Stablecoin Technical Principles

Deep dive into how stablecoins maintain price stability and the technical implementation principles of various stablecoin mechanisms.

Overview

The core goal of stablecoins is to maintain a stable exchange rate with the pegged asset (usually $1 USD). Different stablecoins use different technical mechanisms to achieve this goal. This article will provide an in-depth analysis of the technical principles of various stablecoins.

1. Fiat-Collateralized Stablecoin Technical Principles

Basic Mechanism

Fiat-collateralized stablecoins maintain price stability by holding equivalent fiat currency reserves. When users purchase stablecoins, the issuer deposits equivalent fiat currency into bank accounts; when users redeem, the issuer burns the stablecoins and returns the fiat currency.

Technical Implementation

User Purchase Process:
1. User transfers $100 to issuer
2. Issuer deposits $100 in bank account
3. Issuer mints 100 stablecoins on blockchain
4. Stablecoins sent to user wallet

User Redemption Process:
1. User sends 100 stablecoins to issuer
2. Issuer burns these 100 stablecoins
3. Issuer withdraws $100 from bank account
4. Dollars transferred to user bank account

Reserve Management

Full Reserve

• Reserve assets = Circulating stablecoin supply
• 1:1 ratio, each stablecoin backed by $1 reserve
• Examples: USDC, GUSD

Fractional Reserve

• Reserve assets < Circulating stablecoin supply
• May invest in other assets (commercial paper, bonds)
• Risk: If reserve assets depreciate, may cause depegging
• Example: USDT (partial reserve)

Transparency Mechanisms

Proof of Reserves

• Regular audit reports
• Public reserve asset composition
• On-chain verifiable reserve proofs

Real-time Reserve Queries

• Some projects provide real-time reserve query interfaces
• Users can check reserve status at any time

Technical Challenges

1. Regulatory Compliance: Must comply with financial regulations in various countries
2. Banking Relationships: Depend on traditional banking systems for fiat custody
3. Audit Costs: Regular audits require costs
4. Cross-chain Support: Need to issue on multiple blockchains

2. Crypto-Collateralized Stablecoin Technical Principles

Basic Mechanism

Crypto-collateralized stablecoins maintain stability through over-collateralization of other cryptocurrencies (such as ETH). When collateral value decreases, the system requires users to add collateral or face liquidation.

MakerDAO DAI Mechanism Explained

Core Concepts:

• CDP (Collateralized Debt Position): Collateralized debt position
• Collateralization Ratio: Typically requires 150%+ collateralization
• Stability Fee: Borrowing interest rate
• Liquidation Threshold: Price point that triggers liquidation

How It Works:

Creating DAI Process:
1. User deposits ETH into Maker protocol (Vault)
2. System locks ETH as collateral
3. User can borrow up to 66.67% of ETH value (150% collateralization)
4. Example: Deposit $1500 worth of ETH, can borrow $1000 DAI
5. Must pay stability fee (annual interest rate)

Stability Maintenance Mechanism:
- If ETH price rises: Collateralization ratio increases, safer
- If ETH price falls: Collateralization ratio decreases, approaching liquidation threshold
- When collateralization ratio < 150%: Triggers liquidation, auction collateral to repay debt

Price Stability Mechanism:
- Target price: 1 DAI = 1 USD
- If DAI > $1: Lower stability fee, encourage more DAI borrowing
- If DAI < $1: Raise stability fee, encourage DAI repayment

Liquidation Mechanism

Liquidation Process:

1. Monitoring system detects collateralization ratio below threshold
2. Triggers liquidation auction
3. Liquidators purchase collateral at discount
4. Auction proceeds used to repay debt and liquidation penalty
5. Remaining portion returned to original user

Liquidation Protection:

• Users can add collateral at any time to increase ratio
• Can repay partial debt to reduce risk
• Set automatic liquidation protection (via DeFi tools)

