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Stablecoin adoption has exploded over the last year, seeing a collective market cap rise from around $10 billion to over $100 billion. This was at least partly amplified by yield generating opportunities from the DeFi market boom and a growing interest in digital assets, providing the tokenized and frictionless benefits of moving between crypto and fiat over permissionless blockchains.

Broadly, there are two forms of stablecoins types available – centralized custodial stablecoins or decentralized non-custodial stablecoins, each with its own selling points.

Centralized Stablecoins

Centralized, custodial stablecoins are generally fiat collateralized off-chain. Stability is achieved via 1:1 backing of token liabilities with the corresponding asset, either directly or via a third-party custodian like a bank, creating a bridge between traditional finance and the crypto world. 

Industry leaders such as Tether (USDT) and the USD Coin collaboration between Circle and Coinbase (USDC) are examples of such centralized stablecoins, alongside the more recent examples of True USD (TUSD), Pax Standard (PAX), Binance USD (BUSD), and the Gemini Dollar (GUSD). In addition, Facebook and JP Morgan will soon launch their JPM and Diem centralized stablecoins. 

Such cryptocurrencies are essentially tokenized IOUs deployed onto a blockchain like Ethereum, balancing supply and demand to maintain the peg via a minting and redemption mechanism. Under this model, users can mint stablecoins by depositing the equivalent fiat to the custodian, redeeming or burning the tokenized versions to retrieve fiat back. With high levels of liquidity, discrepancies in the peg are rare and minimal. In any case, discrepancies would incentivize arbitrageurs to take advantage of any price dislocations until remedied. The centralized custodians profit and maintain the operation via the yield generated by fiat held in reserve alongside minting or redemption fees. 

As things stand, centralized stablecoins are popular partly due to them being the first stablecoin model to market, but also fairly intuitive to understand and use. Their external auditing requirements and single entity accountability leads to simple deployment of changes to the model, but this is often a double-edged sword. 

Minting and redemption costs can be high, being compounded by the custodian’s operational, auditing, and compliance costs, as well as the slow and expensive connections to the legacy banking system. The centralized nature of the custodian also creates a single point of failure that is open to censorship.

Decentralized Stablecoins

Decentralized, non-custodial stablecoins can be further divided into crypto-collateralized and algorithmic stablecoins.

Crypto-Collateralized Stablecoins

Crypto-collateralized stablecoins, like those represented by the DAI model issued by MakerDAO smart contracts or Synthetix’ sUSD, swap the fiat-collateralized concept for cryptocurrencies, transfering the minting and redemption mechanism on-chain with incentive mechanisms to maintain the peg. This creates a blockchain-native alternative that takes on the decentralized and censorship-resistant properties of the network on which it is built.

Given the volatility of crypto, these models achieve stability by allowing lenders to generate interest from borrowers. To issue DAI, borrowers open collateralized debt positions, locking up collateral at specific loan-to-value (LTV) ratios and receiving a proportional amount of DAI as a loan.

More recently, Onomy Protocol builds on this concept while taking inspiration from traditional banking models to deliver crypto-collateralized stablecoins, called Denoms.

Onomy Protocol’s NOM native token provides the underlying collateral for Denoms. It derives its value from the ability to mint stablecoins from the Onomy Reserve, with the Onomy Decentralized Exchange providing Automated Market Maker (AMM) price discovery to rebalance the collateral ratios of the minting accounts. 

Operating as a decentralized reserve bank managed via a DAO of participants, this protocol provides a non-custodial bridge between centralized and decentralized finance, with its stablecoins benefiting from non-custodial ownership of collateral with on-chain transparency that doesn’t need to be entrusted to a third-party custodian or auditor, as well as price stability achieved through a multi-layered based on reserve rates, staking rates, minimum collateralization ratios, reserve collateralization ratios, and collateral liquidation fees. 

The general drawbacks to decentralized and crypto-collateralized stablecoins are the scalability issues of the dominant Ethereum base layer, oracle manipulation, volatility risks, and the need to dedicate too much collateral. 

In the case of Onomy, for instance, pegging mechanisms are kept in a closed loop within the system, voted on by NOM token holders to avoid external oracle manipulation. Built on Cosmos, it offers 100 times the efficiency of Ethereum-based protocols, with its interoperable bridges to external blockchains delivering the type of cross-chain liquidity required to on-board the $6.6T per day Forex market into DeFi. 

Algorithmic Stablecoins

Algorithmic stablecoins are another alternative, bypassing collateralization, and relying on complex algorithms and smart contracts to manage price stability. Seigniorage Shares were an early example, and Terra (UST) represents the latest example of a successful algorithmic stablecoin.

Essentially, these work by issuing new tokens when the supply is too low and burning tokens when the demand is too low, balancing between the two to manage market conditions and maintain a peg.

However, the complexity in developing algorithmic stablecoin designs has led to a history of failed projects, with a structure that relies on future growth in demand. Moreover, they are open to greater vulnerability during unpredictable market downturns, and subject to oracle manipulation. They also don’t include the same safety mechanisms of collateralized and decentralized alternatives, making this model fairly unsustainable over the long term. 

The Road Ahead

Centralized custodial stablecoins are likely to become increasingly regulated and restricted. Over time, the non-custodial nature of decentralized stablecoins will continue to disrupt the market share of their centralized alternatives, growing to become one of the largest verticals in DeFi as the market matures and users realize that on-chain multi-fiat exposure is the only rational choice for monetary transfers, lending, and the securement of interest. 

As we embark on this great finance migration, stablecoins must scale for mass adoption and acquire the censorship-resistant properties of their underlying blockchains. This entails a decentralized design, cross-chain compatibility, and robust peg mechanisms that protect against volatility, deployed within a scalable, efficient, and trustless environment.

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