What Makes a Stablecoin So Stable?
One of the central pieces to a strong DeFi ecosystem are stablecoins that people can trust will maintain their value. This allows participants to sell their tokens for profit, cut down further losses, and remain on the network for future investments.
There are a large number of stablecoins on Ethereum and Polygon, some more trustworthy than others. This article compares the different types of stablecoins, how they maintain peg to $1 USD, and why I love Qi DAO’s MAI stablecoin so much.
What does it mean to maintain the peg?
A stablecoin isn’t worth much if it doesn’t retain consistent value. The goal of any stablecoin protocol is to keeps its value around $1 USD (no major stablecoins utilize another fiat peg like the Yuan or Euro). If the stablecoin moves significantly away from that value it means it is not pegged. It can be under peg (worth less than $1) or over peg (worth more than $1).
Why do stablecoins change value?
Different market factors are constantly pulling the value of a stablecoin up or down. A good stablecoin mechanism needs to account for these forcss to stick to its peg. When a stablecoin is in demand and liquidity for it is low, the value will go up. If a stablecoin is not in demand and is being sold for other tokens, without a contra mechanism in place, the token value will go down in value. It’s all about supply and demand!
How collateral helps a stablecoin maintain value
The most successful stablecoins have some sort of collateral asset behind them. You can trust the stablecoin is worth what it should be because you can exchange it for the valuable collateral that is backing it. As with the market forces that are constantly pushing and pulling the value of a stablecoin, these same market forces can be used to maintain the peg of stablecoin. If a stablecoin starts to go under peg because it is oversold on the market, traders (or bots) can buy the stablecoin off the market and redeem it for the backing collateral. Buying the stablecoin off the market in turn decreases its availability and increases its value.
Not all stablecoins are alike though and their relationship to collateral can be different depending on their mechanism to maintain peg.
What are the various types of stablecoins?
Broadly speaking there are four types of stablecoins based on how they attempt to retain their value:
- Overcollateralized stablecoins
- Guaranteed stablecoins
- Partially collateralized stablecoins
- Algorithmic stablecoins
The list above goes from tokens that have the most collateral behind them, to the least. I’ll detail more on each below.
You can find a massive list of stablecoins here.
When a stablecoin is overcollateralized that means the backing collateral that was used to create it is worth more than $1 USD. This allows volatile collateral like Ethereum or MATIC to be used as backing since these assets tend to shift in value. The popular stablecoin DAI, made by the Maker DAO, is an excellent example of an overcollateralized stablecoin. MAI from the Qi DAO is an example of this type of stablecoin on the Polygon network (we will talk about why it is one of my favorites later).
The benefit of an overcollateralized stablecoin is that it is very easy to maintain (once the smart contracts are created it can exist persistently). The risk of this type of stablecoin is that the collateral behind it exists in the same market setting as the stablecoin itself.
Other stablecoins are guaranteed with collateral that should always be worth at least $1 USD. This guarantee is usually put in place by a large centralized authority, and the collateral is usually stored outside of the cryptomarket to avoid major issues there. Guaranteed stablecoins are sometimes backed by fiat money (like the dollar) or a real-world asset (like gold). The USDC coin is an example of this type. Coinbase, Circle, and a consortium of financial institutions guarantee that behind every USDC coin made is $1 stored safely somewhere else.
Guaranteed stablecoins are typically seen as less risky than the other types since their backing collateral exists outside of the same market as the stablecoin. These types of stablecoins are somewhat expensive to maintain since they require work outside of creating a smart contract. These types of stablecoins can still be risky though since the centralized authority that oversees the stablecoin could fail entirely at backing up its guarantee (a worry many have of the USDT stablecoin).
Partially collateralized stablecoins
Other stablecoins are only partially backed up by a steady collateral source, while the remaining portion of their collateral is based on a more volatile token or another system to maintain peg. These stablecoins, like FRAX, can be incredibly complex and at least a portion of them is maintained by an algorithm in the protocol. This means part of the stablecoin is “floating” or unbacked by collateral except within the same crypto ecosystem. The value of this type of token is that it is incredibly easy to make with less overall collateral. The risk however is if the protocol fails to adjust for market events or is exploited.
Totally algorithmic stablecoins only ever exist on the network, and maintain their value by incentivizing the market to speculate on the token using their own protocol. These types of stablecoins make adjustments on the network to maintain peg, and do not require collateral to mint new coins. The risk of these types of tokens is if the market does not utilize the protocol for arbitrage, or refuses to do so in the way the designers intended. A large number of algorithmic stablecoins have failed in the past and this type of protocol is largely unfavored by the market.
My favorite stablecoin on Polygon
One of the safest ways to create a stablecoin is to overcollateralize it and also include a stability pool of guaranteed immediate collateral available to exchange for it. The Qi DAO’s MAI stablecoin is a great example of this type. Not only is it backed by at minimum 150% MATIC collateral, but the Qi DAO also lets you swap MAI for USDC directly to maintain stability.
MAI is made by vaulting MATIC and then minting from this collateral, or by swapping for USDC.
How does MAI maintain its peg?
It retains its value on the market through a couple of means:
- If MAI on the open market is above the peg folks can buy it and arbitrage using the USDC swap on Mai.finance. For example, if MAI is worth $1.05 at the time, someone could swap $1.01 of USDC for MAI, sell it, and make around 4% profit — increasing the number of MAI on the market and bringing its value nearer to $1.
- The swap also works if MAI is under the peg since the price floor to sell it on the swap is set to $0.99. For example, if MAI’s value decreases to $0.96 someone could buy it for $0.96 USDC on the market and then swap it Mai.finance for $0.99 worth of USDC.
- The collateral-to-debt ratio of MAI must always be above 150% for each vault that has minted MAI. If it falls below that the vault can be totally or partially liquidated. When the price of MATIC falls this causes more liquidations and fewer MAI to be minted. When it increases the number of MAI can increase. The back and forth of the market brings stability to MAI as users repay their loans by buying the stablecoin off the market, or increase their loans as the collateral-to-debt ratio changes
What’s the benefit of MAI?
What makes MAI such a great tool in crypto is the ability to maintain collateral whilst also being able to leverage that in other applications like in a trade, to engage in liquidity pool mining, etc.
With MAI a user is able to take out a 0% loan and take a long position on MATIC (and in the future other collateral). As well, that MAI can then be used on DeFi apps elsewhere allowing users to “HODL” but still engage in DeFi. Further, MAI can be used to buy other assets like ETH to cut down on exposure to an asset like MATIC, or another stablecoin to pay off debt elsewhere. Learn more about the use cases here.
I’ve loved investing in MAI to decrease my exposure to a volatile market. Especially as things get bearish it’s nice to be able to mint some MAI and combine it in a stablecoin LP with USDC. And because the Qi DAO incentivizes that LP pair with their governance token Qi as a reward I can then take that over to a site like Adamant Vaults to increase my yield on two stablecoins.
You can quickly see why having a rock-solid stablecoin on Polygon is a huge thing for DeFi.
About the Qi DAO
The Qi DAO is the organizing community behind the stablecoin MAI and the governance token Qi on Polygon. Their protocol allows you to make loans on your MATIC collateral and mint the stablecoin MAI. Learn more at Mai.finance
About Revolutionary Spaces
At Revolutionary Spaces I bring the latest news, discussion, and how-tos on the DeFi world, especially on Polygon. I love helping folks out and can usually be found on the Discords for Adamant Vaults, the Qi DAO, and Balancer Protocol. I am currently looking for opportunities in product management, documentation or technical writing, and community management in the DeFi space. Reach out!
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