Multi-Collateral System

Modern crypto-collateralized stablecoins support multiple collateral types:

DAI Supported Collateral Types:

• ETH
• WBTC (Wrapped Bitcoin)
• USDC (as collateral)
• Other ERC-20 tokens

Risk Parameters:

• Different collateral types have different collateralization requirements
• High-risk assets require higher collateralization
• Stablecoins as collateral typically require lower collateralization

Technical Advantages

✅ Decentralized: No need to trust centralized institutions ✅ Transparency: All operations verifiable on-chain ✅ Censorship Resistant: Not controlled by single institution ✅ Composability: Can be combined with DeFi protocols

Technical Challenges

⚠️ Price Volatility Risk: Severe collateral price fluctuations may cause large-scale liquidations ⚠️ Smart Contract Risk: Code vulnerabilities may lead to fund losses ⚠️ Governance Risk: Governance token holders may change protocol parameters ⚠️ Liquidity Risk: May lack sufficient buyers during liquidation

3. Algorithmic Stablecoin Technical Principles

Basic Concepts

Algorithmic stablecoins don't rely on traditional collateral, but maintain price stability by automatically adjusting supply through algorithms and smart contracts.

Basic Algorithm Mechanism

Rebase Mechanism (Supply Adjustment)

When price > $1:
- Increase token supply
- Each holder's token count increases proportionally
- But total value unchanged, price returns to $1

When price < $1:
- Decrease token supply
- Each holder's token count decreases proportionally
- But total value unchanged, price returns to $1

Example:

• Current price: $1.10
• Your holdings: 1000 tokens
• After rebase: Your holdings become 1100 tokens
• But total value still $1100, price returns to $1

FRAX Fractional Algorithmic Stablecoin Mechanism

FRAX uses an innovative Fractional Algorithmic Stablecoin mechanism:

Core Components:

1. FXS (Governance Token): Protocol governance and revenue token
2. Collateral Pool: Assets like USDC
3. Algorithmic Market Operations (AMO): Automatic adjustment mechanism

Minting Mechanism:

When FRAX = $1:
- Need $1 collateral + 0 FXS (fully collateralized)
- Or $0.5 collateral + burn $0.5 FXS (partially algorithmic)
- Collateral Ratio (CR) adjusts dynamically based on market

When FRAX > $1:
- Lower collateral ratio requirement
- Encourage more FRAX minting
- Increase supply, lower price

When FRAX < $1:
- Raise collateral ratio requirement
- Encourage FRAX redemption
- Decrease supply, raise price

Dynamic Collateral Ratio:

• Initial: 100% collateralized (fully backed by USDC)
• If system stable: Gradually lower collateral ratio (e.g., 90%, 80%)
• If depegging occurs: Automatically raise collateral ratio
• Goal: Find optimal algorithm/collateral ratio

LUSD Interest-Free Algorithmic Stablecoin Mechanism

Liquity protocol uses a unique interest-free borrowing mechanism:

Core Features:

• No Interest: Borrowing LUSD requires no interest payments
• One-time Fee: Only pay one-time borrowing fee (approx. 0.5-5%)
• ETH Collateral: Only accepts ETH as collateral
• 110% Minimum Collateralization: Lower than other protocols

Stability Mechanism:

1. Redemption Mechanism: Anyone can redeem $1 worth of ETH with 1 LUSD
2. Arbitrage Opportunity: If LUSD < $1, arbitrageurs buy and redeem ETH for profit
3. Automatic Balance: Maintains price stability through market arbitrage

Liquidation Mechanism:

• Triggers liquidation when collateralization ratio < 110%
• Liquidators receive 0.5% reward
• Remaining portion returned to original user

Algorithmic Stablecoin Risks

Historical Failure Cases:

