DOMANI – Stablecoin Risk Management
(DOMANI is an oracle-less Digital Asset Management platform that enables users to create, mint and manage ETF-style tokenized funds. The views expressed in the article below should not be taken as investment advice. Always do your own research.)
The recent LUNA-UST crash, which caused the price of UST to fall over 98%, has brought to light some fair criticisms of algorithmic stablecoins, and has also caused people to be more cautious of what stablecoins they are using as an on-chain reserve currency. One of the few positives to be taken out of this situation, is that it has taught investors that not all stablecoins are built the same, different stablecoins have differing levels of collateralization and centralization, which give them inherently different risk profiles. In this article we will look at the different types of stablecoins that exist, how their risks differ, and finally the DAO will propose the creation of XAVSTABLE, a tokenized fund composed of different stablecoins to mitigate individual stablecoin-depegging risk.
What are stablecoins?
Stablecoins is a digital currency whose value is designed to maintain price parity with another asset or currency. In most cases, stablecoins choose to be pegged against 1 US dollar but there are certainly other options, as we have seen Mexican Peso and Gold stables created as well.
What are the different types of Stablecoins?
As the DeFi and crypto ecosystems have developed over time, stablecoins have become an integral part of how the system operates, however we must not assume that just because a stablecoin labels itself as such, it will always be “stable” and retain its peg. All stables are not built the same, the main differences lie in how the stablecoins retain their peg. The value of stablecoins can be maintained through various mechanisms. Namely, there are two main ways a stablecoin can maintain its value, through collateralization or through algorithmic mechanisms and smart contracts that contract and expand the supply of the stablecoin, driving the price of the asset back to its peg. Stablecoins can also be issued by centralized institutions or be collateralised in a decentralized way.
What are algorithmic stablecoins?
Algorithmic stablecoins are stablecoins whose value stability is not derived from independent collateral, and instead relies on algorithmic formulas or targeting mechanisms that push the price towards the intended peg if the price diverges from the peg in either direction. This makes algorithmic stablecoins completely decentralized as there are dependencies for individuals or asset custodians to maintain the peg. In practice, this means that a smart contract deploys monetary policy for a stablecoin using a reserve of crypto assets. In the case of a downward depegging event, the smart contract will sell the reserve of crypto assets and buy the stablecoin to prop up the price. In the case of an upward depegging event, the smart contract will sell the stablecoin to drive the price back down. Some examples of algorithmic stablecoins would be UST, Empty Set Dollar and Dynamic Set Dollar.
Algorithmic risks: UST, LUNA and the self-fulfilling crash
UST operated under a two token seigniorage system along with LUNA. If the price of UST exceeded the $1 target, the algorithm would issue new stablecoins, buying and burning LUNA in the process until the price is back to $1. If the price of UST went below $1, the algorithm would issue LUNA, and use the funds to buy back UST, until the price returns to the target. As noted by Vitalik when evaluating algorithmic stablecoins, you must analyze if a specific stablecoin will be able to steadily wind down without major implications. In the case of LUNA, it was proven that a wind down was not possible, as the price of LUNA was derived from the expectation of future activity in the system, as this expectation dropped to near-zero, the price of LUNA crashed. The market cap of LUNA was much smaller than that of UST, meaning a downward depegging event of UST caused hyperinflation in LUNA, at which point UST’s price was negatively affected as well. Quoting Vitalik’s point of view on the collapse:
“The system's collapse can even become a self-fulfilling prophecy: if it seems like a collapse is likely, this reduces the expectation of future fees that is the basis of the value of LUNA, pushing the LUNA’s market cap down, making the system even more fragile and potentially triggering that very collapse.”
The explosive, and self-fulfilling crash experienced by UST and LUNA shows that this example of an algorithmic stablecoin is not sustainable, as the system assumes endless growth in part of LUNA. When the market sensed that the future value of LUNA was overvalued, the system entered a self-fulfilling inflationary crash. Clearly, UST was not as stable as advertised, showing the importance of understanding how stablecoins derive their stability. UST carried a significant amount of general market risk as well as LUNA risk, which came rapidly crashing down, wiping over $20bn in “stablecoin” market cap and more than $60bn in total market cap (LUNA + UST).
Centralized Stablecoins: safer, at what cost?
Centralized stablecoins are issued by centralized institutions. Examples include collateralised stablecoins like USDC and USDT, which have off-chain dollar reserves held by regulated financial institutions. Also includes PAXG, which is a gold stablecoin backed by real gold reserves. These examples of centralized stablecoins, holders can redeem their stablecoins for the underlying assets at any point by burning their stablecoin and receiving fiat by the centralized institution that issued the tokens. In the case of USDC, the tokens are issued by Circle, USDT is issued by Tether and PAXG is issued by Paxos Gold. Whilst, centralized stablecoins offer higher security as they are backed by off-chain assets, held by asset custodians, they also offer less decentralization and rely on trusted actors to maintain the peg, unlike algo stablecoins.
In order to facilitate Stablecoin risk management, DOMANI DAO is proposing the creation of a multi-token stablecoin fund, XAVSTABLES. The fund will include decentralized stables, FRAX and DAI.e as well as centralized stables, USDC and USDT.
The fund composition is proposed as follows:
DAI.e - 12.5%
FRAX - 12.5%
USDC - 37.5%
USDT - 37.5%
Due to the higher risk associated with decentralized and algorithmic stablecoins, the tokens will represent 25% of the total fund composition, whilst centralized stablecoins will represent 75% of the total.
DEXTF holders can vote on the creation of the sponsored fund by voting on Snapshot: