How to Use Stablecoins with DeFi

How to Use Stablecoins with DeFi

Stablecoins like USDT, USDC, TUSD, PAX and DAI are essential for decentralized finance. Knowing how they work can help you get the most out of your crypto.

By Kosala Hemachandra

5 min read

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).

A stablecoin’s value can be tied to something in the real world (a fiat currency like the US dollar or a commodity like gold), or based on smart contracts that keep the value from fluctuating through algorithms and market mechanisms. There are many stablecoins available on Ethereum and other blockchains, but the top consistent top performers are USDT (Tether), USDC (USD Coin), BUSD (Binance USD), and DAI. All of these stablecoins are pegged to $1 USD, but offer different governance protocols, features, and levels of decentralization. They can be purchased or obtained by swapping, and managed using an Ethereum wallet, such as MEW wallet or Enkrypt.

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. 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 dependent upon the physical assets that they’re tied to, which are governed by a centralized entity.

This means that the users who rely on Tether for their asset-backed tokens must have faith that Tether actually has those physical assets. The team that built Tether and controls these physical assets are closely tied with a popular cryptocurrency exchange Bitfinex.

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. 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%.

BUSD (Binance)

BUSD was launched in 2019 in partnership between Paxos, an established blockchain company that has issued its own stablecoins in the past, and Binance, one of the largest centralized crypto exchanges in the world. Available both on Ethereum as an ERC20 token and on Binance's proprietary blockchain in a format known as BEP2, BUSD is backed by USD 1:1, approved and regulated by the New York State Department of Financial Services (NYDFS).

Like USDC, BUSD aims to provide transparency to users and issues monthly audit reports that 'verify at specific points in time that the entire supply of Binance USD (BUSD) tokens is consistent with USD in reserve accounts at U.S. banks held and managed by Paxos'. On one hand, a centralized and regulated stablecoin like BUSD should provide more protections to the investor. On the other, it has the same drawbacks as any other centralized service – one point of control and potential failure. That being said, a stablecoin issued by a major exchange like Binance is a convenient solution for its users, as evidenced by BUSD's high market cap, the third highest among stablecoins at time of writing.

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 one of the most used DeFi DApps in all of Ethereum. MakerDAO uses a specialized 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 established and widely used 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 powered by the MKR token. Anyone with MKR can vote on new collateral types, policy changes, and general governance issues.

Over 400 different wallets and services have integrated MakerDAO to make interacting with DAI and MKR easier than ever. 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. Then, this DAI can then be used with the confidence that it will always be valued at $1 USD. However, when you’re withdrawing DAI, it’s recommended to leave room for market shifts. If the value of ETH drops, there is risk of liquidation. This is necessary to keep the entire system balanced.

Stablecoins and DeFi

Stablecoins are extremely important to the DeFi ecosystem, because they mitigate the volatility of the crypto market. Popular platforms like MakerDAO, Aave, and Yearn allow users to take out stablecoin loans against collateral and accrue interest on stablecoin deposits. The stablecoins' tie to the US dollar gives retail and institutional investors the confidence to use DeFi instruments for operations that may also involve non-crypto assets, connecting the crypto ecosystem with traditional finance. If the volatility of the crypto market has been your deterrent to exploring the DeFi space, consider the ways stablecoins can make the most of your investment. Be the first to hear about DeFi earning opportunities in MEW web and MEW wallet app – subscribe to our newsletter and follow MEW on Twitter!

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