Decentralized stablecoins are pitched as crypto’s holy grail, so where are they?

A large portion of the media attention paid to Bitcoin is due to the crypto asset's wild price fluctuations, and while it has tended to become less volatile over time, the fact that the bitcoin price in US dollar terms is roughly a quarter of what it was last year is too much for many potential users to bear.

Stablecoins have seen tremendous growth in recent years as a result of price volatility issues, accounting for more than $130 billion of the total crypto market.

However, contrary to what stablecoin promoters claim, these alternative digital currencies are not at all similar to bitcoin. The vast majority of stablecoins are centralized tokens issued on top of blockchains such as Ethereum, Tron, BNB Chain, and Solana, and they include backdoors that allow issuers to do things like freeze funds and blacklist addresses. They could also be regulated out of existence with the stroke of a pen.

Due to the limitations of traditional, centralized stablecoins, decentralized stablecoins have long been regarded as a sort of crypto Holy Grail. The idea is to combine bitcoin's censorship resistance and permissionless nature with a much more stable asset.

Alex Gladstein, Chief Strategy Officer of the Human Rights Foundation, stated:

“I think censorship-resistant stablecoins are a very important short-term humanitarian goal,”

Gladstein added:

“I think that people in places like Cuba, Lebanon, Palestine, and Turkey really need digital dollars that cannot be frozen or confiscated. Especially for friends in places like Iran, Cuba, et cetera; the current model isn‘t quite good enough . . . Tether, right now, is a very powerful humanitarian tool for tens of millions of people. It is doing what the U.S. government refuses to do, which is give dollar access to people in vulnerable regions. But the problem is; whether it’s Tether, Circle, or Binance; which constitute the overwhelming majority of stablecoin [issuance] in the world, they‘re all completely centralized. They essentially exist at the pleasure of the U.S. government, to be honest. And they can be shut down at any time. Addresses are frozen. It can be confiscated. And obviously, what’s happening with DAI and their reserve—even though they claim to be decentralized, they have similar concerns.”

John Light, a Sovryn contributor, sees value in the pursuit of censorship-resistant stablecoins.

“Not everyone can afford to stomach the purchasing-power volatility of BTC.”

Light stated:

“Many businesses operate on thin margins that BTC value swings way outside of. People with low income often cant afford to save, and rely on their cash to hold value until their next paycheck. In light of these facts, a censorship-resistant stablecoin would be a hugely valuable tool that could be used as an alternative to physical cash or bank accounts and a short or medium-term savings asset to complement using BTC as a long-term savings asset. Maybe one day BTC purchasing power will be stable enough to render stablecoins redundant. Until then, I think censorship-resistant, BTC-backed stablecoins have a legitimate place in the world.”

Of course, the concept of a censorship-resistant stablecoin has been tried numerous times in the crypto space over the last decade, with no real success story to date due to the difficulties associated with creating a stable crypto asset in a way that does not reintroduce attack vectors through various forms of centralization. So, can this idea work, or is it just another example of the crypto space being all hype and no substance？

The Failures of DAI and Other Decentralized Stablecoins

MakerDAO's DAI has been the most successful crypto-collateralized stablecoin to date. The dollar-denominated value of the circulating DAI supply is now more than $6 billion, more than eight times that of its closest competitor in the category of stablecoins intended to be more decentralized than USDC or USDT.

Furthermore, DAI is deeply embedded in Ethereum's decentralized finance (DeFi) ecosystem. However, in order to achieve its current level of adoption, DAI has abandoned its original promise of decentralization. Notably, USDC and other similarly centralized assets currently back the majority of DAI. In other words, DAI inherits the centralized nature of USDC and other assets.

Outside of DAI, the most successful decentralized stablecoin project in history has to be Terra's UST, which crashed and burned earlier this year, causing cascading liquidations across the industry. In addition to its own issues with centralization, the UST token's economics simply did not work. UST was once larger than DAI, with a total valuation of nearly $19 billion in May. The UST price, which was supposed to be $1.00, is now around $0.02. UST, unlike DAI, was designed to be an algorithmic stablecoin rather than one backed solely by crypto collateral.

There have, of course, been numerous other decentralized stablecoin projects over the years. Last year, billionaire Mark Cuban was widely mocked for his involvement in the Iron Finance algorithmic stablecoin project debacle, and the whitepaper for Bitshares, which spawned the BitUSD stablecoin, was published nearly a decade ago. FRAX, LUSD, RAI, and sUSD are other notable projects in the space right now; however, activity around these stablecoins is not particularly high at the moment. Tron's USDD stablecoin is more widely used, but it, like DAI, has chosen centralized collateral.

