A comprehensive understanding of the mechanisms and risks of mainstream stablecoins

Written by: veDAO

Since the collapse of LUNA and the fallout from Silicon Valley Bank triggering the decoupling of USDC, the second-largest crypto stablecoin, a series of black swan events have led to a threshold of distrust in the concept of stablecoins in the market.

Whether centralized stablecoins, algorithmic stablecoins, or partially decentralized stablecoins, they are all seen as a threat to some extent: if tokens known for their stability are no longer stable, what can we trust?

In fact, stablecoins are merely a form of cryptocurrency, and their value is often maintained within a roughly controllable exchange range by anchoring to real-world currencies or through algorithmic adjustments. However, this does not mean that stablecoins themselves can avoid volatility. When faced with significant black swan events, stablecoins can also decouple from their pegged currencies, meaning they can deviate from their pegged value.

The key issue is not whether stablecoins will fluctuate, but whether they have a scientific and reasonable self-correction mechanism that can timely address risks and maintain reasonable value when facing unknown risks.

Therefore, the veDAO Research Institute has compiled several common stablecoins in the market, analyzing them to interpret the mechanisms of different stablecoins and their responses to risks.

Centralized Stablecoins

Currently, the stablecoin sector is mainly divided into three categories: centralized stablecoins, algorithmic stablecoins, and decentralized stablecoins. So far, centralized stablecoins remain the mainstream in the market and can even be considered the cornerstone of the crypto world to some extent.

USDC, USDT, and BUSD are the three largest centralized stablecoins at present. All three are issued by off-chain entities and claim to be backed 1:1 by fiat currency collateral (i.e., "real" US dollars).

As of now, USDT, USDC, and BUSD together occupy over 80% of the entire stablecoin market share. According to Dune data, USDT remains the undisputed leader with a market share of 46.2%; USDC follows closely with 36.7%; and BUSD accounts for 9%. Despite the significant market share of centralized stablecoins and their scalability being the best in the industry (almost all projects have USDT or USDC trading pairs built-in), the design of these stablecoins is opaque and completely centralized, and they cannot be audited on-chain. This means we cannot know whether the issuance and collateral of centralized stablecoins are matched; all we can do is hope that centralized stablecoins truly fulfill their promises.

For example, USDT, despite Tether's constant claims that USDT is backed by equivalent assets (including cash and bonds), has never provided proper audits, only "proving" its ability to fulfill obligations.

However, an audit from June 2022 showed that the proportion of cash collateral for USDT is not high.

Overall, there are differences in the liquidity of collateral for centralized stablecoins. Once extreme events trigger a bank run, there is a certain risk regarding whether USDT's collateral can be redeemed in a short time. Due to the user base's distrust of excessive centralization, a new demand has emerged in the market: algorithmic stablecoins.

Algorithmic Stablecoins

Algorithmic stablecoins are primarily represented by UST and OHM. These stablecoins maintain stability through a floating minting and burning mechanism without any external collateral backing. For example, when the trading price of UST is higher than its pegged rate (i.e., $1), market participants are incentivized to mint new UST to increase its supply and lower its price, and vice versa.

The fatal weakness of algorithmic stablecoins is the downward spiral. For AMPL, when the price enters a downward range, holders expect a decrease in the number of tokens held, which may lead them to sell AMPL, causing the price to drop further until it reaches a very low level. For UST, we have witnessed the historical moment of the death spiral. Whether the partially USDC-backed algorithmic stablecoin FRAX can avoid the death loop during a sharp decline remains to be seen.

The core issue with algorithmic stablecoins is the lack of value collateral, making them more like speculative products. In applications such as trading and DeFi, algorithmic stablecoins find it difficult to fulfill the duties of stablecoins.

Finally, we have decentralized stablecoins, which are gradually gaining favor in the market.

Decentralized Stablecoins

Decentralized stablecoins are represented by DAI, which is a decentralized stablecoin pegged to the US dollar and issued by Maker DAO. DAI is based on an over-collateralization mechanism, allowing users to deposit different forms of collateral (such as ETH) into a vault to mint DAI stablecoins. Users must maintain their collateral positions as over-collateralized because when the collateral falls below a set collateralization ratio (which varies by collateral asset), the collateral can be liquidated.

Compared to centralized stablecoins, decentralized stablecoins have several advantages:

• Anyone has the opportunity to participate in minting decentralized stablecoins.

• The collateral situation is on the blockchain, publicly transparent, immutable, and cannot be misappropriated.

• With blockchain protocols as the main executors, the possibility of human manipulation is very low.

• Using DAOs (Decentralized Autonomous Organizations) aligns more with the interests of holders.

• Decentralized stablecoins issued based on blockchain protocols face lower regulatory risks.

However, decentralized stablecoins also have some shortcomings:

• Most adopt over-collateralization, which reduces the efficiency of capital use.

• They have liquidation mechanisms, which increase the understanding threshold for participants to some extent.

• They cannot completely detach from centralized stablecoins, as a significant component of the collateral in decentralized stablecoins comes from centralized stablecoins. When USDC decoupled during the collapse of Silicon Valley Bank in March 2023, DAI also experienced a prolonged decoupling.

Decentralization Plus Distribution: The New Player HOPE

To address the issues with decentralized stablecoins, the emerging player HOPE has made some improvements. According to its official definition, HOPE is a "pricing token supported by BTC and ETH reserves, evolving into a distributed stablecoin through a multi-stage growth plan."

