Decentralization, DeFi

How to Use Stablecoins: DeFi, Governance, and Decentralization

Stablecoins are arguably the most exciting aspect of cryptocurrency right now. While blockchain technology offers decentralization, immutability, and security, many cryptocurrencies suffer from extreme volatility. This creates an atmosphere of uncertainty and hinders the global adoption of cryptocurrencies. Stablecoins pair the tenets of blockchain technology with the stability and familiarity of fiat currencies, creating an accessible and exciting new field of decentralized finance (DeFi).

The reliability of a stablecoin’s value can come from many different places, depending on which stablecoin you’re talking about. As of now, there are over 200 stablecoins available on the Ethereum blockchain alone. At time of writing, the highest performers are USDT (Tether), USDC (USD Coin), PAX (Paxos Standard), TUSD (TrueUSD), and DAI. All of these stablecoins are pegged to $1 USD, but each offers different governance protocols, features, and levels of decentralization.

USDT (Tether)

USDT, also referred to as Tether, is the most widely used stablecoin by far. It is available on a variety of blockchains, most notably Ethereum, and currently has the third highest market cap of all cryptocurrencies. Tether uses physical assets to back their stablecoins, meaning for every 1 USDT, there is $1 USD in a Tether reserve. Tether also offers many different stablecoins pegged to fiat currencies other than USD, such as euros (EURT), offshore Chinese yuans (CNHT), and even gold (XAUT).

The process for redeeming your Tether for physical assets requires a KYC validation through their services. For this reason, in addition to the Tether reserve mentioned previously, Tether is not considered a completely decentralized stablecoin. All Tether stablecoins are completely dependent upon the physical assets that they’re tied to, which are governed by a centralized entity. This raises concerns, such as the ability for Tether to be hacked as it’s been in the past. It also means that the users who rely on Tether for their asset-backed tokens must have faith that Tether actually has those physical assets.

In April of 2019, Tether was found to only have 74% of the physical assets necessary to cover the tokens that had been distributed. The team that built Tether and controls these physical assets are closely tied with a popular cryptocurrency exchange Bitfinex. In fact, the teams that operate Bitfinex and Tether share the same CEO, CFO, and General Counsel. They claim to be backed 100% by physical assets, but their lawyers also admit that even most traditional banks are not holding the complete amount of funds deposited by their users. They’ve stated in their defense,

“Tether’s reserves of cash and cash equivalents alone (without the line of credit) would cover approximately 74 percent of the outstanding amount of Tether. This sort of ‘fractional’ reserving arrangement is similar to how commercial banks work. No bank holds in liquid cash more than a small percentage of depositors’ money.”

USDT can be purchased and stored using any Ethereum address and accessed through an Ethereum wallet, such as MyEtherWallet (MEW).

USDC (Centre)

USDC is similar to USDT in that it’s backed by physical assets. For every 1 USDC, there is a physical US dollar in a reserve that is being governed by an independent entity called CENTRE. The CENTRE Consortium was set up by Coinbase and Circle to handle the governance and management of USDC. In this way, USDC is also a centralized stablecoin. Even so, fiat-backed stablecoins have no choice but to be centralized on some level, what really matters is the amount of checks and balances they have in place to keep their governance as distributed as possible.

CENTRE prides itself on full transparency and releases monthly reports that anyone can download and audit themselves. This takes a lot of trust out of the equation, allowing users to see and feel confident that their tokens are backed by a real value. CENTRE has also enlisted the assistance of Grant Thorton, an independent Certified Public Accountant (CPA), to make sure their assets are always backed 100%.

Even so, CENTRE still maintains the right to blacklist certain addresses under specific circumstances, assuming it passes a majority CENTRE board vote. Any financial company that meets the strict legal and compliance standards set by the CENTRE team can attempt to join the CENTRE Consortium, but none have yet in USDC’s two years of service. This means that USDC is still pretty centralized at its core.

USDC is available for purchase and storage through any Ethereum address, which can be accessed by an Ethereum wallet, such as MyEtherWallet (MEW).

PAX (Paxos Standard)

The Paxos Standard Token (PAX) is another fiat-backed stablecoin with physical assets reserved by a centralized entity, which was created by the Paxos Trust Company. PAX regulation is handled by the New York State Department of Financial Services, and Paxos is committed to monitoring all transactions that are made through their services.

To encourage trust, Paxos carries out thorough auditing through nationally-acclaimed third parties, such as Withum. They also post monthly reports, similarly to USDC, to prove that they have all the available funds to back each of their issued tokens. In addition, Paxos makes sure all their tokens are issued and burned through the use of smart contracts, which are heavily audited by a third party named Nomic Labs. This keeps their processes blockchain-reliant and out of centralized servers. With that being said, it’s important to note that Paxos maintains the right to freeze or wipe clean any address if they are required to do so by law. This is a side-effect of fiat-backed centralization and financial regulation.

PAX, like all other stablecoins in this list, can be sent to any Ethereum address and accessed with an Ethereum wallet, such as MyEtherWallet (MEW).

TUSD (TrustToken)

TrueUSD (TUSD) is a stablecoin created by TrustToken and backed by physical assets, much like USDT, USDC, and PAX. One of the main features that TrustToken advertises on the TUSD website is the high interest rates that can be gained by those who hold TUSD annually, anywhere from 8 - 12% depending on the exchange they hold it on. Another feature that sets TUSD apart from the other fiat backed stablecoins is their real-time report that shows how much USD they have in comparison to the amount of TUSD being issued.

