Stablecoins and Stablecoins Farming

The concept of stablecoins is actually pretty simple. Think of stablecoins are the “crypto dollars” living in the blockchain.

Stablecoins and Stablecoins Farming
Photo by CoinWire Japan / Unsplash

Introduction to Stablecoins

  • The concept of stablecoins is actually pretty simple. Think of stablecoins are the “crypto dollars” living in the blockchain. If you think of a bank’s balance sheet in which they have assets and liabilities in equal value, you will understand how stablecoins work pretty soon
  • On the left hand side of a bank’s balance sheet, you have assets. These are all the lending you make to your borrowers — in other words, your revenue generator. On the right hand side you have liabilities and equity, and this is a mix of the funds provided to you by your shareholders, as well as those provided to you by your depositors — in other words, your source of funds
  • One of the most famous stablecoins is Tether. Tether’s “revenue generators” / asset refer to its reserves which include traditional currency & cash equivalents, assets and receivables from loans made by Tether to third parties. Its liabilities refer to all Tether coins currently in circulation that are minted on 1:1 basis to USD, which will always be equal or less than the value of its assets. The difference between the assets and the liabilities of Tether is the shareholders’ reserves, which is evaluated on quarterly basis
Source: as of 10 Feb 2022

Below are the general types of stablecoins currently available:

  1. Traditional (offchain) stablecoins: the main distinguishing feature of traditional stablecoins is that the custodial party holds real dollars and other dollar-yielding assets to back the USDs living in the crypto world. There is an inherent risk that the custodial party could refuse the redemption of the crypto dollars back to real life dollar for any reason. As such, traditional stablecoins model is not considered permissionless, which is one of its drawbacks. Investors also rely on third party audits to ensure that the real dollar asset held by the custodial party is real, sufficient and not being artificially inflated. Example of traditional stablecoin include USDT (Tether) and USDC. It is also worth nothing that traditional stablecoins adopt the full reserve bank model, in which the liabilities and equities are fully backed by the assets
  2. Permissionless (onchain) stablecoins: these types of stablecoins live on the blockchain. This simply means, the crypto dollars are backed by crypto assets, instead of real life dollars. You can easily track the asset side of permissionless stablecoins as all the data are onchain. You would only need to know the wallet address and you can simply go to dashboards such as to verify the holdings
  • Full reserve bank model: this model is very similar to the traditional stablecoins, except that the custodial party, which is the protocol, holds asset in the blockchain instead of real dollars, which act as the backing for the liabilities + equities side. The model allows depositors to redeem their stablecoins to fiat in 1:1 ratio, and this is achieved by overcollateralizing the asset side of the stablecoin to act as buffer / cushion given that crypto assets may be very volatile. Examples include Maker DAI and sUSD (Synthetix USD)
  • Algorithmic central bank model: this model is different in a way that they defend their own peg in the market without relying on overcollateralization of assets. Its main features are as follows: 1) it does not have any depositors, meaning its liabilities + equity side of things are not funded by you or me — instead, the stablecoin already has an existing pool funded by the stablecoin project itself, 2) backed by 1 native token, and 3) it naturally follows that the stablecoins are not “redeemable” in a sense that they are redeemable for fiat the way stablecoins operating under full reserve bank model does. To zap in and out of the stablecoin, you can simply buy and sell in the marketplace. An example of algorithmic central bank model is $UST (backed by $LUNA) and $cUSD (backed by $CELO)

How do stablecoins maintain the 1:1 peg?

As per its namesake, stablecoins such as Tether maintains a 1:1 peg with the US Dollars. The peg is maintained by making sure that your assets move hand-in-hand with your liabilities. However, crypto is volatile, so how do we work this out? Different stablecoins company have different methods of maintaining / protecting the peg. Let’s look at some examples

  1. Permissionless stablecoins — full reserve bank model: typically apply very high collateralization rate in order to provide buffer for the asset side fluctuations. These stablecoins usually carry some kind of cost of borrowing, which is usually paid when the stablecoins are returned to the protocol in exchange of the collateral. The cost of borrowing, or the fees charged to the users, are usually pooled together and is used as stability fund / buffer to protect everyone from events such as flash crash & market downturns. Some examples are as follows:
  • MakerDAO / DAI: MakerDAO’s stablecoin, $DAI puts significantly extra cushion of crypto in its balance sheet to act as buffer in case its crypto assets go down. DAI is currently backed by a basket of crypto assets such as $ETH, and the collateralization ratio depends on how much DAI you wish to mint (collateralization ratio= value of your collateral / value of DAI minted). When the value of your collateral falls below value of DAI minted * collateralization ratio, then your collateral will be liquidated by a third party. The converse is also true — if the value of your collateral increases, you can mint more DAIs. When you want to reclaim back your collateral, you would need to pay a certain percentage of fees to the protocol (currently at 3.5%). The fees will go to the stability pool functioning as the buffer mentioned above
  • Synthetix: Synthetix’s stablecoin, sUSD, are backed by one currency, which is the $SNX tokens itself, often referred to as the equity token. Because $SNX is so volatile, minting a $SNX-backed stablecoin requires 600% overcollateralization ratio. Synthetix also charges fees when you want to claim back your $SNX tokens with sUSD.

2. Permissionless stablecoins — algorithmic central bank model: When a stablecoin is trading below the peg, for example, 1 UST = 0.9 USD, then there is too much $UST in the market currently. What will happen is that the protocol will use $UST to mint more $LUNA, thereby effectively burning $UST out of the system to restore the peg. The opposite is also true — when 1 UST = 1.1 USD, it means there are too little $UST in the system. As such, the protocol will use $LUNA to mint more $UST to restore the peg back to USD 1.0

Stablecoins farming

Stablecoins farming simply refer to “putting your money at work” by staking them for the following purposes:

  • Liquidity provider (LP): In crypto, we have both centralized exchanges (CEX) and decentralized exchanges (DEX). CEX typically requires KYC in the platform as it serves on-ramp (swapping fiat for crypto assets) and as such required by law to perform due diligence on its customers. Some people who are very concerned with privacy would prefer permissionless and non-custodial model that DEXes like Uniswap or PancakeSwap can provide. In DEXes, coins are sold in pair in which LP are required to deposit same value of assets into the pool to provide liquidity. LPs get the share of fees in the pool (typically something like 0.20% for stablecoins or even lower). If you have any stablecoins that are not doing anything, you may consider to stake them in a liquidity pool and collect these LP rewards to turn your stablecoin into a yielding asset. LPs typically have no lockup, but it varies from projetcs to projects. Examples would be stablecoin LP farms in (Note: 3Crv refers to the tripool of Curve which consist of $DAI, $USDC and $USDT in equal amounts. It is the LP token in Curve)
  • Lending: You may also lend your stablecoins and in return keep most of the interests paid by borrower. Borrowers typically need to deposit an overcollateralized asset position to secure their loans, and in an event the loan does not get repaid, or if the collateral value drops beyond an acceptable limit and no collateral top-up is received, the protocol may liquidate the collateral to repay the lenders. An example would be the Anchor Protocol (UST lending and borrowing). Note that lending typically provides the highest return for your stablecoin, although it does carry more risk than LP
  • Minting new coins: Stablecoins may also be required in order to mint new coins, usually a native coin of a protocol who requires extra liquidity in form of the stablecoins. Returns would be in form of the new coins, in which user may profit from its price appreciation or very high APYs. This is more risky compared to the previous two ways of obtaining yield for your stablecoins. An example for this would be an Avalanche-network native stablecoin, $MIM, which was required to mint Wonderland Time ($TIME)