Stablecoins: Collateralized vs Algorithmic

20 min readJun 7, 2023

Stablecoins are growing in importance as they account for an increasing proportion of the total crypto market cap, currently exceeding more than 10% (source). They provide a means of transferring value in a decentralized and trustless manner. They offer a way for traders to hedge against market volatility, facilitate the use of DeFi platforms, and bridge the gap between the crypto world and the traditional financial system. This is achieved by providing a familiar and stable asset that can be easily exchanged for fiat currency.

Despite the numerous depegging cases that have shaken the entire crypto world, stablecoins remain the only meaningful way to link the value of digital assets to real-world value. In this article, we will explore how stablecoins are maintained, what constitutes a sustainable stablecoin design, and why some stablecoins fail while others do not. We will begin by examining the mechanics behind how stablecoins maintain their peg.

How Do Stablecoins Maintain Their Peg?

Both collateralized and algorithmic stablecoins use a combination of methods to balance to supply and demand dynamics.

*These are centralized stablecoins. They maintain their reserves through a third party, which acts as a custodian. This is unlike other stablecoins in this list, which use decentralized protocols to handle minting and redemptions.

**Dai uses a combination of algorithmic mechanisms to maintain its peg. In addition to collateralization, Dai utilizes an algorithmic stability mechanism called the MakerDAO protocol, which adjusts supply and incentives based on market dynamics.ntralized protocols to handle minting and redemptions.

***AMPL and RAI are non-pegged, but are still typically recognized as stablecoins.

Collateralized Model

Over-collateralization. Collateralized stablecoins typically require an over-collateralization ratio. This means that the value of the collateral held is higher than the total supply of stablecoins in circulation. For example, if the ratio is 150%, it means that for every $1 worth of stablecoins, there must be at least $1.50 worth of collateral. Over-collateralization provides a buffer against price fluctuations and helps maintain stability. Different types of assets can serve as collateral:

A fiat-backed stablecoin would require establishing banking relationships and ensuring proper reserves are held.
With commodity-backed stablecoins, similar processes would involve custodians holding and safeguarding the underlying commodities. The custodians, such as banks, commodity exchanges, warehousing and storage providers, or commodity merchants and traders, should have robust security measures in place to protect the commodities from theft, loss, or damage.
For crypto-backed stablecoins, a crypto exchange, financial institution, dedicated custody service provider or trust company could act as a custodian to manage the reserves. Notably, collateralization is handled differently in centralized and decentralized stablecoins. Centralized stablecoins rely on reserves held by third-party custodians, while decentralized stablecoins use collateral provided by users in the lending protocol that mints and maintains the stablecoin.

Algorithmic Model

Algorithmic stablecoins do not require interaction with third parties to provide a collateral, since the reserve management is fully under the control of an algorithmic stabilization mechanism.

Algorithmic supply expansion and contraction. When a stablecoin’s price is above the target price, the algorithm triggers various mechanisms to expand the stablecoin supply. This typically involves minting or creating new stablecoins and distributing them to holders or liquidity providers. The increased supply should help decrease the price and bring it closer to the target. Conversely, when the stablecoin’s price is below the target price, the algorithm initiates mechanisms to contract the stablecoin supply. This process often involves burning or destroying stablecoins in order to reduce supply, increase the price, and bring it back to the target.

The algorithmic expansion and contraction of supply can be achieved by utilizing a pair of coins; one stabilizing asset called “volcoin”, and another asset with a variable price. This approach leads us to an important subcategory of algorithmic stablecoins known as “Terra-style stablecoins,” as defined by Vitalik Buterin in his blog. The mechanism works as follows:

If the price of the stablecoin exceeds the target, the system auctions off new stablecoins (and uses the revenue to burn volcoins) until the price returns to the target.
If the price of the stablecoin drops below the target, the system buys back and burns stablecoins (issuing new volcoins to fund the burn) until the price returns to the target.

Source: Vitalik Buterin’s website

This principle is known as a seigniorage.