1. UST (TerraUSD)

   • Used dual-token mechanism (UST + LUNA)
   • When UST < $1, could burn UST to mint LUNA
   • When UST > $1, could burn LUNA to mint UST
   • Failure Reason: Large-scale sell-off caused death spiral, LUNA price crashed, unable to maintain UST stability

2. Iron Bank (TITAN)

   • Algorithmic stablecoin project
   • Price crashed due to liquidity crisis

Common Risks:

• ⚠️ Death Spiral: Price drop → Supply decrease → Panic selling → Further drop
• ⚠️ Liquidity Crisis: Lack of sufficient buy/sell orders to maintain price
• ⚠️ Mechanism Complexity: Users struggle to understand, leading to mistakes
• ⚠️ Governance Attacks: Malicious governance proposals may destroy system

4. Hybrid Stablecoin Mechanisms

FRAX Hybrid Mode

FRAX combines fiat collateral and algorithmic mechanisms:

Advantages:

• Combines advantages of both mechanisms
• Gradual decentralization (from 100% collateralized to partially algorithmic)
• Reduces single-mechanism risks

How It Works:

• Dynamically adjust collateral ratio based on market conditions
• Lower collateral ratio when stable, increase algorithmic component
• Raise collateral ratio when unstable, increase safety

Other Hybrid Modes

Partial Reserve + Algorithmic Adjustment

• Base reserve guarantees minimum value
• Algorithmic mechanism handles short-term volatility

Multi-Asset Collateral + Algorithm

• Support multiple collateral types
• Algorithm optimizes collateral portfolio

5. Price Stability Mechanism Comparison

Mechanism Type	Stability Method	Advantages	Disadvantages	Representative Projects
Fiat Collateral	1:1 Reserve	Most stable, easy to understand	Centralized, regulatory risk	USDT, USDC
Crypto Collateral	Over-collateralization	Decentralized, transparent	Liquidation risk, complex	DAI
Algorithmic	Supply adjustment	High capital efficiency	High risk, prone to failure	FRAX, LUSD
Hybrid	Combined mechanism	Balanced risk-return	Complex mechanism	FRAX

6. Technical Development Trends

Current Trends

1. Multi-chain Deployment: Stablecoins issued on multiple blockchains
2. Cross-chain Bridging: Enable stablecoin transfers between different chains
3. Smart Contract Upgrades: Safer code and mechanism design
4. Regulatory Compliance: More stablecoins seeking compliance

Future Directions

1. Full Decentralization: Reduce dependence on centralized institutions
2. Better Algorithms: More stable algorithmic stablecoin mechanisms
3. Multi-Asset Support: Support more types of collateral
4. DeFi Integration: Deep integration with DeFi protocols

7. Technical Security Considerations

Smart Contract Security

Audit Importance:

• All stablecoin protocols should undergo professional audits
• Multiple audits and bug bounty programs
• Open source code for community review

Common Vulnerabilities:

• Reentrancy attacks
• Integer overflow/underflow
• Access control errors
• Price oracle attacks

Risk Management

User Level:

• Understand protocol mechanisms and risks
• Don't over-leverage
• Set liquidation protection
• Diversify investments

Protocol Level:

• Multi-signature wallets
• Timelock
• Emergency pause mechanism
• Gradual decentralization

Summary

Stablecoin technical mechanisms are diverse, each with its own advantages and disadvantages:

• Fiat-Collateralized: Most stable but centralized
• Crypto-Collateralized: Decentralized but requires over-collateralization
• Algorithmic: High capital efficiency but high risk
• Hybrid: Attempts to balance various mechanisms

When choosing stablecoins, consider:

• Use case (trading, DeFi, savings)
• Risk tolerance
• Need for decentralization
• Transparency requirements

Understanding these technical principles helps make more informed decisions and better manage risks.

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Next Steps:

• 🔒 Security Guide - Learn how to use stablecoins securely
• ❓ FAQ - Answer technical questions
• 🌐 DeFi Ecosystem - Learn about stablecoin applications in DeFi