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#Crypto-backed

Crypto-backed Stablecoins

The Trade-Offs for Decentralization

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 stablecoins is backed by other digital assets such as BTC, ETH, other tokens or any 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 new stablecoins. One prominent example of a crypto-backed stablecoin is DAI from MakerDAO. Due to the open-source approach of on-chain stablecoin protocols, this space has seen rapid innovation and growing competition. 

The Price of Decentralization

Stablecoin protocols are usually governed in a decentralized way, often by a DAO based on the governance token of the protocol. Although decentralized governance creates censorship resistance to a certain degree, operations and decision-making processes are slow and tend to be inefficient. Further, on-chain protocols can only accept crypto-assets as collateral. Thus, the collateral is subject to higher volatility compared to fiat currency as backing. This leads to the fact, that most crypto-backed stablecoins are over-collateralized to account for the volatility of the collateral and ensure that the outstanding stablecoin supply is always backed and redeemable for $1 in value. 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 stablecoins to borrow stablecoins. This shows, that on-chain and crypto-backed stablecoins often trade-off their capital efficiency for decentralization to achieve price stability. Newer decentralized protocols are heavily working on increasing the capital efficiency to mint and borrow stablecoins.

Outlook

To lower the required collateralization ratio without compromising on price stability, some stablecoin protocols are accepting other stablecoins with deep liquidity such as USDC as on-chain collateral. Thus, the collateral has low volatility reducing the risk of a significant drop in its value. DAI and FRAX are good examples of this. However, critics argue that by heavily relying on centralized stablecoins as collateral, the decentralized protocols expose themselves to the same censorship risks they were trying to mitigate.  Other Stablecoin protocols are experimenting with delta-neutral derivative positions to maintain price stability. The design space for on-chain crypto-backed stablecoins is still highly innovative and many interesting approaches are worked on.