic steblecoins are implemented so that it is possible to react to supply and demand indicators to maintain a given peg and price stability.

Algorithmic Stablecoins can be divided into three categories:

• Rebase model.
• Model with income generated from the issuance of steblecoins(senorage).
• Fractional model.

Rebase model

The rebase model controls the value of a Stablecoin by changing the amount of Stablecoin in circulation. If the price of a Stablecoin is above or below the required peg, the protocol will automatically increase or decrease the amount of Stablecoin in each owner's account for a fixed period of time.

This pegging works because by controlling the amount of Stablecoin in circulation, it is possible to influence the value of Stablecoin based on simple inflationary/deflationary economic theory.

Ampleforth project's stablecoin fully implements the rebase model. The quantity of the Stablecoin increases and decreases according to the weighted average price for the day(TWAP). Each holder "participates" proportionally in each change in supply.

Example. If Alice owned 100 AMPL before the 10% increase in supply, after the increase Alice will own 110 AMPL; if Bob owned 10 AMPL, he now owns 11 AMPL.

Ampleforth has a rebase model implemented directly on the token contract.

function is implemented in the contract

 Notifies Fragments contract about a new rebase cycle. * supplyDelta The number of new fragment tokens to add into circulation via expansion. *  The total number of fragments after the supply adjustment. */uint256 epoch int256 supplyDelta    external    onlyMonetaryPolicy    supplyDelta         emit LogRebase _totalSupply         _totalSupplysupplyDelta         _totalSupply  _totalSupplysupplyDelta        _totalSupply  _totalSupplysupplyDelta_totalSupply MAX_SUPPLY        _totalSupply MAX_SUPPLY    _gonsPerFragment TOTAL_GONS_totalSupply    emit LogRebase _totalSupply _totalSupply

The function can be called only by the monetaryPolicy address that was set in advance by the contract owner. The function accepts the supplyDelta parameter, which specifies how much to adjust the totalSupply of the AMPL token.

The most important thing happens next: this function updates the private variable _gonsPerFragment. This variable is involved in calculating the balance of each user, thus increasing or decreasing it.

 The address to query. *  The balance of the specified address. */balanceOfaddress who external view override  _gonBalances_gonsPerFragment

Important! The rebase model has two good rationales: simplicity. The elegant, lightweight and easy-to-understand solution rightfully claims to be the fairest implementation model of algorithmic stablecoin, allowing all token holders to retain their stake in the network after each rebase. However, there is a view that stability of the peg should be achieved not only by stability of value, but also by quantitative stability of savings. The rebase model solves the first problem but not the second.

It turns out that the purchasing power of a stablecoin holder based on the rebase model is as variable as the balance of his wallet changes.

Senorage model

The Senorage model controls the value of the stablecoin through a reward system that influences market dynamics. In other words, the model keeps a peg by controlling the amount of stablecoin.

• If the price is above the peg, new tokens are minuted and issued to protocol participants who provide liquidity.
• If the price is below the peg, tokens stop being mined and the mechanism of supply reduction starts working. It becomes possible to purchase a special coupon in exchange for burning the underlying token to reduce the supply. Often, these coupons can be exchanged for more tokens in the future, but only when the price returns to or exceeds the expected peg.

The mechanics with "coupons" requires the implementation of an additional token that will isolate the main steiblcoin from the market dynamics.

One of the representatives of this model is the Empty Set Dollar project with its DSU and ESS steiblcoin in the form of coupons.

Fractional model

The fractional model of algorithmic steiblcoins is a combination of overcollateralization and algorithmicization. That is, in order to minitize a steiblcoin it is necessary to partially provide it with a real asset (e.g., another steiblcoin) and algorithmically provide the rest. This approach has fewer centralization risks and demonstrates a higher level of stability.

protocol was one of the first to implement such a model. At the moment it supports three stablecoins:

• . A stablecoin pegged to the dollar.
• (Frax Price Index). A stablecoin pegged to a basket of consumer goods.
• (FraxEther). A stablecoin pegged to ETH to be used as a replacement for wrapped ether(WETH)

Important! The ironclad rule of FRAX is that 1 FRAX can always be created or exchanged for 1 dollar. This is one of the key differences from other stablecoins, allowing arbitrageurs to equalize the stablecoin with the rest of the market.

Frax Share() token and (Algorithmic Market Operations Controller) are used to manage the ecosystem and regulate the stability of the peg.

is a group of autonomous contracts that monitor monetary policy until the peg is changed. After the peg changes, AMO controllers can perform market operations to stabilize the peg. That said, AMOs cannot create the FRAX stablecoin itself out of thin air.

The concept of (collateral ratio) is used directly to regulate the peg. This is an indicator that directly correlates with the market value of the stablecoin.

Example. If the FRAX price is above $1, the decreases. If FRAX price is below 1$, CR increases.

A CR of 50% would mean that 1 FRAX (equivalent to $1) would be backed by 50% of FSX and 50% of another asset (e.g. USDC, the first version of the protocol required usdc to be backed).

This means you need 0.5 FSX and 0.5 USDC to get 1 FRAX.

FRAX, 0.5 FSX will be burned and 0.5 USDC will be held as collateral. The reverse procedure is followed to burn FRAX and receive the collateral.

Thus, the AMO is only left to manage the amount of token. Since is a partial collateralization of the stablecoin, its quantity allows the peg to be held.

Stablecoins are not a full-fledged financial application, but they play a critical role in the world of DeFi applications. A few aspects of stablecoin applications:

• Medium of exchange. Stablecoins provide a stable medium of exchange compared to other cryptoassets that are subject to high volatility. This is especially useful for trading and other financial transactions.
• Liquidity. Stablecoins are often used as a pair for trading on decentralized exchanges. They provide the necessary liquidity and stability, allowing users to easily exchange one asset for another.
• Long-term storage. DeFi offers a variety of ways to invest and earn money, while in contrast, stablecoins provide a way to safely store funds without having to convert them into fiat currencies.
• A base for other instruments. Stablecoins can be integrated into smart contracts and provide a basis for more complex financial instruments such as derivatives, loans, insurance and the like.
• Accounting and auditing. The use of stablecoins simplifies accounting and auditing, as all transactions are recorded on the blockchain and available for verification. This is intended to reduce the risks of fraud or errors in financial reporting.

Despite this, the impact of truly decentralized stablecoins is still small. According to CoinGecko, Tether completely dominates the cryptocurrency market. Just under a quarter of the market for USD Coin.

However, there are arguments against the complete decentralization of stablecoins:

• Lack of stability. As practice has shown, some steiblcoins had tangible deviations from the peg, and some lost it altogether. What is only worth the failure of Luna.
• Allegations of fraud. There have been several accusations that teams of decentralized stablecoins are "diverting users' funds". This has a pretty serious impact on user confidence in such projects.
• Centralization. As strange as this point is, there are still a lot of questions about how decentralized steiblcoins are decentralized. The DAO system is often used, but such a system is subject to change against the will of the community.

Still, the ideal decentralized steiblcoin system has many advantages over centralized versions. Such a system is math driven and resistant to third party influence. I think decentralized algorithmic stackablecoins need more time to succeed. Let's keep an eye on them further!