How Should a Decentralized Stablecoin Work？

So, if the ideal decentralized stablecoin project does not yet exist, how should it look？

“The contract model is interesting and, I think, is probably more robust when it comes to resisting state attack but ultimately does rely on liquidity, ideally between pseudonymous parties,”

Gladstein said:

“The dream would be for a bitcoin user in any country in the world to be able to receive bitcoin from you or me, ideally over Lightning, and then immediately peg a certain percentage of it to dollars.”

Gladstein mentioned Fedimint, an anonymous ecash server backed by bitcoin held by a federation in a multisig address, as one of the projects he finds interesting. The federation can not only issue dollar-pegged tokens against their bitcoin holdings, but this setup also provides significant privacy improvements.

“This idea that you can like just take your bitcoin and then deposit it in a community bank and get anonymous ecash that could very easily be dollars—the federation can issue whatever they want (any kind of token)—but the idea that they could just issue these anonymous dollars that you can just use is a very, very powerful one,”

Gladstein said:

“So, stablecoins, they work well enough now, but I mean, there‘s so many different risk areas that I think the Fedimint model honestly may make less tradeoffs at the end of the day. So, it’s kind of the one I‘m most interested in at the moment. But, of course, I’m following all of the attempts to bring dollars into Bitcoin and Lightning because, again, it‘s something that’s very, very important for the coming years.”

Light is one of many Sovryn contributors working on a model that combines a basket of bitcoin-collateralized stablecoins to create the backing for another token. This larger concept is currently being developed by Mynt, and their proposed stablecoin is known as Sovryn Dollar (DLLR).

“By aggregating multiple BTC-backed stablecoins, DLLR benefits from the censorship-resistance of BTC and the diversity of stability and issuance mechanisms used by these different stablecoins,”

said Light.

“This design is intended to make DLLR more robust against BTC price volatility or peg failure, as well as more capable of scaling issuance to meet demand.”

The Limitations of Decentralized Stablecoins

A common counter-argument to the argument that stricter regulations on stablecoins would cause serious problems in the DeFi space is that centralized stablecoins would be replaced by more decentralized options that would be more difficult for lawmakers and regulators to control.

However, as Brown Rudnick Partner Preston Byrne argued roughly five years ago, that may not be possible due to liquidity issues and the requirement of over-collateralization (this explains why DAI is backing itself with USDC). The safety and security assumptions of decentralized or algorithmic stablecoins differ significantly from those of USDC and USDT.

Light pointed out that the scalability of ZUSD, which is based on Liquity's LUSD and one of the bitcoin-collateralized stablecoins in the basket that will back DLLR, should not be as severe as DAI's due to the use of lower over-collateralization requirements (ZUSD's 110% vs. DAI's 130%).

This means that less crypto collateral must be locked up in a smart contract in order to generate more stablecoin. Furthermore, the goal is for ZUSD to be a component of Mynt's DLLR stablecoin offering, which could further limit the scalability issues that led to DAI's embrace of centralization and limited its censorship resistance.

“The diversity of issuance mechanisms available using the different stablecoins supported by Mynt will help DLLR be more scalable than any one of the underlying stablecoins would be on its own,”

Light elaborated. However, Light also stated that ZUSD could eventually run into scaling issues of its own. Time will tell whether DLLR can offer progress in terms of the scalability of decentralized stablecoins. For the time being, there are clear limitations to the level of decentralization, censorship resistance, and scalability that a stablecoin can achieve when compared to bitcoin.

“All stablecoins need to introduce some third-party dependencies that BTC itself does not have,”

Light noted:

“BTC-backed stablecoins such as DOC, ZUSD, and DLLR are no exception. ZUSD relies on five different sets of third parties: Sovryn Bitocracy, Money On Chain Oracles, Powpeg PowHSM Federation, Powpeg Emergency Multisig, and bitcoin miners.”

One of the most persistent (and perhaps overlooked) issues with decentralized stablecoins is the oracle problem, which arises because there is no completely trustless way to get real-world asset data onto the blockchain for use in smart contracts. As a result, when it comes to censorship resistance, bitcoin will always be a better bet than stablecoins.

As a reminder, when it came to ordering transactions in a decentralized digital financial system, Bitcoin's use of proof-of-work mining was itself the solution to the oracle problem. To be clear, this is still an area to keep an eye on. However, the long-term capabilities of these types of projects may be much more limited than previously assumed.