Crypto-Backed (Anchored) Stablecoins

Unlike fiat-backed stablecoins, these tokens are often managed by decentralized protocols, relying on overcollateralization to maintain price stability. If that sounds confusing to you, keep reading.

Referring back to the hypothetical XCAD token that I wrote about here, let’s assume I wanted to design it differently this time. In this case, I want to ensure that anyone can provide collateral to my stablecoin while reducing the counterparty risk that comes along with a centralized custodian. Because in the long term, what’s the point of a decentralized financial network like Ethereum if the underlying tokens used for value transfer are centralized?

Essentially, I would want to structure XCAD so that it was decentralized and maintained its peg with Canadian Dollars at the same time. To do so, I might create a decentralized and permissionless application (DApp) that runs on the Ethereum Virtual Machine (EVM) via a set of smart contracts. This application would allow users to lock up Ether as collateral. Then, a certain amount of XCAD would be minted and transfered to the user in exchange for depositing collateral (Ether).

We can think of newly minted XCAD as a form of debt that the user takes on in exchange for providing collateral to the protocol. To settle this debt, the user would return their XCAD tokens back to the protocol, which would unlock their collateral so that it can be recovered.

But how much XCAD (debt) should be minted for every dollar of collateral?

One-To-One Collateralization Is Problematic

Before discussing overcollateralization, let’s explore the more intuitive alternative. If a proportional amount of XCAD is minted and transfered to users based on the dollar value of their collateral, our stablecoin would struggle to maintain its peg in periods of price volatility. Here’s an example.

Let’s assume I am the first person to lock up some Ether in exchange for a proportional (1:1) amount of XCAD. If I deposit $1000 worth of Ether, the protocol would mint and transfer 1,000 XCAD tokens to my wallet. At this point, each XCAD token would be backed by $1 of collateral in CAD terms.

Now, let’s assume ETH’s market price relative to CAD were to fall by 5% several hours later. Then, the total value of the stablecoin’s collateral would drop to $950, while 1,000 XCAD tokens remain in circulation. As a result, each XCAD token would only be backed by $0.95 of collateral and the stablecoin would quickly lose its peg on the open market. So how can we prevent this?

Overcollateralization Enables a Margin of Safety

While 1:1 collateralization is problematic, we can think of overcollateralization as only moderately so. In other words, ovecollateralization does not solve all of our problems, but can meaningfullly help preserve a stablecoin’s peg.

By enforcing overcollateralization, we can mitigate for a certain amount of price volatility in collateral assets. This would require users to contribute more than $1 of collateral (Ether) for every XCAD token that they wish to mint and receive.

For example, I could encode a minimum overcollateralization ratio of 125% into my DApp’s smart contracts. Then, in the event that the value of ETH falls by 20% or less, the value of my collateral would still be greater than or equal to the number of XCAD tokens in circulation.

In this way, ovecollateralization creates a margin of safety, insulating the stablecoin from certain amounts of volatility in the collateral asset.

Here’s a simple formula that we can use to calculate the margin of safety based on different overcollateralization rates:

Margin of safety (%) = [(100% - Collateral Ratio) / Collateral Ratio]

In our example, the formula would return the following:

20% = [(100% - 125%) / 125%]

Overcollateralization: An Example

To help make sense of this, let’s refer back to our example from above.

If I deposit $1,000 worth of Ether into the XCAD stablecoin protocol, I can only generate up to 800 XCAD in order to satisfy an overcollateralization requirement of at least 125%. The maximum amount of a stablecoin that can be minted against collateral is often referred to as the “debt ceiling”.

Here’s a simple formula used to calculate the debt ceiling:

Debt (XCAD) = Value of collateral (ETH) in CAD / Min. overcollateralization ratio 

In our example, the formula would return the following:

800 XCAD = $1,000 / 1.25

Now, let’s assume that after minting 800 XCAD tokens in exchange for $1,000 of ETH, ETH’s market price falls by 15%. In this case, the value of the stablecoin’s collateral would drop from $1,000 to $850, while 800 tokens are in circulation. As you can see, the collateral value ($850) is still greater than that of XCAD tokens ($800) in circulation. Phew…

But what would happen the user’s collateral? Technically, they have now breached the DApp’s ovecollateralization requirements. The collateral value ($850) now only represents 1.06x the debt position ($800) and is thus lower than the collateralization requirement of 1.25.

In this case, the user would have two choices. First, the user could supply more collateral (Ether) to the protocol, bringing the collateralization ratio back above 125%. Or, the user could repay some of the XCAD that has been borrowed in order to arrive at the same result.

If the user did not perform one of the above actions within a reasonable period of time, then the XCAD protocol would need to liquidate the user’s underlying colltaral in order to eliminate the “bad debt” in the system.

The Trade-offs of Crypto-Backed Stablecoins

While these types of stablecoins are more decentralized and permissionless than their centralized counterparts, they come with their own respective risks.

• Undercollateralization: the stability of a decentralized stablecoin protocol, and thus the underyling token’s ability to keep its peg on the open market, is based on the premise that the value of collateral assets exceed that of liabilities. In this case, liabilities refer to the circulating supply of minted stablecoins. However, there is always a risk that the total value of underlying collateral will fall below the value of all issued stablecoins in circulation. To mitigate for this risk, protocols can adopt conservation overcollateralization requirements near 2:1.

• Scalability: in practice, decentralized stablecoins are meant to generate liquidity that is most often used for leverage. In this way, these types of stablecoins can only scale in proportion to investor’s appetite for leverage. For this reason, overcollateralized stablecoins like only occupy around 5% of the total stablecoin market on Ethereum.