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What Are Stablecoins?

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While cryptocurrencies are often known for their volatility, stablecoins bring newfound stability to cryptocurrency markets by allowing fiat currencies like the U.S. dollar or other stable assets to be represented on the blockchain as digital tokens. These stablecoins allow anyone around the world to hold a synthetic form of fiat currency that’s purposely designed to hold its value in relation to the fiat currency it claims to represent; e.g. 1 USD stablecoin tries to maintain a value of 1 U.S. dollar. The desire for stable assets on the blockchain has resulted in the total value of all stablecoins reaching over $30B in value, as well as the wide adoption of stablecoins within Decentralized Finance (DeFi) applications.

In this article, we’ll walk through the fundamental questions around stablecoins, such as what they are, how they work, and how Chainlink oracles are enabling their development and security, ultimately allowing stablecoins and DeFi markets to reach their full potential.

What Are Stablecoins?

At their core, stablecoins are cryptocurrencies that try to maintain a “peg”, wherein the stablecoin aims to maintain the same market value as the external asset they represent. To achieve price stability of the peg, stablecoins can be backed by external assets (collateralized) or make use of algorithms that dynamically adjust their supply in relation to their demand at a given time (algorithmic).

There are two main types of stablecoins that exist: centralized and decentralized. Centralized stablecoins are traditionally backed by fiat currency in an off-chain bank account that functions as the reserves backing the tokens on-chain. These typically require a layer of trust in the custodian, although they are increasingly providing more transparency through solutions like Chainlink Proof of Reserve (discussed more below). Alternatively, decentralized stablecoins are commonly overcollateralized by on-chain cryptocurrencies and require price data to maintain full collateralization (e.g. a user’s collateral is worth greater than 150% of the loan’s total value). By design, decentralized stablecoins are more resilient and transparent because they are not controlled by a single party and the collateralization of the protocol can be audited by anyone on-chain.

Another increasingly popular form of stablecoin technology are Central Bank Digital Currencies (CBDCs). CBDCs are similar to centralized stablecoins, but they are issued by central banks and thus don’t necessarily have to be backed by fiat in an off-chain bank account. CBDCs are considered legal tender by the government and used for streamlining both high-volume retail payments between individuals and interbank wholesale payments.

How Do Stablecoins Work?

There are many different designs that popular stablecoins use to maintain stability by holding their peg. The most popular examples of these include collateralized debt positions, arbitrage, and elastic supply.

MakerDAO, a decentralized stablecoin protocol, maintains its peg by having users lock up collateral into a smart contract. The smart contract then mints stablecoins (called DAI) as overcollateralized debt with an adjustable interest rate. In order to maintain the 1:1 peg of $1 USD = 1 DAI, MakerDAO’s smart contracts automatically adjust the interest rates to encourage borrowers to pay back their debt or take out more stablecoin loans. By encouraging increases or decreases in the total supply via interest rate changes, the price of DAI will change, either rising in value when the supply and interest rate are low or decreasing in value when the supply and interest rate are high.

DeFiDollar, a stablecoin index that uses arbitrage, is backed by multiple different stablecoins such as DAI, USDC, USDT, and sUSD in order to achieve the stability of the peg to the U.S. dollar. For example, if the price of one of the reserve stablecoins (e.g., USDT) exceeds $1 USD while the index price of DUSD as a whole is below $1 USD, then the smart contract will market sell USDT for DUSD to drive the DUSD price back up to $1 USD. Chainlink oracles provide the price feeds that the DUSD smart contract references when calculating how to rebalance its stablecoin index.

DeFiDollar’s stablecoin index rebalancing using Chainlink oracles
How DeFiDollar uses Chainlink oracles to trigger stablecoin index rebalances to maintain its peg.

Ampleforth is a decentralized, algorithmic stablecoin (AMPL) that uses an elastic supply mechanism to maintain its peg to the current Consumer Price Index (CPI) rate—an index from the Bureau of Economic Analysis on the current value of the inflation adjusted 2019 U.S. dollar. When the price of AMPL is high, wallet balances increase, but when the price of AMPL is low, wallet balances decrease. This automated change in supply subsequently impacts market prices and is called rebasing. The total supply of AMPL is rebased on a daily basis to track the current Consumer Price Index (CPI) rate, an index from the Bureau of Economic Analysis on the current value of the inflation adjusted 2019 U.S. dollar. Both the volume weighted average price (VWAP) of AMPL and the CPI index is provided to the Ampleforth protocol by Chainlink oracles.

Ampleforth smart contract diagram
Ampleforth uses Chainlink oracles to rebase the AMPL token supply every 24 hours.

