The Ultimate Stablecoin Guide.

This is a guide to multiple different stablecoins with an overview of their mechanics.

The idea of stablecoins is an extremely powerful one. In a 24/7 market of constant volatility there is a need for an asset that counteracts this volatility. Stablecoins are coins which are pegged 1:1 to another asset, be it a fiat currency or a commodity. Since the most popular application of stablecoins has been the ones which are pegged to fiat currencies, this guide will solely focus on those stablecoins. The most popular stablecoins are the ones which are pegged to USD but there are some which are also pegged to other currencies such as EUR, GBP, KRW etc.

Stablecoins fulfil a ton of purposes. One major benefit is the unprecedented access they provide. A person in Venezuela who wants to escape hyperinflation by holding their money in dollars would find it difficult and expensive to do so through traditional methods but can now do it rather simply on-chain. For trading, assets can be valued against a stablecoin rather than trading assets against BTC or ETH. When traders/investors are expecting a market downturn they can hold all their funds in stablecoins rather than a slightly safer but still volatile asset like BTC or ETH. Users can earn higher yield on their stablecoins in DeFi compared to holding them as fiat in a savings account. Additionally, participants can also take out loans in stablecoins by using other crypto assets as collateral. These are just a few potential use cases to show you the power of this concept.

If you aren’t convinced about their importance, let’s check the stats. stablecoins absolutely blew up over the last two years. In Jan 2020, the collective market cap of all stablecoins was at around $5b. Fast forward to Jan 2022 and the collective market cap sits at around $175b, that’s a 35x increase in total market cap in just 2 years.

Stablecoins are clearly here to stay, but over the 2 years the innovation in the stablecoin space has been very interesting. With around 75 different stablecoins in the market they can broadly be divided into centralized stablecoins and decentralized stablecoins. Under the banner of decentralized stablecoins, there has been a lot of experimentation. Which one prevails is yet to be seen but given the importance of stablecoins in the crypto economy, I have decided to make a beginner friendly guide to the different types of stablecoins and how they work.

Disclaimer: I have approached this guide from the perspective of mechanics which is why every single stablecoin in the market has not been covered since most of them are fairly similar in how they operate. But, I have tried to be as comprehensive as I can. 

Centralised stablecoins

The top 3 stablecoins by marketcap are all centralized stablecoins in USDT, USDC, BUSD. They collectively make up for $141.9b mcap out of the $175b total mcap of stablecoins. All 3 stablecoins function in the same way, they are pegged 1:1 to USD. For one stablecoin to be minted and circulate on-chain there has to be $1 of fiat depoited as collateral in the reserves of these companies. Tether, Circle, and Binance.

Let’s say a user wants to convert his USD to USDT with Tether. They will go to the website, deposit $100 (for example) and get 100 USDT in return. So each USDT is backed by 1 USD in the reserves. After the user does what they want with this USDT and want to withdraw back to fiat, they will send back the USDT to tether and get back an equivalent amount of USD after which the tether that they sent back will be removed from circulation forever.

These stablecoins have been very useful but they go against the ethos of crypto. The purpose has always been to replace the traditional financial system and have no ties to it, so having a USD backed coin as a cornerstone of the crypto economy is rather counter-intuitive and essentially still leaves a major part of the system prone to failure through dependency on the decisions of centralized authorities.

Hence, the interesting element to me is the rise of decentralized stablecoins and the different types of mechanisms people are using to create a truly independent financial system. Some decentralized stablecoins still try to be pegged to fiat currencies while some try to be backed by a basket of decentralized assets. There’s a lot of interesting experimentation going on so let’s dive a little deeper.

Decentralized stablecoins

Under the banner of decentralized stablecoins you have a bunch of different sub-sectors. There are collateral-backed stables, algorithmic stables, non-pegged stables, and the last category I’ve decided to label as “others” for lack of a better word.  

Collateral-backed stablecoins

DAI-

Let’s start off with the OG DeFi protocol MakerDAO. Maker is a lending platform where users can take out overcollateralized loans. Users can take a loan out in the native stablecoin called DAI using ETH or a few other Ethereum-based assets as collateral. DAI is a stablecoin that is soft-pegged to the US dollar and is backed by a basket of crypto native assets that are held in the Maker Vaults. These Ethereum-based assets are ones that have been approved by the MKR holders.

For example, if users want to take out a loan against their ETH. They can go to Maker, deposit their ETH and get DAI in return. But, the amount of ETH they deposit in dollar value will be higher than the DAI they get in return. If they deposit $150 worth of ETH they will get 100 DAI in return (just an example). It’s this backing through over-collateralization that helps DAI maintain its peg. It’s been around for a couple years and has been stress-tested multiple times. So its stability can’t be questioned.

