Collateralized Stablecoin

The collateralization ratio is the core risk parameter, representing the value of assets backing each stablecoin. Common types include:

• Overcollateralization (e.g., 150%+): Used by protocols like MakerDAO (DAI) to absorb price volatility of crypto assets like ETH.
• Fiat-backed (e.g., 100%): Issuers like Circle (USDC) hold equivalent cash and treasuries.
• Commodity-backed: Pegged to assets like gold (e.g., PAX Gold). A higher ratio increases stability but reduces capital efficiency.

Users create (mint) stablecoins by depositing collateral into a smart contract. To reclaim their collateral, they return (burn/redeem) the stablecoins. This arbitrage loop is the primary peg defense:

• If the stablecoin trades below $1, users buy it cheaply and redeem it for $1 worth of collateral, profitably increasing demand.
• If it trades above $1, users mint new tokens by depositing collateral and sell them, increasing supply. This creates a soft peg enforced by market participants.

These are the protocol's risk management tools. A liquidation is triggered if the collateral value falls below the required ratio (e.g., due to a price drop). The collateral is automatically sold to repay the stablecoin debt, often at a penalty. A stability fee (an annual interest rate) is charged on the generated stablecoin debt. This fee, often paid in the protocol's governance token, regulates supply and funds the system.

This defines who controls the collateral reserve.

• Custodial (Centralized): Entities like Tether (USDT) or Circle (USDC) hold off-chain reserves. Users rely on the issuer's solvency and audits, introducing counterparty risk.
• Non-Custodial (Decentralized): Protocols like MakerDAO hold collateral in on-chain smart contracts. This eliminates issuer risk but introduces smart contract risk and liquidation risk. The choice is a trade-off between trust minimization and operational simplicity.

Collateral reserves can generate yield, which becomes protocol revenue. For fiat-backed stablecoins, revenue comes from interest on treasury bills and cash deposits. For decentralized protocols, revenue primarily comes from the stability fees paid by users. This revenue can be used to buy back and burn governance tokens, fund insurance modules, or be distributed to token holders, aligning economic incentives.

Understanding the risks is critical:

• Collateral Volatility: A sharp drop in asset value can trigger mass liquidations and market instability.
• Liquidity Crises: During market stress, liquidators may be unable to sell collateral efficiently, threatening solvency.
• Regulatory Risk: Custodial issuers face scrutiny over reserve composition and transparency.
• Oracle Failure: Decentralized protocols rely on price oracles; incorrect data can cause faulty liquidations or undercollateralization.
• Bank Run: A loss of confidence can trigger mass redemptions, testing reserve liquidity.

Important Contrast: Algorithmic stablecoins are not collateralized. They use on-chain algorithms and smart contracts to control token supply, expanding and contracting it to maintain the peg.

• Key Example (Historical): TerraUSD (UST).
• Mechanism: Relied on a mint/burn mechanism with a sister token (LUNA) to absorb volatility.
• Risk Profile: Highly sensitive to market sentiment and liquidity crises, as seen in the Terra collapse, because they lack intrinsic asset backing.

Modern protocols often use diversified collateral baskets to enhance stability and decentralization.

• MakerDAO's Evolution: Dai's collateral now includes Real-World Assets (RWAs) like treasury bills alongside crypto assets.
• Frax Finance (FRAX): A hybrid model starting as partially algorithmic and partially collateralized (USDC), moving towards a more collateralized backing.
• Benefit: Diversification reduces systemic risk from any single asset class.

A core risk is the forced liquidation of collateral during market volatility. If the value of the backing assets (e.g., ETH, other tokens) falls below a predefined collateralization ratio, the protocol automatically liquidates positions to maintain the peg. This can trigger a cascade of liquidations, exacerbate price drops, and lead to bad debt for the protocol if liquidations fail to cover the outstanding stablecoin supply.

For fiat-backed (off-chain collateral) stablecoins like USDC, the primary risk shifts from smart contracts to traditional finance. Users must trust the issuing entity to:

• Hold the exact amount of real-world assets (cash, bonds) in regulated banks.
• Undergo regular, transparent audits.
• Resist regulatory seizure or banking failure. A loss of trust in the custodian can trigger a bank run on the stablecoin.

