Author: Alyssa Chen

Stablecoins

What are stablecoins?

Stablecoins are a type of cryptocurrency designed to maintain a stable value relative to a specific asset or basket of assets such as the US dollar, and can be used for various purposes:

1. Facilitate cross-border transactions

2. Reduce transaction fees

3. Provide stable store of value for users who want to avoid the volatility of traditional cryptocurrencies

There are two main types of stablecoins: Fiat backed stablecoins, and commodity backed stablecoins. Fiat backed stablecoins (i.e. USD Coin and Binance USD) are backed by a reserve of fiat currencies which allows their price to be relatively stable (often backed by the US dollar). Commodity backed stablecoins (i.e. Tether Gold), on the other hand, use physical assets held in reserve to back up the price of the coin. They are often pegged to items like gold, oil, precious metals, or real estate, and as a result, can fluctuate more in price than the fiat backed alternative.

Crypto backed stablecoins use another cryptocurrency as collateral. Examples of these include Maker (MKR) and DAI, which are managed on chain and employ smart contracts to deal with issuing the coin and liquidations. Algorithmic stablecoins utilize smart contracts to adjust the supply of stablecoins in circulation in response to changes in demand. This ensures that the price of the stablecoin remains pegged, which can be achieved through various mechanisms, such as buying and selling the stablecoin on exchanges or adjusting the interest rates paid on the stablecoin.

Stablecoins are exempt from the volatility that Bitcoin, Ethereum, and other cryptocurrencies face by allowing users to maintain their money in crypto markets.

Let’s say Bob has $100 and wants to earn interest. One option he has would be to put his money into a bank account, where he could earn ~.5% APY if he is lucky. Another option would be to buy $100 worth of USDC, then deposit it into a lending pool and earn anywhere from ~.5%-.14% APY (As of 4/18/24 dependent on the platform).

Decentralized Lending

Centralized lending relies on a traditional lending model controlled by banks or credit unions that set interest rates and terms of the loans. Lending institutions bear the credit risk, and require extensive documentation and rigorous credit checks.

Decentralized lending is characterized by the lending and borrowing of cryptocurrencies on blockchain-based decentralized platforms without the need for intermediaries or central authorities. As a result, they are able to provide users with access to financial services that were previously only available through traditional financial institutions.

History of Decentralized Lending: A Brief Overview

• 2009: Bitcoin was the first decentralized digital currency that allowed for peer-to-peer transactions without the need for intermediaries.

• 2013:  Bitbond emerged as the first decentralized lending platform to automate the lending process, allowing lenders to earn interest on their funds with faster loan approvals.

• 2016: MakerDAO became the first decentralized lending platform to use collateralized debt positions (CDPs) to issue stablecoins. DAI stablecoin is backed by collateral in the form of other cryptocurrencies, which allow users to access a stable, dollar-pegged asset without having to sell their cryptocurrency holdings.

As decentralized lending became more and more popular, trends with lending and borrowing also began to emerge. Flash loans, (as discussed in our DEX Deep Dive) allow users to borrow funds without any collateral for a very short period of time. Arbitrage trading occurs when users take advantage of price differences between different markets to make a profit, and liquidations occur when the lender seizes collateral assets from a borrower who has defaulted on their loan.

Decentralized lending can allow borrowers with little to no credit history begin to receive loans, and another benefit is that geography does not affect the possibility of receiving a loan. This democratization improves efficiency, flexibility, and customization of loan terms, which can lead to faster loan approvals and lower overhead costs.

Mechanics of Decentralized Lending

Decentralized lending is executed by smart contracts, which we covered in The Rise of DeFi. The process goes like this: A borrower applies for a loan. A smart contract is then created with loan terms, interest date, repayment schedule, and collateral requirements. Once the loan is funded by lenders, the borrower receives their portion of funds in their wallet. The smart contract then enforces the loan, deducting payments from borrower’s wallet and distributing interest payments to lenders.

Smart contracts may also allow users to collateralize their cryptocurrency assets in exchange for a stablecoin or another asset. When a user creates a collateralized debt position (CDPs), the cryptocurrency collateral is locked in a smart contract and they receive a stablecoin or other asset in return. The amount received is determined by a collateralization ratio: the ratio of value of collateral to the value of asset received. For example, if the required collateralization ratio is 150%, the user must provide $150 worth of cryptocurrency (i.e. ETH) to receive $100 worth of the stablecoin (such as DAI).

Liquidity pools in lending are pools of assets used to facilitate trades on DEX. A user will provide collateral in the form of cryptocurrency assets, which are then deposited into a liquidity pool where it serves as a source for other users who want to borrow funds. Stablecoins received by borrowers are generated by the liquidity pool, which holds a reserve of stablecoins that can be used to facilitate loans. Loans are repaid when stablecoins are returned to the liquidity pool, which maintains the pool’s reserve of assets.

Interest rates are highly variable— generally fluctuating depending on supply and demand, and are determined via an algorithmic interest rate model.

Decentralized Lending Protocols

1. AAVE is a platform that allows users to borrow and lend a variety of cryptocurrencies, including Ethereum, Bitcoin, and stablecoins and also features flash loans.

2. Compound allows users to earn interest on their cryptocurrency holdings by lending them to other users and supports a variety of cryptocurrencies, including Ethereum and stablecoins.

3. MakerDAO operates on the Ethereum blockchain, and allows users to borrow the stablecoin DAI by providing collateral in the form of Ethereum. It uses a system of governance tokens to allow users to participate in decision-making for the platform.

4. Curve allows users to trade and lend a variety of stablecoins, including USDT, USDC, and DAI. Curve uses an automated market maker (AMM) system to facilitate trades and ensure liquidity.

5. Balancer uses an automated market maker (AMM) system to allow users to trade and lend a variety of cryptocurrencies, and features liquidity pools that allow users to earn rewards for providing liquidity to the platform.

Risks & Limitations

Decentralized lending relies on smart contracts, and while smart contracts are meant to be secure, they are not immune to errors or hacking, which could lead to significant financial losses.

In addition, since cryptocurrencies are volatile, the value of the collateral used to secure a decentralized loan can change rapidly, and if the value of the collateral drops below a certain threshold, the borrower may be forced to sell their collateral to repay the loan, which could lead to a (potentially significant) loss. This is known as market volatility risk.

Liquidity risk occurs when decentralized platforms don’t have enough liquidity to meet demand or provide a quick enough exit for borrowers, which could potentially lead to a delay in loan approvals, high fees and inability to withdraw funds. Additionally, DeFi trading platforms are not regulated by traditional financial authorities, so there may exist a regulatory risk— less protection and a lack of oversight which could lead to fraud and other types of misconduct.

In summary, decentralized lending platforms typically do not offer protections like insurance or government guarantees, which means borrowers and lenders would have to assume more risk and responsibility for their own financial decisions.

If you’re interested in learning more about decentralized finance— including exchanges, stablecoins, derivatives, MEV and more… stay tuned for Blockchain at Berkeley’s Fundamentals of DeFi article series!

In the next week, we will be covering derivatives!

This series is based off Blockchain at Berkeley’s DeFi lecture series. Credits to Tiffany Liu, Riteka Murugesh, Aditya Bhandari, Nate Pola, Daniela Fajardo, Jaylem Brar, and other previous contributors.