This article will give UX Designers an understanding the stablecoins wars that are currently being waged. Many types of stablecoins exist – we’ll talk about what has worked, and what is currently being experimented on in the area of algorithmic and non-pegged stablecoins – very cool stuff! This is part of an overall Web3 Design Bootcamp that teaches UX Designers about Web3 concepts and design patterns so they can land a job in the rapidly merging field.
Interest rates have been at all time lows in traditional markets over the past several years as the U.S. 10 Year Treasury Bond hit 0.60% APY in 2020. At the same time, DeFi was on the rise, giving investors alternative markets to earn much higher (albeit riskier) yields. All the DeFi products we’ve talked about were some of the first to find product-market fit in Web3, evidenced by the fact that they onboarded millions of users onto Ethereum; however, like any first iteration of technology, there exist some problems in the current DeFi ecosystem. Let’s discuss some of the problems facing DeFi 1.0, and peer into the emerging DeFi 2.0 landscape, which seeks to address them – starting with stablecoins.
Demand for stablecoins is rapidly increasing as the Web3 ecosystem is more and more in need of non-volatile assets for things like payment. There are many types of stablecoins each with their pros and cons. And it’s also an active area of experimentation as entrepreneurs search for optimal stablecoin designs. Let’s take a look at the different stablecoin categories.
The first category is fiat-collateralized stablecoins. These are, by far, the most popular right now based on market cap. Here, regulated companies, like Tether and Circle, issue stablecoins that are fully-backed by their fiat reserves. USDC and USDT are pegged to the US-dollar, but some stablecoins track other currencies (e.g. EURS). Historically, fiat-collateralized stablecoins have maintained their peg better than others; however, their fiat reserves are custodied within the traditional financial system. Governments have the ability to seize these reserves and undermine fiat-collateralized stablecoins, which many consider unacceptable for a means of payment in the world of Web3.
Enter crypto-collateralized stablecoins. This brings us back to MakerDAO where users can deposit crypto into Maker vaults and mint DAI – a stablecoin also pegged to the US-dollar. This is a big deal, because the crypto collateral backing the stablecoins cannot be seized by centralized entities. Thus, crypto-collateralized stablecoins are truly decentralized; however, the problem is that crypto is volatile, and using it as collateral is risky because the value of collateral can quickly fall below the loan’s value. Therefore, crypto-collateralized stablecoins must be over-collateralized, which isn’t an efficient use of capital.
MakerDAO was the first crypto-collateralized stablecoin protocol. Since then, other DeFi protocols have iterated on, and improved the original MakerDAO concept. For example, the crypto locked in Maker vaults is just sitting there, not earning yield. On Alchemix, users deposit crypto collateral to generate alUSD – Alchemix’s stablecoin. But here, Alchemix deposits collateral into Yearn Vaults that earn interest, which is used to automatically repay the user’s alUSD loan. It’s a self-repaying loan. Similarly, Abracadabra.Money supports yield-bearing tokens as collateral, like Yearn (e.g. yvDAI) and Convex (e.g. cvx3pool) tokens. But I digress – let’s move onto the third stablecoin category – algorithmic stablecoins.
The first two stablecoin categories are asset-backed. Either fiat reserves, or crypto collateral in vaults, support the price of the aforementioned stablecoins. A lot of recent experimentation has been done on algorithmic stablecoins, which have no assets backing them. An algorithm automatically maintains the peg of a stablecoin based on real-time market conditions for that stablecoin. This is usually done through mint and burn mechanics. Let’s pause and talk about the most popular algorithmic stablecoin – UST.
UST is built on the Terra blockchain, and is pegged to the US-dollar. UST is paired with Terra’s native token – LUNA, which is a volatile crypto asset. UST and LUNA can be exchanged in a 1:1 ratio with each other. At any point, 1 UST can be minted by burning $1-worth of LUNA. Alternatively, 1 UST can be burned in exchange for $1-worth of LUNA. Arbitrageurs utilize this mint-burn mechanism when UST is trading on centralized exchanges for a premium, or at a discount. For example, let’s say UST breaks its peg, and trades at $1.02 on a CEX. Arbitrageurs can burn $1-worth of LUNA, and mint UST in order to realize a 2% gain. On the other hand, if UST is trading at $.98, then it can be exchanged for $1-worth of LUNA. This is how UST maintains its peg.
However, it’s ironic that I’m writing this now. Just last week UST failed massively. There was a major sell-off in UST as investors lost faith, reflexivity kicked in, and caused an even greater sell-off. Billions of dollars of UST were liquidated over several days, and UST is sitting at around $.09 at the time of writing. This points to the immaturity of algorithmic stablecoins, and puts into question the feasibility of algorithmic stablecoins in general.
There is another category of stablecoin – fractional reserve stablecoins – that is a middle ground between algorithmic and crypto-collateralized. These stablecoins are partially crypto-collateralized hence the term “fractional reserve”, and partially rely on an algorithm to maintain their peg. FRAX is the most popular example of fractional reserve stablecoins.
All the stablecoins we’ve discussed so far are pegged to fiat currencies. The issue with this is that pegged stablecoins are beholden to central banks that control the monetary policies of fiat currencies. Some argue it’s unacceptable to have any reliance on central institutions in the decentralized Web3 ecosystem. The final category of stablecoins we talk about is non-pegged stablecoins. OlympusDAO is the most popular project in this space with its non-pegged OHM stablecoin.
“Stablecoin” is a bit of a misnomer for OHM. Currently, its price is around $17 – and it’s been as high as $1,300+. So OHM can be highly volatile, but one of the main features of OHM is its floor price, or risk-free value. Users exchange crypto with OlympusDAO for discounted OHM in a process called bonding. All bonded crypto is held in OlympusDAO’s treasury, which ensures a floor price of at least $1 OHM. Thus, the value of OHM is free-floating, but users can always have faith in the floor price, backed by Olmypus’ war chest.
This leads into the next problem that DeFi 2.0 is attempting to solve – that of deep, permanent token liquidity. OlympusDAO controls a massive treasury, which is a great example of an upcoming concept – “protocol controlled value” (PCV). The protocol can deploy liquidity as it sees fit to ensure liquidity for its native token, or to earn yield and grow the treasury larger. Also, their protocols can rent out their liquidity to help other protocols bootstrap token trading, or bolster their liquidity pools.
If you enjoy videos over reading when it comes to online learning then checkout the course on YouTube. This is part 9 of 10 in the DeFi for UX Designers Course. Also, make sure to stay tuned for future Web3 Design Courses, which will cover emerging Web3 product categories.