Fundamentals of Stablecoin Mechanics & Variants
Types of stablecoin mechanisms, Collateral Debt Position (CDP), Rebase model & seigniorage model for purely algorithmic stablecoins.
Here is what we are going to cover:
Types of stablecoin mechanisms
Collateral Debt Position (CDP)
Rebase model for purely algorithmic stablecoins
Seigniorage model for purely algorithmic stablecoins
This article provides a buildup for a fractional algorithmic stablecoin $FRAX. The information is basic and foundational to understanding the complex mechanics behind the stablecoin mechanisms and it is the first article in a series of articles dedicated to Frax Finance.
⚠ Disclaimer: All information presented here is my perspective and should be considered educational content. I won’t be responsible for any kind of financial profits or losses derived from your decisions. Financial and investment advice
Similar to currency in the traditional markets, stablecoins are the backbone of the Defi ecosystem. There are many mechanisms for a stablecoin originating from some fundamental models. Some of these models are hard to replicate in traditional financial systems whereas some are inspired by the traditional financial system itself.
Types of stablecoins
Fiat-backed stablecoin
Stablecoins originated through a debt position with 100% collateralization of tangible assets.
Just like traditional finance where gold is kept as a reserve for the circulating dollars, physical dollars can be kept as a reserve for the circulation of the digital dollar (stablecoins) in the Defi ecosystem. Stablecoins like UDCS, USDT, BUSD, etc are fully backed by dollars and they provide digital dollar(stablecoin) in exchange for a physical dollar. These are known as fiat-backed stablecoins.
Crypto asset-backed (CDP):
Stablecoins originated through a debt position with more than 100% collateralization of crypto assets.
Digital assets can also be used as a backing for a digital dollar but due to higher volatility the prices may fluctuate and redemption might get hard to pull off in the case of bear markets.
It is wise to over-collateralize the position to mitigate the risk of being unable to execute the redemptions.
People can enter the ecosystem by proving crypto assets in exchange for stablecoins and they can exit by redeeming the collateral by giving up their stablecoins. The value of crypto assets provided is always more significant than the provided stablecoins.
A valid question to ask here is why would someone pay extra collateral to get stablecoins.
There are two reasons:
To establish a leveraged position.
Stablecoins might offer better yield opportunities along with the full upside price appreciation of the collateral supplied. The price appreciation can be used to increase the loan amount or can be withdrawn by squaring off the debt position.
Algorithmic stablecoins
Fully governed by algorithms: Stablecoins with no debt position i.e. no collateral is required. Two models are explained: Rebase model and the seigniorage model.
Algo stables can be easy to create but very difficult to induce confidence in them. In a free market, there are only 2 things driving the demand for any particular asset and those are supply and price. One of the easier models relies on altering the supply based on the demand of the underlying asset to keep the price stable.
The impact of demand is usually seen in the price of the assets that we hold, but with the rebasing model, the impact of demand is seen in the quantity of an asset.
Algorithmic stablecoins: Rebasing Model
This rebasing model checks the price of a stablecoin in the secondary market and when the price increases beyond $ 1 that signifies that the coin is in demand. To square off this demand the model mints more of that stable coins, increasing the supply. The newly minted coins are distributed to the stablecoin holders thus increasing the overall quantity in the wallet in the rebasing event.
This graph depicts the impact of demand and supply on the price.
In a case where demand is higher, the supply is increased to keep the price stable.
In a case where demand is lower, the supply is decreased to keep the price stable.
Thus for a stablecoin with a rebase model, the quantity of the coins in the wallet will change whenever the price move.
Algorithmic stablecoins: Seigniorage Model
The seigniorage model has a stablecoin, a bond token, and a shares token. A bond is a contract that promises ownership of a particular asset. Share token simply accrues value when the demand rises.
When the price of a stablecoin rises due to the demand, the mechanism mints more stablecoins and distributes them to the share token holders.
When the price drops, demand for bonds increases as bonds will get cheaper and they present an opportunity to buy stablecoins at a discount. whenever the price goes above the $1 mark newly minted stablecoins will be directed to the bondholder first thus squaring off those debt positions. Bonds for an asset are an excellent vehicle to absorb the excess supply.
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