Another non-collateralized subtype of algorithmic stablecoin is the rebasing stablecoin. Rebasing algorithmic stablecoins, also known as elastic supply stablecoins, adjust their token supply periodically based on market conditions to achieve price stability. Through a process called rebasing, the token supply expands or contracts proportionally for all holders in response to deviations from the target price. The goal is to incentivize market forces to bring the stablecoin price back towards the target value, typically a pegged value like 1 USD. Ampleforth (AMPL) is often used as an example of a rebasing stablecoin. However, there are several factors indicating that Ampleforth is not actually a stablecoin. This includes the presence of volatility and, as a result, the inability to use AMPL in trading pairs or for payments in the same manner as other stablecoins.

Many algorithmic stablecoins are now at least partially collateralized following the UST — Terra/LUNA collapse. The fully algorithmic model is now uncommon among popular stablecoins today. For example, over-collateralized algorithmic stablecoins achieve price stability by maintaining a surplus of collateral that exceeds the value of the stablecoin supply. Users lock up collateral to generate the stablecoin, and the protocol monitors the collateral value and stablecoin supply. If the collateral value falls below a certain threshold, corrective actions are taken. Redemption options and arbitrage opportunities help restore the stablecoin’s peg. Examples include MakerDAO’s Dai (DAI) and Synthetix’s sUSD. Monitoring the collateralization ratio and governance mechanisms is important for assessing stability and risk.

Fractional algorithmic stablecoins are another subtype that also uses collateral. Instead of being fully backed by collateral or over-collateralized, these stablecoins maintain a fractional reserve of assets relative to the circulating stablecoin supply. The algorithmic mechanisms aim to maintain stability by adjusting the supply based on market conditions and the target value. By holding a fractional reserve, these stablecoins offer a degree of flexibility and scalability, but they also introduce additional risk compared to fully collateralized stablecoins. Examples of fractional algorithmic stablecoins include Frax (FRAX), Carbon (CUSD) and Fragments (FRAG). Notably, Frax used to be 80% until the community voted to adopt a collateral ratio of 100% (source).

Other Methods

We have already discussed the primary methods specific to either collateralized or algorithmic stablecoins for maintaining the peg. However, there are various alternative methods that can serve as supplementary stabilization mechanisms in both models:

Arbitrage opportunities: Collateralized stablecoins rely on market forces to maintain the peg. If the stablecoin’s value deviates from the target price, arbitrageurs can exploit the price difference by either buying or redeeming stablecoins. If the stablecoin is trading below the target price, arbitrageurs can buy it on the market and redeem it for the underlying collateral, effectively driving the price back up. Conversely, if the stablecoin is trading above the target price, arbitrageurs can mint new tokens by providing collateral and sell them on the market, bringing the price down.
Incentive mechanisms (stability fees): Some stablecoins implement stability fees or interest rates on outstanding stablecoin loans. These fees incentivize users to maintain the peg by adjusting the supply and demand dynamics. For example, if a stablecoin’s value is below the target price, the stability fee may increase to encourage users to redeem stablecoins and reduce the supply.
Governance and voting mechanisms: In some stablecoin systems, there is a governance model where token holders can vote on various parameters and decisions. This enables the community to adjust the stablecoin’s parameters, such as the collateralization ratio or stability fees, in order to maintain the peg in times of volatility.
Emergency shutdown and blacklisting: In extreme circumstances, collateralized stablecoin systems may use emergency shutdown mechanisms. These mechanisms temporarily suspend the system when it becomes difficult to maintain the peg. Furthermore, specific addresses may be blacklisted or assets frozen in certain scenarios to mitigate potential risks and ensure stability.
Market forces and speculation: Algorithmic stablecoins are subject to market forces and speculative activity. The interaction of supply and demand, along with market participants’ expectations, can influence the stablecoin’s price dynamics and its ability to maintain the peg.

It is important to note that the issuance and redemption processes are managed by the smart contract, while a price oracle is responsible for translating market conditions, such as the present value of collateral. Price oracles play a vital role in both collateralized and algorithmic stablecoins by ensuring that the peg accurately reflects market conditions and by being able to initiate appropriate actions in the event of a peg deviation.

We have summarized the two major stablecoin mechanisms in the charts below.

