What is Decentralized Stablecoin

Decentralized Stablecoin refers to a stablecoin that is issued and operated in a decentralized manner, without the involvement of a central authority or intermediary.

Stablecoins are cryptocurrencies whose value is pegged to a "stable" asset, such as fiat currencies, baskets of currencies, other cryptocurrencies, or commodities such as gold. For Decentralization, please refer to the "What is DeFi" chapter. For Stablecoin, please refer to the "What is Stablecoin" chapter.

Unlike other cryptocurrencies (e.g. BTC and ETH), stablecoin prices don't usually fluctuate much. This makes stablecoins a more reliable unit of account and medium of exchange, which is similar to traditional payment methods. Since it is more stable than other cryptos, it is more acceptable to normal users for short-term holdings and daily usage.

Two Types of Decentralized Stablecoin

Generally, there are two types of decentralized stablecoins, Overcollateralized Stablecoin and Algorithm Stablecoin.

Overcollateralized Stablecoin

Overcollateralized Stablecoin is backed by a reserve of other cryptocurrencies, where the value of the reserve is higher than the stablecoins issued. This extra collateral provides a buffer against potential fluctuations in the value of underlying assets, which helps maintain the stability of the stablecoin. DAI, LUSD, and MIM are some examples of overcollateralized stablecoins.

Algorithm Stablecoin

Algorithm Stablecoin, on the other hand, manages stablecoin token supply through automated and algorithmic mechanisms, instead of relying on underlying reserves. More specifically, when the price of stablecoins exceeds the peg, the protocol will issue more tokens to draw it back, and vice versa.

There are two types of algorithmic mechanisms, Rebase and Seigniorage. The Rebase mechanism adjusts stablecoin token supply through mint and burn processes. Ampleforth adopts a rebase mechanism, which means the number of AMPL tokens in users' wallets varies every 24 hours.

The Seigniorage mechanism uses a dual-token model of stablecoin and governance token. For example, Terra's UST (now USTC) and LUNA (now LUNC) follow the Seigniorage mechanism. Users can exchange UST and LUNA for arbitrage. In the Terra market, UST is hard pegged to the US dollar (1 UST = $1). Users can mint 1 UST with $1 worth of LUNA, or exchange UST back to LUNA as $1 at any time.

More specifically, when UST is in short supply, pushing the price up to above $1, let's say $1.05, the arbitrageur can burn $1 worth of LUNA to mint 1 UST, and then buy back $1.05 worth of LUNA, equivalent to risk-free arbitrage of $0.05 profit. By repeating this operation over and over again, the circulation of UST will increase, eventually stabilizing the balance of supply and demand at 1 UST = $1. The continuous burning of LUNA leads to a decrease in circulation, which will eventually indirectly lead to an increase in price.

The Rebase mechanism tends to adjust stablecoin's token supply by the protocol. While under the Seigniorage mechanism, the platform maintains the dynamic stability of stablecoin prices by encouraging users to actively arbitrage.

Centralized Stablecoins vs. Decentralized Stablecoins

Centralized and decentralized stablecoins differ in various aspects, including decentralization, censorship resistance, reserve, transparency, and use cases.

Decentralized

Decentralized stablecoins differ from centralized ones because they are not controlled by a single entity or institution. Instead, they are managed by a decentralized network of users, making them more resilient to the collapse of any one entity or institution. For example, the decentralized stablecoin DAI is issued by MakerDAO and managed by a network of token holders.

In contrast, centralized stablecoins like USDT and USDC are issued and controlled by companies or financial institutions. In 2023, one of Circle’s six banking partners, Silicon Valley Bank went bankrupt. It managed about 25% of $USDC’s cash reserves. As a result, USDC’s reserves were questioned, and the price of USDC dropped to around $0.8 on March 11.

Censorship-Resistant

Decentralized stablecoins are designed to be censorship-resistant. This is because these stablecoins are managed by a decentralized network of users, instead of a single entity. This means that no central authority has the power to freeze or control the transactions or funds of decentralized stablecoins.

In addition, decentralized stablecoins typically operate on a blockchain, which records all transactions in a transparent and immutable manner. Once a transaction is recorded on the blockchain, it cannot be altered or deleted.

In 2022, Circle has warned the New York Regulator about Binance’s mismanagement of reverses. In Jan 2023, Binance Acknowledges Past Flaws in the Management of Stablecoin's Reserves.

Feb 2023, BUSD issuer, Paxos was investigated by NYDFS and BUSD experienced outflows. SEC planned to sue Paxos, alleging that $BUSD issued by it is unregistered security. On the 13th, new BUSD issuing was not allowed anymore. 

On 13th Feb, Binance CEO CZ tweeted that Binance might no longer use BUSD as the main pair for trading. 

28th Feb, Coinbase announced that it would suspend trading of BUSD from 13th, Mar. Later in March, AAVE DAO voted to remove BUSD from its lending platform.

Transparency

Centralized stablecoins keep their reserves in the bank accounts of the issuing institutions, so users can't see the actual reserves unless the institutions disclose them. Decentralized stablecoins, however, use smart contracts to manage issuance and reserves. Thus, the stablecoin's issuance, burn, and transfer records can be viewed publicly.

Reserve

Centralized stablecoins are backed by fiat currency, while decentralized stablecoins are over-collateralized or algorithmic stablecoins. For USDT, 82.13% of its reserves are cash and cash equivalents, 8.73% are secured loans, 5.14% are commercial bonds, funds, and precious metals, and 4.01% are other investments. While DAI's reserve assets include 63.8% other stablecoins, 16.1% ETH, 13.3% RWA, 3.6% LP, and 3.2% other assets. (2023.3.29)

Algorithmic stablecoins are risky due to insufficient reserve support, so most decentralized stablecoins are overcollateralized. USDD is the only well-known algorithmic stablecoin. UST used to be one of the largest decentralized stablecoins, but it collapsed due to many reasons such as market panic and the excessive inflation of LUNA.

FRAX recently changed from a hybrid model (partially overcollateralized and partially algorithm-backed) to a pure collateral model through a DAO proposal.

Use Case

Decentralized stablecoins have a less usage scenario than centralized stablecoins. While USDT and USDC are commonly used as the standard currency on centralized exchanges and decentralized applications, the use cases for decentralized stablecoins are currently limited to on-chain applications. Some decentralized stablecoins, such as FRAX, are designed to complement their primary products with specific application scenarios. Hence they are less composable and are not widely adopted by third parties.

Related Reading: Current Status and Outlook of Stablecoins 2023