VAI-

VAI is the stablecoin of the Venus Protocol on the Binance Smart Chain (BSC). Like most of the others, it is pegged to $1, but unlike the others it does not use other stables or something like ETH or in their case BNB as collateral. They use the vTokens of the protocol as collateral. vTokens are basically synthetic assets that users get after depositing some amount of collateral. People can use these synthetic vTokens itself as collateral to borrow VAI at 50% of the value of the collateral.

Other than the basket of collateral assets and the market forces, the protocol also has certain programmatic safety mechanisms in place to help maintain this peg. It’s important to note that the team has stated they wish to use these mechanisms as infrequently as possible. If the peg value is lost, through the governance system the protocol can activate something called the price adjustment module. Depending on which direction the peg has been broken, this module will change parameters such that it is either beneficial to buy/hold the stablecoin or mint/borrow the stablecoin.

sUSD-

sUSD is the native stablecoin of the synthetix protocol. Much like how DAI requires users to deposit ETH as collateral to mint DAI, in Synthetix users have to use the governance token SNX to mint the stablecoin sUSD. The price of USD is tracked using oracles and the oracle data is what helps keep sUSD at $1. However, this is highly over-collateralized. It is around a 600%-800% collateralization ratio. So if a user deposits $800 worth of SNX then they can mint 100 sUSD.

OUSD-

Origin USD is stablecoin built to help the DeFi yield farmers and crypto novices alike. It is pegged to $1 by being 100% backed by USDT, USDC, and DAI. Users can take any one of these 3 stablecoins to the Origin Dapp and swap them for OUSD. The differentiator here is that they have yield strategies built-in to their smart contracts. So as soon as users hold OUSD in their wallet they automatically start earning-yield while still being able to use that OUSD as they please. No lockup or staking required. You earn money while still being able to spend that money.

alUSD-

alUSD is the native stablecoin of the alchemix protocol. Alchemix runs by having vaults in which users can deposit DAI as collateral against which they can borrow alUSD. The incentive for users is that the DAI is deposited in to Yearn vaults to earn yield which ensures that a user’s debt gradually decreases. This is one way in which it maintains its peg. The other way is similar to MIM (discussed below) in that arbitrage is incentivized so its users can either pay back their debt quicker if alUSD falls below the peg or make some profit by borrowing alUSD if it goes above peg.

MIM-

MIM (or Magic Internet Money) is the native stablecoin of abracadabra.money. On abracadabra.money, users can deposit collateral in the form of interest-bearing tokens against which they can borrow the USD pegged stablecoin MIM. MIM is backed by the collateral in the protocol (the interest-bearing tokens) but it also maintains its peg through incentivizing arbitrage. If a user has already borrowed MIM and they notice that MIM is below $1 on some market, they will then buy the cheaper MIM in order to make it easier for them to pay back their debt and in turn drive the peg back to $1. If a user has collateral and notices that MIM is above $1 on some market, then they will borrow MIM against that collateral and sell it on that market which will drive the price back down to $1.

In addition to this MIM also uses the Curve Finance protocol. If you don’t know what Curve is then check this article. So basically, MIM is listed on Curve in its own MIM3POOL. This is basically a pool of 4 stablecoins in DAI, USDT, USDC, & MIM. Being in this pool ensures that MIM’s price stays relatively similar to the other coins in the pool. This is primarily through arbitrage because bots or users will constantly seek to make profit whenever any of the coins lose their peg thereby ensuring that they all stay relatively stable at the $1 mark.

MAI-

MAI is also a collateral-backed stablecoin but it is different in the sense that it takes collateral in a suite of different. Users have 3 options, they can either use static tokens such as LINK, CRV, and others as collateral to mint MAI, or they can use interest-bearing tokens from beefy, yearn, and Aave as collateral, or they can directly swap other stables such as USDC, USDT, or DAI for MAI through something called anchor. The protocol works through overcollateralization at around 130%-150%. Hence, each MAI is sufficiently backed.

Empty Set-

Empty Set is currently launching v2 of their protocol with the stablecoin DSU. DSU will also be pegged to $1 dollar and this peg will be maintained through the collateral in their reserves. If users want to DSU it can be minted from the reserve for 1 USDC. Fairly straightforward. However, when the protocol initially launched they intended on being more algorithmic so the plan is that as the network around DSU and Empty Set begins to grow, they will work with members of the DAO and figure out the best way forward in terms of which algorithmic method to follow.