The specific operational logic will be divided into three phases:

• Phase One: In the early stages of development, $HOPE will be supported by BTC and ETH, with minting and burning of tokens. For every HOPE generated, a corresponding amount of BTC and ETH must be reserved. During this process, HOPE will also obtain the opening price, highest & lowest prices, and closing price of BTC & ETH from Binance, OKX, and Coinbase every minute, calculating the average to determine the actual price of HOPE.
• Phases Two and Three: The funding reserve pool of $HOPE will add more stablecoins until the reserve pool's funds reach several times the market value of $HOPE. Subsequently, as the prices of BTC and ETH appreciate, the price of HOPE will rise along with the expansion of the market value of crypto assets, ultimately reaching $1.

It is worth noting that as the market value of BTC and ETH collateral increases, there will always be a point where the collateral value of HOPE exceeds $1, but once HOPE itself reaches $1, it will choose to remain stable and not rise further.

This creates a situation of global over-collateralization between the market value of BTC & ETH collateral and the price of HOPE. This, in turn, can validate the robustness of the HOPE token's value. More importantly, for individual users, minting HOPE does not require over-collateralization, significantly improving the efficiency of capital use.

The next question then becomes: how will the market verify the actual BTC & ETH collateral value in the HOPE ecosystem? Currently, HOPE has chosen to entrust crypto assets to Coinbase and has publicly disclosed the wallet address of the custodian, the flow of funds, and the amounts involved. In the future, HOPE will also entrust crypto assets to other custodians and custodial protocols to further enhance the distributed nature of the collateral assets and reduce the impact of black swan events.

To further enhance the liquidity of HOPE and attract more BTC & ETH holders to enter the HOPE ecosystem with peace of mind, HOPE has also innovated its economic model:

• $HOPE: The native pricing token supported by reserves in the ecosystem, will be launched at a discounted price of $0.5 and will gradually achieve pegging as the cryptocurrency market recovers.

• $stHOPE: A tokenized representation of staked $HOPE. Users can obtain $stHOPE by staking $HOPE and earn $LT rewards by holding $stHOPE.

• $LT: The incentive and governance token of the HOPE ecosystem, used to incentivize users to participate in the HOPE ecosystem and governance.

• veLT: A tokenized representation of $LT that is locked for voting when exercising governance rights, allowing veLT holders to receive $LT reward bonuses.

Currently, due to the hard cap on the price of HOPE and the infinite imaginative space for the amount of BTC & ETH collateral and its market value, the value overflowed from the collateral market value in the HOPE ecosystem will be carried by LT, which itself comes from users' actions of increasing and staking HOPE tokens based on their optimism about the market and the HOPE ecosystem.

In other words, to gain more rewards from LT, users need to hold more HOPE and actively participate in the governance of the ecosystem (veLT exercising rights can also earn LT rewards), which in turn promotes the positive flywheel operation of the entire HOPE ecosystem.

In addition, HOPE has launched four main protocols, providing a complete and rich set of application scenarios around HOPE and stHOPE, including exchange, lending, and margin trading, and incentivizing users to participate in ecosystem applications and community governance through $LT.

• HopeSwap: An AMM Swap built on Ethereum, serving as the gateway for users to the HOPE ecosystem. Users can quickly trade between $HOPE, $stHOPE, $LT, and other assets or provide liquidity for trading pairs to earn $LT rewards and fee sharing.

• HopeLend: A non-custodial lending protocol with multiple liquidity pools. Lenders can earn interest by depositing liquidity, while borrowers can provide collateral assets to obtain over-collateralized loans.

• HopeConnect: An on-chain custody and settlement protocol that allows any application to build and expand on top of it. HopeCard is the first application based on HopeConnect.

• HopeEcho: A synthetic asset that tracks the prices of real-world assets (RWA), including stock indices, fixed-income instruments, commodities, foreign exchange, etc., lowering the threshold for accessing TradFi services.

Currently, the emergence of HOPE draws on mechanisms from other products in the industry while also innovating on this basis, primarily providing a solution to the problem of users needing to over-collateralize, thus improving capital utilization efficiency.

Conclusion

In fact, while classic stablecoins have faced continuous questioning, a new batch of stablecoin projects has emerged in the industry, such as HOPE, which advocates for decentralized and distributed collateral; or ANGLE, which chooses to peg to the euro and deeply imitates Curve; as well as Reflexer, which is favored by Vitalik and sets dynamic redemption rates. However, despite innovations, the latter two still do not escape the inherent logic of individual users needing to over-collateralize. In this regard, HOPE performs relatively better.

At the same time, we should also note that as a rising star in the stablecoin space, HOPE has its merits but also poses some considerations: for instance, while HOPE proposes a method for overall over-collateralization and distributed storage of collateral assets, it may need to provide clearer statements on how to prove the public custody address's relevance to the HOPE ecosystem. Additionally, since HOPE places the actual market value of BTC & ETH collateral on the HOPE stablecoin + governance token LT, will this lead users to focus more on LT and overlook the scalability and innovation of HOPE as a stablecoin?

Finally, there is a common problem faced by all non-centralized stablecoins: how to gain more market share and user base? This issue is a long road for emerging stablecoin projects. However, with the market recovering and BTC returning to the $30,000 mark, the future development of HOPE is worth maintaining optimism.