While most of these stablecoins rely on third-party custodians and auditing firms to ensure security, their fiat deposits backing these coins are guarded by centralized entities. Therefore, there still exists a certain level of risk as users do not have access to full transparency. On the other hand, those who wish to withdraw may need to wait for a set period of time before the transaction is approved, thus sacrificing efficiency.
An alternative for this is to use crypto-backed stablecoins, coins that offer the same purpose as fiat-backed stablecoins but run on a decentralized platform. Crypto-backed stablecoins are linked to reserves of other and the mechanisms behind these coins are slightly more complex. The strengths and weakness of crypto-backed stablecoins are summarized in the following chart.
Generally, the procedures for obtaining these coins are as follows: users will first create a smart contract on the and send another transaction to fund it with the specific type of collateral. In return, the smart contract will deploy the associated amount of stablecoins while locking up the collateral. Over time, a so-called stability fee is accrued. When users wish to retrieve their collateral, they must pay back the stablecoins plus stability fee. The entire process is similar to that of obtaining a crypto-backed loan.
Unlike fiat-backed coins, the value of crypto-backed stablecoins can be more uncertain due to the price fluctuation of the underlying collateral. Stabilizing their prices is rather difficult and extensive measures must be taken to keep prices pegged to the dollar value.
Crypto-backed stablecoins generally require a collateral ratio much greater than 100%. DAI, the largest crypto-backed stablecoin, for example, requires an initial deposit of 150% in collateral. Still, there exists the possibility that in a volatile market, the price of the collateral plunges and the value of collateral drops below the borrowed amount. As a result, a liquidation ratio is set slightly below the initial collateral ratio. When reached, the deposited collateral will be liquidated, similar to a margin call.
Furthermore, stablecoins such as DAI have a global settlement mechanism. When triggered, it freezes the protocol and users can claim collateral worth $1 for each stablecoin they own. Users have no time limit to claim this collateral. However, the amount they receive is fixed at the time of the global settlement. This is used as the last resort to protect investors during extreme market conditions.
Investors that receive their stablecoins through smart contracts may also help contribute to price stability. Suppose that a stablecoin is backed by and an investor initially receives $100 worth of stablecoins by depositing $150 worth of ETH. The investor soon uses the stablecoins to purchase another coin. When the price of the stablecoin drops to a value of $0.9, the investor is incentivized to quickly buy back 100 units of stablecoins with $90 and close the smart contract, receiving the initial ETH deposit in full and saving $10 in total. This sudden increase in demand by contract creators will push up the stablecoin coin’s market price, allowing it to move towards its target price of $1.
Despite these price stability mechanisms, crypto-backed stablecoins may still struggle to hold their peg in the short run. Since February 2019, DAI has been traded below its pegged value of $1 on many exchanges. The main reason for it to fall below its peg is due to an excess supply of DAI. While MakerDAO, the lending system behind the stablecoin, uses ETH as collateral, many speculators deposit their ETH to take out DAI and buy more ETH on the market. This is used as an alternative way to leverage their position on ETH. Since the price of ETH has been rising over the past few months and investors have been expecting a bull run, more and more DAI has been created and sold on the market, pushing the price of DAI downwards.
For the past few weeks DAI has received a lot of coverage regarding its increase in stability fee. Since DAI has been traded at a discount, MakerDAO has voted to raise fees to push prices back to $1. By raising the cost of creating new DAI, coin holders wish to stop speculators from taking out new DAI and selling it for ETH as a way of leverage. The goal is to control the supply of DAI and reduce the ongoing selling pressure.
As shown in the chart above, even though the supply of DAI has been slightly reduced, the recent fee hike has already pushed the stability fee to up to 16.5%. While this serves as a temporary solution to the restore its peg, MakerDAO must soon address the issue with high fees, as new investors are unlikely willing to pay such a high fee for creating DAI, which would eventually create an issue for the coin’s future scalability.
Recently MakerDAO has introduced new coins that could be used as collateral, meaning that users could stake coins other than ETH to borrow DAI. This provides users greater freedom and easier access while making the total value of the collateral pool more stable, as it is no longer dependent on a single coin.
Currently, DAI has a market cap of around $83 million, while USDT has a market cap of $2800 million. Clearly, the market is still in favor of fiat-backed stablecoins. Hopefully, as crypto-backed stablecoins introduce new price stability mechanism and gain increased , we will see a greater balance between the two types of stablecoins.
Thank you for reading this week’s report! Please leave a comment below to share your thoughts and ideas on crypto !
Published at Fri, 10 May 2019 16:41:23 +0000