Arbitrage opportunities: Collateralized stablecoins rely on market forces to maintain the peg. If the stablecoin’s value deviates from the target price, arbitrageurs can exploit the price difference by either buying or redeeming stablecoins. If the stablecoin is trading below the target price, arbitrageurs can buy it on the market and redeem it for the underlying collateral, effectively driving the price back up. Conversely, if the stablecoin is trading above the target price, arbitrageurs can mint new tokens by providing collateral and sell them on the market, bringing the price down.
Incentive mechanisms (stability fees): Some stablecoins implement stability fees or interest rates on outstanding stablecoin loans. These fees incentivize users to maintain the peg by adjusting the supply and demand dynamics. For example, if a stablecoin’s value is below the target price, the stability fee may increase to encourage users to redeem stablecoins and reduce the supply.
Governance and voting mechanisms: In some stablecoin systems, there is a governance model where token holders can vote on various parameters and decisions. This enables the community to adjust the stablecoin’s parameters, such as the collateralization ratio or stability fees, in order to maintain the peg in times of volatility.
Emergency shutdown and blacklisting: In extreme circumstances, collateralized stablecoin systems may use emergency shutdown mechanisms. These mechanisms temporarily suspend the system when it becomes difficult to maintain the peg. Furthermore, specific addresses may be blacklisted or assets frozen in certain scenarios to mitigate potential risks and ensure stability.
Market forces and speculation: Algorithmic stablecoins are subject to market forces and speculative activity. The interaction of supply and demand, along with market participants’ expectations, can influence the stablecoin’s price dynamics and its ability to maintain the peg.

We have summarized the two major stablecoin mechanisms in the charts below.

Collateralized Model:

Pure Algorithmic Model (No Collateral):

As previously stated, contemporary algorithmic stablecoins typically incorporate a combination of the two aforementioned structures, resulting in a collateralized setup to varying degrees.

Why Do Stablecoins Depeg?

Before summarizing the list of factors that commonly precede a depeg, we must examine the most widely recognized instances of both failed and successfully recovered stablecoins.

Case Studies

Terra/LUNA

According to the timeline provided by Mika Honkasalo, Delegate at MakerDAO and Uniswap, in his blog, the UST crash commenced with an imbalance in the UST-3pool on Curve. This imbalance was triggered by UST-to-USDC swapping. Despite efforts to recover from the minor depeg, selling pressure escalated following a $250M selloff from a single wallet address. The subsequent selling pressure was intensified by the economics and mechanics of UST itself.

Whenever a user wants to sell UST, they need to burn 1 UST in exchange for every $1 worth of newly-issued LUNA (referred to as volcoin in the “Algorithmic model” section). This LUNA-based mechanism helps balance the supply and demand dynamics of UST. However, if LUNA’s value depreciates rapidly and UST continues to be sold off and exchanged for LUNA, LUNA could lose value at a faster rate than LUNA holders could sell their $1 worth of LUNA for $1. This would be further exacerbated by the hyperinflation caused by the rapid issuance of LUNA. Notably, at the time of the crash, LUNA had a lower market cap than UST ($5.7B versus $16.52B). This also intensified the situation because the market cap of LUNA approached zero more quickly than UST’s market cap as the crash continued. As a result of all this, remaining users were left holding UST, unable to receive an adequate equivalent in LUNA and exchange it for fiat.

Theoretically, the big players could have supported UST by pumping LUNA and limiting selling pressure on UST. However, this defensive action never took place.

Depegs that recovered: USDT, USDC

In 2017, USDT faced a depegging following concerns about the validity of information regarding Tether’s reserves and the resultant negative market sentiment. However, immediate arbitrage buying did not occur due to suspended wallets, restricted withdrawals, and limitations on bank deposits. These factors impeded market forces and exacerbated the psychological pressure to sell. Eventually, as redemptions were progressively carried out, sentiment stabilized, and market forces drove the price back towards its peg.
In May 2022, USDT experienced another depegging down to $0.94 as a result of $3B in withdrawals. Reports indicated that hedge funds began shorting USDT in the aftermath of the Terra/LUNA collapse. The redemptions were liquidated through banking channels. As market sentiment gradually normalized, traders closed their short positions, while others took long positions to capitalize on the arbitrage opportunity. USDT eventually regained its peg in July.
The most recent case of depegging occurred in March 2023 when USDC was at risk following Circle’s disclosure of a $3.3B exposure to Silicon Valley Bank. This revelation created an arbitrage opportunity that enticed trading firms, with one wallet earning $16.5M by swapping USDT for USDC and DAI. Mike van Rossum, the founder of trading firm Folkvang, noted that the market was pricing in “more risk than reasonable” in light of the government’s intervention during the collapse of Silicon Valley Bank (source).

