How to defend the peg
As has been described elsewhere on this site, stablecoins are smart contract derivatives, and from the world of finance we know that derivatives derive their value based on some underlying asset and the derivative structure placed on top. This opens us up to a broad spectrum of stablecoin implementation, and we’ll be touching on a few of these below.
In its simplest from, a stablecoin is a 1-to-1 value match with some added programmable money attributes. Perhaps the purest stablecoin out there is wrapped ETH, deployed to address 0xc02aaa39b223fe8d0a0e5c4f27ead9083c756cc2. As of writing this, over 6.5 million Ether has been put into the wrapper contract, governed by around 60 lines of code. Because of the simplicity of the smart contract, it is easy do to a review, and you can have full faith in its immutability as there’s no admin functionality available to change or upgrade the code.
Because the wrapped Ether contract is so simple, and it’s wrapping the native Ether coin on the same blockchain as where the contract is deployed, its easy to conclude that one WETH token equals one ETH. If you hold some amount of one or the other, wrapping or unwrapping on a 1-to-1 basis is always available to you. There’s no liquidity risk, and the code is short, simple and immutable, hence also no third-party risk. There’s no need to actively defend the peg, as it defends itself.
Bitcoin does not run on the Ethereum blockchain, but on its own blockchain system. The Bitcoin blockchain does not have the same stablecoin feature set as Ethereum, as it is a lot more limited in its abilities to offer programmable money. But because there’s a large market cap tied to Bitcoin, bringing it to Ethereum is of value to DeFi and other use cases. Hence, we find several stablecoins that wrap Bitcoin on Ethereum, creating a link between Bitcoin and the broader Ethereum ecosystems. Like with the wrapped Ether stablecoin contract, you can redeem one BTC for one wrapped BTC, creating a simple value proposition. But, because Bitcoin is on one blockchain and its wrapped equivalent on another, there’s additional risks involved. These risks might be centralized third-party risks, as with the WBTC custodian, or more technically oriented risks, as with the more decentralized tBTC model.
On the more traditional CeFi arena we find stablecoins like USDC and TrueUSD. Because these involve off-chain assets, i.e., money or comparable assets held somewhere not on a blockchain, there’s a non-technical trust and value requirement, i.e., more third-party risk. While the smart contract code governing these are simple enough, they depend on this external entity to mint and burn according to their underlying reserves. This uncertainty has been highlighted many times by regulators and other entities, especially against Tether. As these are not decentralized stablecoins, this trust requirement will forever be present. Also, because of this centralized aspect, regulating stablecoins like these don’t involve much required novelty.
The above stablecoins, and traditional money market funds for that matter, all use assets that, in value, closely resemble the pegged value. This makes it relatively easy to defend the peg. What if you did a stablecoin with collateral that could dramatically deviate from the pegged value? This is what we find with stablecoins like DAI and LUSD. These use highly volatile cryptocurrencies, like ETH, as collateral to mint a fiat pegged token. To ensure sufficient collateral availability, a larger buffer is required. This makes these options economically inefficient or costly, as more collateral is required. But they do offer this in a decentralized manner, and assuming the collateral is highly liquid, offering a stablecoin build on these provide both much needed stability and also decentralized leverage, all on-chain.