The Importance of Decentralized Stablecoins: The Maker Protocol and the Terra Blockchain

By 2sats | 2sats | 18 Aug 2021

*obligatory not financial advice*

What are Stablecoins?

A stablecoin is a token that is pegged to the value of a fiat currency and has the same price as its fiat counterpart. Essentially a stablecoin that is pegged to the US dollar is a tokenized dollar that can be used on a smart contract blockchain and its DeFi protocols. Fiat currencies are pretty much shitcoins, but we do measure value with them so there is a huge demand for them in trading and so decentralized finance needs to have some way of using them and DeFi lending platforms also often offer much higher interests when banks do, so there is a high demand for stablecoins.

Their value does fluctuate a little bit, if there is suddenly a huge pressure the swap cryptocurrencies into stablecoins for example, constantly but it is generally stable. Usually their value is held stable by a centralized entity that holds the same amount of cash, or other assets that is issued in their stablecoins and guarantees that the stablecoin holders can exchange their tokens for fiat at any time. The problem here is that you depend on this centralized entity.

Tether, the most used centralized stablecoin, is not very transparent about their holdings and barely ever gets audited if at all, so really you need to blindly trust them if you hold USDT. Another problem is that such institutions can be targeted by regulators, recently they began demanding that all stablecoin issuers check the identity of their users, which would make it nearly impossible to use them in DeFi. Lastly, there is no point in even using DeFi if you still depend on a centralized entity. This is why we need a decentralized way of using fiat in DeFi. Here I want to show 2 different ways of getting stablecoins without depending on a centralized third party.

The Maker Protocol and the DAI stablecoin

Maker is a DeFi protocol on the Ethereum blockchain that allows its users to take loans in the decentralized stablecoin DAI. To mint the USD based stablecoin you need to lock up a collateral in the form of a cryptocurrency like ETH. This is useful if you need liquidity but don't want to sell your assets because you think that they will keep growing. You can mint DAI in the value of 80% of your collateral, for example if you have $100 worth of ETH you can get $80 worth of DAI. Once you have the DAI you can use it however you want, if you want to get your collateral back you will need to pay back the loan.

The value of DAI is kept stable by a control in supply and demand. Should the value get lower than $1, then Maker will start charging higher fees to discourage people from having a DAI loan and therefor lower the supply. Should the value get higher then it will increase the interest rate you could earn with DAI on Maker to encourage people to get DAI and increase the supply, which would lower the price.

DAI is different from most stablecoins because its value is not backed by fiat but by crypto which can be very volatile. Because of that there are certain precautions in place to ensure that it is always fully collateralized. Should the value of your ETH fall to $90, then it will be sold and you don't have to pay back the $80 DAI because there is nothing to get back anymore, the remaining $10 will be paid to you minus a fee that goes to a treasury. Should the value of your collateral fall even further before Maker could react then this treasury will cover for the loss. And if not even the treasury can cover for a loss then the protocol will MKR tokens to cover for it.

MKR is the governance token of Maker and gives its holders voting rights for the changes in the protocol. The value of the token depends on the success of the protocol, the more funds a locked in Maker, the more desirable voting rights will become. Since new tokens are created and sold if the collateral cannot back up the DAI, there is a strong incentive for MKR holders to participate in governance and to make sure that everything is fine because otherwise their tokens will lose value.

The Terra blockchain and the LUNA coin

Terra is a proof of stake blockchain that allows everyone to create various stablecoins that can be pegged to various fiat currencies. The created stablecoins can be send to various other blockchains via a bridge. The unique thing about Terra is that their stablecoins are not collateralized per se, they are kept stable by an algorithm.

To create UST (USD based stablecoin on Terra) you need to burn an equivalent dollar amount of LUNA tokens. If you want 10 UST and the price of 1 LUNA is $1, then you would need to burn 10 LUNA. But you can also burn the stablecoins to receive the equivalent dollar amount of LUNA tokens. If you burn 10 UST and the value of 1 LUNA is $0.50, then you would get 20 LUNA back. This creates an environment where you are incentivized to redeem stablecoins if their value would ever drop and therefor make their value higher by a smaller supply. Should the value of 1 UST crash down to $0.50 then you could make an instant 50% profit by burning it because you would get $1 worth of LUNA per UST. Should their value get higher than $1 then people would have an incentive to burn LUNA and create the stablecoins, which would make their supply higher and lower their value.

The LUNA coin is also used for staking, but since it is not inflationary stakers can only earn the low network fees and get 1.4% interest per year. LUNA has a max supply of 1 billion and the more stablecoins are being created the lower the supply becomes and the more value a coin will have. However, should the demand for stablecoins get lower then they can be redeemed for LUNA which would increase its supply and lower their value.

Closing Thoughts

There is a growing demand for decentralized stablecoins and it could be wise to invest into some of their infrastructures. The DAI stablecoin is already very popular on Ehtereum and Maker will likely grow in value but Terra is much more versatile and can be used to create stablecoins for many different fiat currencies and for many different blockchains. Both of them could be very good investments for the next few years.

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