When comparing the 1-year charts for USDT and USDC, there is a noticeable difference between their respective depegging incidents. The initial depegging of USDT in 2018 unfolded gradually over the course of several weeks. In contrast, the more recent depegging events for USDT in 2022 and USDC in 2023 witnessed an immediate surge in buying, leading to a swift recovery of most of the price losses within a matter of days.

USDT price, 01/01/2017–31/12/2017

USDT price, 01/01/2022–31/12/2022*

USDC price, 18/05/2022–18/05/2023

*The second drop in price in this chart (November 2022) occurred during a period of market volatility triggered by the collapse of FTX. These events had a notable influence on the overall market sentiment surrounding cryptocurrencies, leading to a more gradual upward trend due to prevailing uncertainty in the market.

Every major collateralized stablecoin has experienced at least one case of an unusually high number of redemptions, resulting in a temporary depeg. These depegging events can be attributed to a variety of factors ranging from market conditions, regulatory influences, and the specific design of the stablecoin. In general, the most common reasons for such incidents include:

Insufficient collateralization: Insufficient collateralization means that the value of the collateral backing the stablecoin is not enough to maintain the peg. External market factors or changes in the value of the collateral can contribute to this imbalance.
External market shocks (including speculative attacks): Collateralized stablecoins can be affected by external events or market shocks that impact the value of the collateral assets. Sudden price fluctuations or market volatility in the assets backing the stablecoin can lead to depegging.
Lack of market liquidity: If the stablecoin’s market lacks sufficient liquidity, it can become susceptible to price manipulation or large buy/sell orders that cause significant price swings. Illiquid markets may not have enough participants to maintain stability resulting in depegging.
Liquidity crunch: During periods of significant market stress or liquidity shortages, users may rush to redeem their stablecoins for the underlying collateral all at once. If the issuer is unable to meet these redemption demands or encounters liquidity constraints, it can result in a depegging scenario.
Inefficient stabilization mechanisms: The stabilization mechanisms in place may not effectively respond to price deviations. If mechanisms are slow to adjust or fail to address market imbalances, the stablecoin may struggle to maintain the peg.
Lack of trust or transparency: If there are concerns about the transparency of the collateral reserves or the stability of the stablecoin issuer, users may lose trust in the stablecoin. This loss of confidence can trigger an escalation in selling pressure, pushing the stablecoin’s price away from the peg.

A truly sustainable stablecoin would be designed to withstand external shocks, such as a complete wind-down in demand that necessitated full redemption of the entire supply.

The Sustainability of Collateralized and Algorithmic Stablecoins

Both empirical evidence and theoretical analysis indicate that purely algorithmic stablecoins are unsustainable.

A Fragile Equilibrium article provides compelling evidence to support this conclusion. It demonstrates that in the absence of continuous external funding (such as the buying of UST and LUNA prompted by the unsustainable 20% APY of Anchor prior to the Terra/LUNA crash), purely algorithmic stablecoins inevitably incur losses for issuers.

The chart below illustrates how an algorithmic stablecoin, with no real utility beyond unsustainable APYs, invariably experiences a depegging unless there is constant price stabilization from major players through continuous buying. However, this latter scenario is unrealistic since a system that is perceived as fragile would inevitably attract short-sellers whose selling volumes are likely to outweigh the number of buyers.

A necessary condition for a stablecoin to be sustainable is for it to be able to safely wind down. In the case of Terra-type stablecoins, the balancing asset (volcoin) would wind down at a faster rate than Terra itself, becoming incapable of fulfilling its stabilizing function. If the wind down occurs too rapidly for redemptions to be efficiently processed, any other model lacking full collateralization would face a similar fate.

Would full collateralization at 100% allow a stablecoin to wind down safely? The assumption that a stablecoin is redeemable creates demand due to the arbitrage opportunity. This arbitrage opportunity would prevent the stablecoin from winding down completely, as doing so would mean missing out on the chance to buy at a discount and earn arbitrage profits. Even in the event that demand approached zero, redemptions could still be satisfied with the help of reserves.

