Why Stablecoin-Backed Credit is Deflationary by Design

Collateralized Debt Obligations are the core primitive. Protocols like MakerDAO and Aave require users to lock volatile assets (e.g., ETH) to mint stablecoins (e.g., DAI, GHO). This process does not inherently reduce supply.

Stablecoin-Backed Credit inverts the model. Users deposit a stablecoin like USDC or DAI as collateral to borrow a different stablecoin. The borrowed asset is newly minted, creating a synthetic liability against the deposited reserve.

Deflationary Settlement occurs upon loan repayment. When the borrower repays the minted debt, the protocol permanently burns the repaid tokens. This destroys the synthetic liability and reduces the total outstanding supply of that stablecoin.

Evidence: MakerDAO's Spark Protocol, which mints DAI against sDAI deposits, has a direct burn mechanism upon loan closure, creating a measurable deflationary sink for the DAI supply.

Credit is collateralized by stablecoins. Unlike fiat systems, on-chain credit requires overcollateralization with assets like USDC or DAI. This creates a direct, code-enforced link between the base money supply and the credit layer.

The multiplier is fixed and transparent. Protocols like Aave or Compound use immutable smart contracts to set Loan-to-Value (LTV) ratios. This hard-caps credit creation, unlike fractional reserve banking where the multiplier is opaque and variable.

Repayment destroys the derivative. When a loan is repaid, the minted credit tokens are burned. This is a net reduction of the circulating token supply, applying constant deflationary pressure to the system's native asset.

Evidence: MakerDAO's PSM demonstrates this. For every $1 of USDC deposited to mint DAI, $1 of DAI is destroyed upon redemption. The system cannot create DAI without an equivalent, verifiable liability on its balance sheet.

Protocol-enforced collateral burning is the core mechanism. When a loan is liquidated, the protocol sells the user's collateral to cover the debt, but the stablecoin debt itself is permanently burned from circulation. This reduces the total stablecoin supply, increasing the purchasing power of all remaining tokens.

Contrast this with TradFi rehypothecation. Traditional systems reuse collateral, creating multiplicative credit. Protocols like MakerDAO and Aave destroy the credit instrument upon settlement. This creates a negative monetary lever that tightens automatically during market stress.

The cycle is self-correcting. Price declines trigger liquidations, which burn stablecoins, creating upward price pressure on the remaining supply. This intrinsic stability mechanism is absent in fiat systems, where central banks inject liquidity during crises.

Evidence: During the March 2020 crash, MakerDAO liquidated over $4 million in ETH collateral, burning an equivalent amount of DAI. This contraction helped DAI maintain its peg while other stablecoins like USDC required direct issuer intervention.

Protocols burn their own token. Every loan origination triggers a mandatory buy-and-burn of the protocol's native token using a portion of the interest. This creates a direct, verifiable link between economic activity and token supply reduction, unlike governance tokens that rely on speculative buy pressure.

Credit demand drives deflation. The system inverts traditional finance where credit expansion is inflationary. Here, more borrowing accelerates the burn rate, making the underlying token scarcer as utility increases. This contrasts with MakerDAO's MKR, which burns tokens but lacks this automatic, activity-gated mechanism.

The flywheel is self-reinforcing. As the token supply shrinks, stakers capture a larger share of fees, increasing yield. Higher yields attract more capital to secure the protocol, which lowers borrowing rates and incentivizes more loan origination, accelerating the burn cycle.

Evidence: Aave and Compound distribute fees to stakers, but the token supply remains static. A protocol like Ethena's USDe demonstrates the power of yield-backed stability, but a credit protocol applies this mechanic to its governance token, creating a deflationary asset backed by real yield.