USDN-

USDN is a stablecoin made by the neutrino protocol. USDN is an algorithmic stablecoin that is collateralized by the native governance token WAVES. If a user wants to mint 1 USDN then they have to deposit $1 worth of WAVES. The peg is maintained through arbitrage bots as well as the collateral that is deposited in the protocol.

Algorithmic Stablecoins (Algo-stables)

UST-

UST is currently the leading decentralized stablecoin. It just recently passed DAI in Market cap. UST is the native stablecoin of the Terra blockchain. UST also aims to be pegged 1:1 with the dollar but it does so through a burn-and-mint mechanism with the native token LUNA. It works like this, when 1 UST is minted $1 worth of LUNA is burned and when 1 UST is burned then $1 worth of LUNA is minted. If UST breaks its peg and goes higher then users are incentivized to burn LUNA and mint UST in order for the supply of UST to catch up to the demand thereby brining the peg back down to $1. If UST breaks peg and goes lower, then users are incentivized to burn UST and mint LUNA which will bring down the supply to match the demand for UST thereby bringing it back up to the $1 peg.

Algorithmic-stablecoins like UST are very dependent on usage and demand for them to maintain their peg. Hence, the entire Terra ecosystem is built around generating demand and usage for UST. There have been many other algo-stables that have been made and failed relatively quickly. One reason is of course that it may not have been designed well enough but the another important factor is that as soon as the usage/demand dries up and it loses it peg, it can go into the so-called “death spiral” where it basically just goes to 0 and never recovers. This has been the fate of many algo-stables but UST has not been a victim so far.

DOLA-

DOLA is the native stablecoin of the Inverse Finance protocol. It can be borrowed through lending markets such as Scream or Rari capital, it can also be bought through multiple Decentralised Exchanges (DEXs). The pegging mechanism is fairly straightforward, it is meant to be pegged to $1 so if the DOLA breaks the peg above $1 then the inverse protocol will mint more DOLA and increase the supply in lending markets. This decreases the interest rate thereby incentivizing more people to borrow DOLA, this will increase the circulating demand to a point where it can match up to the demand and the peg should return to $1. In the reverse scenario, when DOLA goes below $1 then more of it is burned in the lending markets to drive up the interest rate. This creates buy-pressure on DOLA as people are incentivized to buyback DOLA to pay back their debt.

There have been other algo-stables in the market but most of them have either failed or not been as successful as these 2 which is why they haven’t been mentioned.

Non-pegged stablecoins

RAI-

RAI is a stablecoin made by the Reflexer Finance team. They took some elements from DAI but differentiate themselves from all other stablecoins in that they don’t aim to be pegged to USD (or any other fiat currency) but rather stable through dampened volatility. It has no attachment to the traditional financial world and therefore has no centralised point of failure. Down the line they aim to remove/minimize governance over the system as well.

The stability mechanism & monetary policy of RAI is relatively complex so this is a simplified explanation. For a more detailed explanation check this. ETH is the collateral used in the protocol but the stability is achieved through having a target price (or redemption price) and interest rate (or redemption rate) which is algorithmically adjusted depending on the market price.

Initially the target price of RAI was around $3.14. So when the market price goes above or below the target price, the interest rates are adjusted accordingly to drive the market price back to the target price. They have something called a PID controller which is responsible for this dampening of volatility. Take a scenario where the market price is above target price, the system will make interest rates negative which will incentivize borrowers to take out loans and holders to sell thereby driving price back down towards the target price. In the reverse scenario, when the market price is below target price, the interest rates will be positive to incentivize borrowers to pay back debt and holders to continue holding.

Others

FRAX-

FRAX is a stablecoin that uses a combination of a collateral-backed stablecoin and an algorithmic stablecoin. They try and achieve this middle ground through a gradual process. So at the beginning, FRAX will be fully 100% backed by collateral such as USDC, USDT or any other such stablecoin, as the usage of Frax develops they will gradually move towards using less collateral and more algorithm based backing with the aim to still remain as tightly pegged to $1 as possible.

The algorithmic aspect is done through using chainlink price oracles which take price data from the ETH/USD pair on Uniswap to get the most accurate USD price, plus they will use a burn mechanism (similar to LUNA & UST) with their native governance FXS to ensure that the peg is maintained. As FRAX gradually moves away from being fully collateral backed, the coin is likely to lose its peg at some point in adverse market conditions. In this scenario they have a function in the contract that increases and decreases the collateral:algorithmic ratio as necessary, usually in 0.25% bands. So, if FRAX goes above $1 the protocol will decrease the collateral ratio and if it goes below $1 then the protocol will increase the collateral ratio. These increases and decreases will be done in 0.25% bands until the peg is restored.