Obviously, collateral does not guarantee that a stablecoin won’t depeg, as demonstrated by the examples of USDT and USDC mentioned above. In these examples, we can see that sudden selling pressure caused by negative market sentiment can start a depegging. However, the presence of collateral enables the execution of redemptions without the risk of some holders being trapped with an unsellable asset. As redemptions are promptly and efficiently processed, panic selling diminishes and the opportunity to buy at a discounted price emerges as a viable option.

Collateralized stablecoins carry the risk of mismanagement or fraudulent activities by custodians or governing entities responsible for holding and managing the collateral. If these entities face operational issues, insolvency, or governance failures, it can jeopardize the stability and redeemability of the stablecoin.

The managers of stablecoins could be lying about collateralization and, during a bank run-like event, opt for deceptive measures such as the suspension of redemptions. For instance, Tether’s critics have accused it of failing to maintain adequate reserves or produce a financial audit. Previously, Tether dissolved its relationship with its first auditor, Friedman LLP, due to the “excruciatingly detailed procedures Friedman was undertaking for the relatively simple balance sheet of Tether”.

IMF Director Tobias Adrian made a statement about fiat-backed stablecoins being vulnerable to runs after the Terra collapse, and added that stablecoins backed by cash and cash-like assets are seeing inflows because they are viewed as more reliable.

This leads to another risk – the potential for the underlying collateral to lose value, leading to inadequate coverage for the stablecoin's outstanding supply. Market volatility, economic downturns, or regulatory changes affecting the collateral assets can impact the stability and redeemability of the stablecoin.

There have been debates about whether USDT is fully backed by cash. In February and March 2019, Tether replaced its claim about USDT being backed purely by cash to a new one mentioning a basket of assets, including unspecified commercial paper. In its 2021 disclosure, Tether also listed assets such as gold, commodities, secured debt, bonds, and secured loans (source). The most recent claim, as of the time of this article's publication, stated that cash and cash equivalents, along with short-term deposits, accounted for 82% of reserves. The report also mentioned a reduction in exposure to commercial paper (source).

It's worth noting that some stablecoins can be used as collateral for others, but they often have completely different management models. This further complicates the question of the legitimacy of reserves backing popular stablecoins.

Stablecoins can be categorized as centralized, over-collateralized, and algorithmic, based on the type of risk they carry. For instance, USDT, early DAI (SAI), and FRAX each employ entirely distinct risk management strategies.
It’s noteworthy that over-collateralized DAI has more than half of its collateral in the form of USDC — a centralized stablecoin launched by Circle. Furthermore, the value of DAI is directly tied to USDC. This implies that the real-world risk models are far more intricate than they appear…

Furthermore, pegging the stablecoin to the US dollar makes it susceptible to volatility in purchasing power caused by centralized government policies.

…It's important to note that all these mentioned stablecoins are pegged to the USD in various ways. As a result, they could potentially be susceptible to centralized governance from the US Treasury Department and law enforcement agencies. This brings us to the point of exploring alternative methods for achieving stability that do not necessarily involve pegging to the USD. Such strategies could allow us to mitigate the risks associated with centralized governance and to create more resilient, diversified stablecoins.

Roman Degtiarev, domain expert

While it is uncertain whether collateralized stablecoins can safely and completely wind down in practice, it is clear that a stablecoin can only be viable when it has collateral. Transparency regarding reserves and the exploration of alternative price targets that could enhance stability compared to the US dollar still pose challenges for future blockchain developers.

TON Needs Its Own Collateralized Stablecoin

Currently, USDT, USDC, DAI, TUSD, and BUSD are available in TON Ecosystem via ton.bridge.org and Orbit Bridge.

According to a private report conducted by Whiterabbit, one of the main reasons to create a decentralized stablecoin on TON instead of attracting liquidity from other chains is to provide utility to unused TON tokens that can be used as collateral. Decentralization still remains a challenge for the TON community. Inactive early miners are currently holding 1,081,390,573 TON (21.6% of the total supply) (source). The high concentration of TON tokens in these addresses could create abnormal token price volatility in the future, moreover, it limits the potential TVL, since the tokens are not being used in the ecosystem. Collateralization would provide a yield opportunity for holders and thus decrease the token concentration.

There are two main design options for a decentralized stablecoin on TON:

Over-collateralized (LUSD, MIM, GHO, crvUSD)

Over-collateralization implies a collateralization ratio higher than 100% and typically no algorithm to support the peg.