The TUSD token is the highest performing fiat-backed stablecoin that wasn’t created by an exchange. Instead, the TrustToken team states in one of their Medium articles that they do not have access or control over the fiat funds that TUSD tokens are tied to, but leave that to the “licensed trust companies and banks” that they partner with. Their team partners with multiple, separate companies to ensure that no one entity has full control over USD that backs TUSD tokens. This system keeps order by removing the power from any one company, but this stablecoin is still considered centralized as it remains vulnerable to hacks and organized power plays.

The TrustToken team is in charge of TUSD governance and distribution through their own smart contracts, which also adds to their centralization. TrustToken maintains full control over all TUSD because it holds the power to freeze user accounts, in cases of ‘bad acting’ or law enforcement requests.

TUSD is available through the Ethereum blockchain, from wallets like MyEtherWallet (MEW) that allow you to store, send, and swap ETH and ERC20 tokens.

DAI (MakerDAO)

DAI is a stablecoin soft-pegged to the US dollar, which means it’s not backed by physical assets but instead through a series of smart contract checks and balances leveraging several different cryptocurrencies for their value. It was created by MakerDAO, an open-source project built on the Ethereum blockchain that has become the most used DeFi DApp in all of Ethereum. MakerDAO uses a Multi-Collateral DAI (MCD) system, also known as the Maker Protocol, to offer users the option for depositing collateral in the form of approved cryptocurrencies for the withdrawal of DAI. The entire system is managed by smart contracts, keeping the process autonomous and verifiable. It is also the only truly decentralized stablecoin on Ethereum.

One of the main talking points of decentralized finance is how the management and distribution of power is handled without the existence of a centralized entity. The Maker Protocol utilizes a two-token system to keep their financial structure decentralized, with the first token being DAI. The second token MakerDAO issues, Maker (MKR), allows their token holders to have a say in Maker Protocol governance. MakerDAO governance is completely powered by the MKR token. Anyone with MKR can vote on new collateral types, policy changes, and general governance issues through the MakerDAO voting site.

Over 400 different wallets and services have integrated MakerDAO to make interacting with DAI and MKR easier than ever – for example, MyEtherWallet (MEW) offers instructions on how to use MakerDAO directly in the interface. Generally speaking, the process involves accessing your wallet, heading to the MakerDAO DApp, and opening your first vault. Each MakerDAO vault becomes a permanent part of the blockchain, so you can rest assured your vault is uniquely yours and private.

When you’re ready to take out your very first decentralized loan, you first need to deposit some cryptocurrency as collateral. The deposited collateral can be any pre-approved Ethereum asset, such as ETH or an ERC20 token. The approval process for which cryptos can be offered as collateral comes directly from MKR holders, who have the ability to offer their MKR for votes. Anyone can hold MKR, so anyone can vote on these Governance decisions.

After you’ve deposited a sufficient amount of collateral, you can withdraw DAI up to that amount’s equivalent in USD. For example, depositing 1 ETH valued at $250 will allow the user to withdraw up to 250 DAI. This DAI can then be used with the confidence that it will always be valued at $1 USD.

When you’re withdrawing DAI, it’s recommended to leave room for market shifts. If you withdraw the full amount and the value of ETH drops, the smart contracts that make up the Maker Protocol would flag your Vault and liquidate it through automated Maker Protocol auctions. This is necessary to keep the entire system balanced. The auctioned collateral is bought for DAI, which in turn pays back the outstanding debt of the Vault. As little collateral as possible is auctioned, only enough to cover the difference caused by shifting markets. To avoid these auctions, try and keep your Collateralization Ratio to around 200% or more. You can see this score in your Vault directly on the MEW interface.

Using DeFi with Aave

To take full advantage of decentralized finance, open-source platforms built on Ethereum like MakerDAO and Aave have made it possible to take out decentralized loans against crypto deposits for collateral. We’ve already touched on MakerDAO in the previous ‘DAI’ section, so let’s take a look at Aave.

Aave lets users borrow Ethereum assets, such as the stablecoins mentioned previously or other ERC20 tokens, against a deposited amount of crypto. They also let users accrue interest on their deposited collateral over time, with annual interest rates listed for each type of crypto deposit. Aave has developed its own token as well, called LEND, which they mainly use for fees but hope to one day expand it into a governance token.

Here’s how Aave works. When you deposit a token, let’s say you deposit ‘DAI’, you get an equivalent amount of that token back in the form of ‘aToken’, such as ‘aDAI’. This amount gradually increases over time based on the annual interest rates of your deposited crypto. When you’re ready to close out, you can exchange this ‘aToken’ back for your original asset, including any extra interest you’ve accumulated.

When you borrow funds from Aave, there is also an interest charge on that crypto, which can be changed between a stable and variable interest rate. You can only borrow up to the maximum amount you’ve deposited, much like MakerDAO, and you must pay back your borrowed assets before you can withdraw your collateral. It’s important to keep track of your account’s Health Factor when using Aave, as scores of ‘1’ or less are at risk of being liquidated automatically to keep everything balanced. For a good Health Factor, keep your deposits large and your borrowed assets modest.

Aave is available through any Ethereum wallet that has integrated it, such as MyEtherWallet (MEW). MEW has even put together a useful guide on how to make the most out of your Aave experience.

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About Stephen Wooldridge II

I'm Educational Project Lead at MEW, dedicated to bringing awareness and education about blockchain technology to the masses. The only way to move forward is by moving together.
  • Los Angeles, CA