What are Collateralized Stablecoin?

By October 13, 2021DeFi
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The topic considered for this research is Collateralized Stable Coins, research downloadable here. Together with Algorithmic Stable Coins, research downloadable here, these digital coins are attracting lots of attention from investors and are greatly innovating the world of DeFi with increasingly efficient protocols creating new use cases for users. The research has considered 6 projects with their pros and cons for stabilization strategies. In this post we’re going to give an introduction to the internal functioning of these protocols and the framework we used to get the data and analyze it.

What are Collateralized Stablecoins?

A Collateralized Stable Coin is a fungible token that is entirely or almost entirely backed by collateral held in a reserve of the protocol that issued that token. Each of the protocols that were analyzed has mechanisms that allow it to maintain the collateral ratio even in the event of adverse events in the market. In fact, each protocol implements its own settlement algorithm, introducing new ways of stabilizing prices and the digital currency demanded by users.

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Ecosystem and main players

This area is one of the last to develop. Although stablecoins have been part of the crypto ecosystem for a long time, smart currencies that never deviate from their peg and try to be as decentralized and stable as possible are being developed in the last period.

At the moment the main players in the space are Liquity, sUSD, Fei, Venus, MakerDAO and Alchemix. These are the protocols we selected for the research that aims to analyze the functioning and approach adopted in the protocol that supports stablecoins. Since DeFi is expanding, it should be noted that the protocols analyzed are not only part of the Ethereum ecosystem but also include other chains that are proving to be performing and EVM compatible.

Metrics and key areas to be analyzed

In previous research, a framework for defining metrics was adopted and has yielded some excellent results. The research of metrics for protocols that are sometimes difficult to analyze is perhaps the fundamental part because it defines general aspects on which all projects are exposed.

The framework is divided again in the 3 macro areas of reference that are:

  • Market Design,
  • Mechanism Design,
  • Token Design.

MARKET DESIGN: is the ecosystem that the participants transact in and the token exists in. It is important to constrain the digital environment because market design defines the structural limit of the mechanism’s effectiveness.

MECHANISM DESIGN: The mechanism design in a protocol defines the fundamental rules that govern the interaction of users with the protocol. Generally, these metrics refer to how the protocol manages the volatility of the underlying assets to maintain a constant peg over time.

TOKEN DESIGN: Token design defines the rules that govern project tokens. They include a basket of different metrics that define behavior, incentives, and stability indexes. Within these metrics we also find analysis of how the secondary token works and the role it plays in the stability and rules of the protocol.

Discussion session

Once the various facets of the protocols were explored and their behavior in the individual metrics was analyzed, the research delved into the “Discussion” section. The focus is to understand which parts of the different designs most influence the final scenarios of the Stable Coin algorithms in production. The discussion is also divided here, as in the previous part, in several parts that try to define the fundamental points on which to find insights.

The goal of this research is to understand which parts of the different protocol designs have the most effect on the final scenarios we are seeing play out in the reserve based stablecoin market. Specifically, the goal of a stablecoin is to optimise for stability. To do that, we divided the discussions into 6 categories: network effects, demand, governance, stability, incentives and secondary token.

NETWORK EFFECT: A decentralized network spreads transactional information across multiple channels rather than relying on a single point of contact. The number of links held between each transaction determines the degree of centrality score.

DEMAND: Demand of a stablecoin is determined by the number of transfers over the amount in circulation. Generally, a higher percentage will suggest a higher usability rate of a stablecoin. Ideally, we want a stablecoin with a high and growing monthly transaction, and transaction growing faster than supply expanding.

GOVERNANCE: Governance can be divided into hard governance and soft governance. Hard governance includes the rules, mechanisms and ecosystem policy fully embedded in code. Soft governance is where parameters of the ecosystem can be changed by a governing body, like changing interest rates, inflation rates or redemption rates.

STABILITY: Since it is difficult to define stability as it is the primary aspect of these coins, the definition and its identity has been divided into several points such as Frequency distribution of prices, Speed, Efficiency and Stability Mechanism

INCENTIVES: We have identified two major approaches to analyse incentives around collateralized stablecoins. One, of course, focuses on the recurring theme and fulcrum of this research: stability. The second one instead includes ‘mere’ incentives that do not contribute or help the stability of the protocol but rely simply on economic interests.

SECONDARY TOKEN: Secondary tokens can cover a multitude of different use cases, some notable examples could be: governance, risk reallocation, incentivization and use cases linked to game theoretic mechanisms in the protocol.

MAKER DAO

The winner according to the metrics defined above is $DAI from MakerDao. MakerDao is a decentralised lending platform that takes crypto collateral to issue a crypto-backed stablecoin called $DAI, it allows different collateral types and is governed by Maker ($MKR) holders. In fact, it seems to be the most decentralized protocol and one in which the secondary token has the most utility and use by holders. The system allows its users to deposit different types of collateral to obtain loans denominated in $DAI. Leans are overcollateralized with different ratios depending on the type of asset posted as collateral. The Governance mechanism and the token stability seem to be two other strong points for one of the most dated protocols in DeFi history. The only flaw is the demand for DAI that tends to be lower than other tokens like sUSD that instead have more usability in the decentralized world.

Recommendation

We conclude the research by providing actionable advice to the protocols considered and future protocols that would like to innovate in the field. The main themes we feel compelled to advise on after the careful analysis and the discussion are the same as those set in the discussion part. The recommendations part aims to highlight what are the most important and critical aspects to improve on the protocols analyzed so that the whole ecosystem can take a huge leap forward.

Conclusions

Collateralized stablecoins are one of the most interesting parts of DeFi and are increasing their influence across the ecosystem day by day. The basis for perfect protocols is to have tokens and currencies that can react optimally to external events by making stability and robustness central. Many of the fundamental problems that have been found in the research should be taken as a cue to improve the current state.

As mentioned earlier, we are talking about protocols that are still very young but potentially disruptive. The research should be taken as a personal insight to better understand the current state of work but in no way should be identified as final or complete. DeFi, tokens and stable coins are a fast growing sector that month by month can disrupt the ideas and dynamics previously taken for granted.

Although it may seem like a very distant sector from the mainstream, collateralized stable coins have a chance of entering any person’s wallet given the steady and inexorable growth of the digital economy. Given the investments, developers and enthusiasm in this sector it is hard not to think of a bright future in this field.

A shorter version of the report in slide format is downloadable here.

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