The Trade-Offs for Decentralization

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Crypto-backed Stablecoins

Crypto-backed stablecoins are the answer to the shortcomings and trade-offs of centralized Fiat-backed stablecoins. Trustless systems and decentralization are the main pillars of the crypto ecosystem and thus, the creation of decentralized on-chain stablecoin protocols was inevitable. This type of stablecoin is backed by other digital assets such as BTC, ETH, other stablecoins or any other tokenized asset and is usually created through decentralized protocols to issue and redeem the tokens. Thereby, digital assets are locked as collateral in smart contracts to issue or mint the new stablecoin. One prominent example of a crypto-backed stablecoin is DAI from MakerDAO.

The Price of Decentralization

Stablecoin protocols are often governed in a decentralized way, often by a DAO based on the governance token of the protocol. Since these protocols can only have crypto-assets as collateral, they often have to cope with higher volatility compared to Fiat-currency as backing. Thus, most crypto-backed stablecoins are over-collateralized. The Maker protocol for instance requires a collateral ratio of 150% for borrowing DAI. This leads to capital inefficiency since users need significantly more capital than the actual value of the minted stabelcoins to borrow stablecoins from the protocol. This shows, that on-chain and crypto-backed stablecoins often trade-off their capital efficiency for decentralization in order to achieve price stability.

Outlook

To lower the required collateralization ratio to maintain and defend the peg of the stablecoin, some stablecoin protocols are accepting other stablecoins as the collateral which have a low volatility reducing the risk of a significant drop in value of the collateral. Other Stablecoin protocols are experimenting with delta-neutral derivative positions to maintain price stability.