A direct competitor to FRAX is Sperax with USDs. The main differentiator is that sperax has a yield aggregator component for USDs so users can potentially have more earning potential.

FEI-

FEI is a very innovative stablecoin in that it is pegged to $1 but it does not use the typical collateral backed method or the algorithmic method since both methods have problems of long term scalability and sustainability. Instead, FEI uses the strategy of allowing users to buy FEI using ETH along a bonding curve. Users cannot sell their FEI for ETH on the bonding curve because that ETH is used as collateral in a different way, through something called Protocol Controlled Value (PCV). This means that when users want to convert their FEI back into ETH, they can only do so on the secondary market such as a uniswap FEI/ETH pair. So all the ETH that is deposited into the Fei protocol is controlled algorithmically to provide liquidity in secondary markets so users can sell their FEI for ETH. Hence, FEI can be under-collateralized or over-collateralized depending on volatility of the PCV. Currently, FEI bonding curve only exists for ETH but there are plans to accept other ERC-20 coins in the future.

Coupled with PCV is something called direct incentives. Fei label themselves as a direct incentives stablcoin. This basically means that the peg is maintained by directly affecting a traders’ balance. So, if there is a large sell order of FEI on Uniswap then there will be a large burn of FEI tokens, this reduces the supply but it also means that the sellers pay the price of the burn. Similarly, with large buys there will also be a larger mint and buyers earn a portion of the mint. This combination helps FEI maintain its peg.

BEAN-

Bean is a very unique & somewhat complex stablecoin created by the Beanstalk protocol. Rather than using collateral or algorithms, they have chosen to use a credit based system. The incentive system is created such that users end up participating in peg maintenance without the need to be active everyday. It has 3 main components:

·      Decentralized price oracle

·      The silo: governance mechanism

·      The field: a decentralized credit facility

The price oracle aspect is fairly simple. The ETH/USDC and ETH/BEAN liquidity pools are both used together to create a Chainlink oracle in order for BEAN to have a similar peg to USDC but without any direct exposure to minimize the risk from centralization.

The purpose of the silo is essentially to create stability around the entire Beanstalk network which indirectly helps the stability of BEAN. Since we’re only focused on stability mechanics I won’t dive deeper into the silo but if you’re interested you can read more about it here. The field is where the stability is achieved.

Yet again, this is the simplified version, click the link above for a detailed overview. So when the price of BEAN goes above $1 there is either participation from arbitrageurs who drive the price back down OR Beanstalk will carefully mint new BEAN into the circulating supply until it catches up to demand and finds the equilibrium. The newly minted BEAN is distributed accordingly, 50% goes to users who have staked BEAN in the silo and the other 50% is used to pay off the debt of previous creditors. If BEAN goes below $1 then Beanstalk issues debt as a means to allow people to burn circulating supply, in exchange the user gets a debt coupon (called pods) at a set interest rate. Once the price reaches back to equilibrium or even slightly above $1, these debt coupons mature and new BEAN gradually enters back into circulation.

Concluding thoughts:

I will end this guide with my personal thoughts. Out of all the stablecoins listed here I personally prefer RAI. While it may sound overly idealistic I still believe that if we are trying to creating a new financial system then a key component of it should not be so dependent on the traditional world. Every coin being pegged to $1 means that there is still some dependence on the dollar, and as we know, fiat currencies are only backed by the full faith and trust in the government that makes it.

In my opinion, RAI is a true decentralized stablecoin, one that is made for a DeFi. I do agree that building a network around a stablecoin like RAI will be difficult and it also needs to be stress-tested before its true power can be gauged, however I like the mission that Reflexer Finance is trying to achieve with RAI.

Therefore, I believe over the coming years we are likely to see more innovation in the space of non-pegged stablecoins which aim to be completely free from traditional bounds. Even if RAI isn’t the winner of this race, I believe in the long run a similar type of stablecoin will see great success. I will be keeping my eye on stablecoins that have similar goals to RAI.

Thank you for reading,

If you enjoyed this guide and are feeling generous then please consider sending me a donation to my ETH Address: 0x43A5D9C141125Cd67B9268ef28C7c6a9dC15F3c9 It would help me out a lot.

If you want to more content like this then please subscribe to the substack and follow the Medium (ITS FREE)

Follow me on Twitter