Despite the differences in various stablecoins’ architecture and design, they all require accurate price data when used in decentralized applications and for their underlying pegging mechanism. Since exchange rates are constantly fluctuating, real-time price data needs to be fed to these stablecoins in order for them to maintain their pegs. Furthermore, since stablecoins are usually backed by other crypto assets or off-chain bank reserves, tamperproof methods of acquiring that data are needed to ensure the security and reliability of these systems.

Blockchain oracles like Chainlink provide the link from the external world to the blockchain ecosystem. Since stablecoins collectively hold substantial value in DeFi applications, they require the same assurances and security guarantees of the blockchain on which they operate. Effectively, this means that the oracles providing data to stablecoins need to be robust, decentralized, and have multiple layers of security to ensure that stablecoin pegs remain backed 1:1. This provides transparency and trust to the users of these stablecoins, as they can confirm that the stablecoin asset they are using to hold real economic value is secure end-to-end and does not contain a single point of failure.

Stablecoins are usually backed by another asset, most popularly with a fiat currency such as the U.S. dollar. Oracles not only provide the price data required by most stablecoins to maintain their pegs, but also valuable information about the current collateralization of the system itself. An example of this is TrueUSD (TUSD), which uses Chainlink to bring collateralization levels on-chain and give users a clear understanding of whether their assets are fully backed. With this newfound transparency, DeFi users can verify in real-time the true collateralization of all minted TUSD tokens and the protocol itself can automate the protection of users’ funds from any fractional reserve practices or potential black swan events.

TUSD Chainlink Proof of Reserve diagram
TrustToken uses Chainlink Proof of Reserve to provide smart contracts proof of the off-chain fiat reserves backing the TUSD stablecoin.

This mechanism of verifying the reserves of an asset is called Chainlink Proof of Reserve. These are on-chain reference feeds that provide smart contracts with the data needed to calculate the true collateralization of any on-chain asset backed by off-chain reserves. These reference feeds are operated by a decentralized network of oracles on the Chainlink Network and allows the autonomous auditing of collateral used within a protocol in real-time, ensuring users’ funds are protected from unforeseen fractional reserve practices and other fraudulent activity from off-chain custodians.

Paxos, the leading financial market infrastructure and crypto brokerage platform, uses Chainlink to provide DeFi smart contracts with a highly available, tamperproof, and accurate source of on-chain pricing data for the USD-backed stablecoin Paxos Standard (PAX) and the gold-backed token PAX Gold (PAXG) to reference when executing critical on-chain functions. Additionally, Chainlink’s Proof of Reserve data feeds for Paxos tokens allow DeFi applications to quickly verify on-chain that tokens are fully backed 1:1 by U.S. dollars and gold bars held off-chain in Paxos’ custody.

Paxos stablecoins Chainlink Proof of Reserve
How Paxos uses Chainlink Proof of Reserve to verify the collateralization of off-chain assets.

Another stablecoin protocol using Proof of Reserve is Neutrino USD, an algorithmic crypto-collateralized stablecoin pegged to the U.S. dollar. Chainlink nodes continually ping the Ethereum-based USDN contract and Waves API off-chain for their current balances. Whenever a deviation in balances is spotted beyond a specific threshold, Chainlink oracles will trigger an on-chain update to the balances stored in the Proof of Reserve Reference Contract.

Stablecoins that use Chainlink Proof of Reserve allow for a higher degree of transparency for their users as they can prove that there is a true backing to the tokens that they hold. Chainlink Proof of Reserve can also be constructed to provide collateralization data regarding any type of pegged asset, including alternative fiat currencies such as GBP or commodities like gold, increasing the transparency of any stablecoin protocol utilizing this mechanism.

Central Bank Digital Currencies (CBDCs) will likely have a peg to an external asset meaning that they need to be able to receive price data about that asset. Chainlink helps these government-issued stablecoins by providing the price data that allows them to maintain their pegs and important information about the current collateralization of the system itself.

Since many stablecoins are backed by fiat in off-chain bank accounts, it’s necessary to bring that data into blockchain environments to foster trust in these assets storing stable value. For stablecoin protocols that utilize off-chain reserves, recurring audits enabled by Chainlink oracles enhance transparency and ensure the healthiness of the reserves backing a stablecoin.

Conclusion

The backbone of any stablecoin protocol is the data that it receives about the asset it is pegged to. Chainlink provides a data infrastructure for ensuring the reliability, security, and transparency of stablecoins and for increasing stability across the larger DeFi ecosystem.

If you’re a developer and want to integrate Chainlink into your smart contract applications, check out the developer documentation or reach out to our integration experts.

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