Liquity USD (LUSD) is supported by the Liquity lending protocol on Ethereum. Liquity uses a Stability Pool, which ensures the solvency of the system by acting as a liquidity source to repay debt from liquidated Troves (a tool linked to the user’s ETH address which acts as collateral for the loan). The Pool is funded by Stability Providers transferring LUSD into it. When a Trove is liquidated, an amount of LUSD corresponding to the remaining debt is burned from the Stability Pool’s balance to repay its debt and the collateral is transferred to the Stability Pool. Since Troves are likely to be liquidated at just below 110% collateral ratios, Stability Providers will receive a greater dollar-value of collateral relative to the debt they pay off (source).
Curve Finance also recently announced the launch of its own stablecoin crvUSD. According to their Twitter post, stETH is one of the assets that will be used as a collateral, ETH and wBTC are also being considered. The stablecoin has a novel lending-liquidating automated market maker algorithm called LLAMMA, which continuously rebalances users’ collateral as crypto prices fluctuate, thus reducing the risk of liquidation for the user by converting the supplied assets into crvUSD when there is a price drop, and then back to the original provided asset as the price recovers. (source).
Magic Internet Money (MIM) utilizes a similar model through the Abracadabra.money protocol. However, what sets it apart is the ability for users to deposit interest-bearing tokens like Yearn.finance’s yTokens or SushiSwap’s xSUSHI as collateral.
GHO is another stablecoin backed by a lending protocol. GHO is native to the Aave protocol that is currently in testnet and will be backed by a basket of assets that users supply in Aave.

Collateralized and algorithmic (DAI, FRAX)

A partially algorithmic model allows for a collateralization ratio of less than 100%, since the supply and demand dynamics are also supported by an algorithm.

DAI is supported by the MakerDAO lending system. Users can mint DAI once they provide collateral. Since DAI is over-collateralized, the amount minted is always less than the amount provided. When the supplied asset value declines to a point where the collateralization ratio is no longer satisfied, the position is liquidated. The borrowing and provision fees serve as one of the mechanisms to balance supply and demand and maintain the peg. Notably, DAI employs an algorithm to balance its supply and demand. The MakerDAO algorithms automatically burn and mint DAI if the token’s price deviates from the peg.
FRAX pioneered a fractional collateralization model, which assumes partial collateralization. As mentioned above, the FRAX community later voted for a full collateralization. This means that FRAX is going to operate in a similar way to DAI. However, the algorithm enables the use of a lower collateralization ratio compared to non-algorithmic stablecoins.

Before implementing its own stablecoin, TON needs to develop a reliable price oracle that can precisely reflect the value of collateral. This will enable the protocol to effectively balance the supply and demand of the stablecoin in a timely manner.

The decentralized stablecoin market is currently saturated with options. While some new generation stablecoins are gaining popularity based on the reputation of their supporting protocols (such as GHO) or the innovative stability mechanisms they offer (like crvUSD), others struggle to compete with existing alternatives and fail to gain adoption. There will undoubtedly be challenges in terms of market acceptance when introducing a stablecoin in TON. Nevertheless, there are several factors that could potentially contribute to its success and help it capture a significant market share among other decentralized stablecoins:

Higher APYs and lower fees compared to those offered by competitors;
Protection against losses associated with supplied asset volatility, similar to the LLAMMA algorithm used by crvUSD;
Additional safety provided by innovative mechanics and/or the reputation of the protocol that maintains and regulates the stablecoin;
Ability to use popular and underutilized assets as collateral.

TLDR:

What is the main difference between collateralized and algorithmic stablecoins?

The difference lies in the mechanics employed to balance supply and demand. Collateralized stablecoins utilize reserves to enhance liquidity and manage redemptions, whereas algorithmic stablecoins rely on automatic supply and demand contraction.

Are algorithmic stablecoins really unsustainable?

Purely algorithmic stablecoins are unsustainable. This is because of their inability to safely wind down without imposing losses on some holders as well as their reliance on continuous external funding. As of now, all acknowledged algorithmic stablecoins incorporate some degree of collateralization.

What should be built on TON now?

A decentralized collateralized stablecoin, powered by a lending protocol and a price oracle.

Are you ready to build with us? DM us on Twitter. Visit our official website: https://top.co.

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