The entire system depends on the security of its code and data feeds. Key vulnerabilities include:

• Smart contract bugs in the core minting, borrowing, or liquidation logic.
• Oracle manipulation, where an attacker feeds false price data to trigger unjustified liquidations or mint unbacked stablecoins.
• Governance attacks, where a malicious actor gains control of protocol upgrades. These are technical risks inherent to all decentralized finance (DeFi) protocols.

Stablecoin issuers, especially centralized ones, are subject to increasing regulatory scrutiny. Key actions that can impact users:

• Address blacklisting: The issuer can freeze or seize funds in specific wallets (e.g., for sanctions compliance).
• Protocol-level shutdown: Regulators could compel an issuer to halt minting or redemptions. This creates censorship risk and challenges the permissionless nature of the underlying blockchain.

The type and concentration of backing assets create specific risks:

• Crypto-collateralized (e.g., DAI): Exposed to high volatility and correlation within the crypto ecosystem.
• Fiat-collateralized: Exposed to traditional banking risk, inflation, and interest rate changes.
• Algorithmic/ Hybrid models: May hold other stablecoins or LP tokens, creating circular dependencies and depeg contagion risk if one asset fails.

Protocols employ various mechanisms to maintain the peg, each with its own risks:

• Arbitrage incentives: Rely on market participants to correct price deviations, which may fail during extreme stress.
• Stability fees/interest rates: Changing rates can affect demand and collateral health.
• Emergency shutdown: A last-resort mechanism to settle all positions at a fixed collateral price, which can be chaotic and result in losses if executed during a market crisis.

A stablecoin that maintains its peg through algorithmic mechanisms and smart contracts, not direct collateral backing. It uses rebasing, seigniorage shares, or dual-token systems to algorithmically expand or contract the token supply in response to market demand. This model aims for capital efficiency but carries significant risks of de-pegging if the algorithmic logic fails under market stress, as seen with TerraUSD (UST).

A critical risk-mitigation practice where the value of the collateral reserve exceeds the value of the stablecoins issued. This creates a safety buffer to absorb price volatility in the collateral assets. Key aspects include:

• Collateral Ratio: The ratio of collateral value to debt value (e.g., 150%).
• Liquidation: If the ratio falls below a threshold, positions are automatically liquidated to protect the system.
• Examples: MakerDAO's DAI (backed by crypto assets) and Liquity's LUSD (backed solely by ETH) use this model.

A digital form of a country's fiat currency, issued and backed directly by its central bank. Unlike decentralized stablecoins, a CBDC is a centralized liability of the state, representing direct legal tender. It is often explored for wholesale interbank settlements or as a retail digital cash equivalent. CBDCs represent the sovereign digital competitor to private, collateralized stablecoins.

The most common type of collateralized stablecoin, where each token is backed 1:1 by traditional currency reserves (e.g., USD, EUR) held in bank accounts. These are off-chain collateral models. Key characteristics:

• Issuance & Redemption: Users trust a central entity to mint/burn tokens against deposits/withdrawals.
• Transparency: Relies on regular attestation reports or audits to verify reserves.
• Custodial Risk: Users bear counterparty risk with the issuing entity.
• Examples: USDC (Circle), USDT (Tether), and BUSD (Paxos).

A decentralized stablecoin collateralized by other cryptocurrencies (e.g., ETH, WBTC) locked in on-chain smart contracts. This model enables permissionless minting and redemption while mitigating reliance on traditional banking. It introduces volatility management challenges, addressed through:

• Overcollateralization (e.g., $150 in ETH to mint $100 DAI).
• Liquidation engines to maintain solvency.
• Stability fees or interest rates to manage supply.
• Examples: DAI (multi-collateral), LUSD, and alUSD.

Collateral assets that generate a native yield or reward while securing a stablecoin debt position. This innovation improves capital efficiency for minters by offsetting borrowing costs. Mechanisms include:

• Staked ETH (stETH): Used as collateral while earning staking rewards.
• Liquidity Provider (LP) Tokens: Tokens representing a share in a liquidity pool can be used as collateral.
• Reward Streaming: Protocols may automatically claim and apply rewards (e.g., Aave's aTokens) to a user's debt position, a concept central to DeFi composability.