The Risk of Cryptocurrency-Collateralized Stablecoins

Categories: GeneralPublished On: November 30th, 20184.1 min read

If you haven’t already, read this story to gain an understanding of the different types of stablecoins. This is the second article in a series focusing on the risks of different stablecoin models. This piece is focused on cryptocurrency-collateralized stablecoins. The most notable project is Dai, created by MakerDAO. The inner workings of Dai are quite complicated and won’t be completely explained in this piece.

Collateralization

Dai is collateralized by Ether or other ERC-20 tokens. However, cryptocurrencies like Ether are volatile, therefore the collateralization needs to be more than 1-to-1. This means that for every Dai (priced at $1) there needs to be more than $1 of Ether backing it, typically $1.50. This is 50% over-collateralized, meaning the stablecoin is not very capital efficient. This extra collateral allows for Dai to still be backed by at least $1, even if the price of Ether goes down. The Ether backing Dai is put into a collective pool with all of the other Ether backing Dai.

There is a risk here because the price of Ether could drop so much that the collateral falls below the required threshold (150% in the scenario above). The cryptocurrency market is very volatile, as an example, Ether has lost nearly half its value over the last couple of weeks. If the collateral does fall below the threshold, the Ether will be liquidated (sold off) for Dai. This lowers the supply of Dai until it is sufficiently collateralized again.

If the price of Ether increases, Dai becomes more collateralized dollar-wise. When the price of the collateral increases, more Dai can be created without dropping below the collateral threshold.

Liquidation

Let’s assume Ether is $100, a user locks up 1 Ether and creates 50 Dai (they could create more, but that is riskier). This is known as creating a collateralized-debt-position (CDP). To get their Ether back, they must pay back the 50 Dai, plus a little interest. However, let’s say the price of Ether drops to $60, the Dai is now undercollateralized according to the smart contract. There is only $60 worth of Ether backing the 50 Dai, this is well below the 150% collateral threshold. In this situation, the 1 Ether will be liquidated and sold to the highest bidder, paid for in Dai.

The idea is that the buyer will pay more than 50 Dai, such as 55. This process will destroy 55 Dai, and destroy the CDP. The person that locked up their Ether gets to keep their 50 Dai, but can no longer retrieve their Ether. On the net, this has removed 5 Dai from the supply. This system shares concepts with margin trading in that positions get liquidated as they become too risky. The owner of the CDP can pay back some Dai if they notice the price of Ether dropping, however, this requires constant monitoring of the cryptocurrency market to ensure they don’t lose their collateral.

Oracles

Similar to uncollateralized stablecoins, cryptocurrency collateralized stablecoins require an oracle. The smart contract needs a price feed for the collateral. In the case of Dai, the price of Ether needs to be given to the smart contract.

Capital Inefficiency

 

 

Image Source: https://bit.ly/2CaDmRd

 

The image above explains the key properties of different stablecoins. While cryptocurrency-collateralized stablecoins are decentralized, the lack of capital (collateral) efficiency hinders its ability to increase supply.

As a quick comparison, view the rapid growth of a fiat-collateralized stablecoin compared to Dai.

On March 12th, TrueUSD was around 6 million in total market cap while Dai was around 20 million. It took just a couple months for TrueUSD to overtake Dai in market cap. Currently, TrueUSD is approaching 200 million in market cap, Dai sits around 60 million.

There are many reasons for this, but Dai’s system of over-collateralization undoubtedly impacts its ability to gain market cap (create more Dai). This website provides valuable insight into the Dai system. Currently, total collateralization of Dai is 277%.

This signals that CDP owners are cautious, not wanting to create as much Dai as they could. Remember, if a CDP becomes less than 150% collateralized, it becomes liquidated. The volatility of the cryptocurrency market will likely keep CDP owners from going near the 150% mark, which is why the ratio is currently much higher.

277% collateralization means there’s approximately $2.77 of Ether for each Dai. While this is good from a safety perspective, it’s quite costly. As mentioned above, there is around 60 million Dai currently, yet over $170 million in Ether locked up.

This isn’t inherently a risk to the stablecoin. However, if demand spikes for Dai and the price goes above $1, will the owners of the CDPs mint new Dai to bring the price back down? Or will they be too worried about liquidation to take a more risky position? For now, the Dai system has worked pretty well, but more time is needed to validate its robustness.


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