Understanding the Impact of Dual Collateral-Backed and Overcollateralized Stablecoins In Uncertain Times

TL: DR

- Over-collateralization (OC) means the provision of locking up assets as collateral worth more than enough to buffer potential losses in the event of a default.
- The happenings in the crypto industry with the crash of many once viable projects are driving greater adoption of over-collateralized stablecoins.
- The impact of dual collateral-backed and overcollateralized stablecoins in uncertain times includes generally rekindling hope in crypto, proving a safer option for keeping assets, and facilitating trade.

Keywords: collateral, stablecoins, volatility, impact, assets, crypto

In uncertain times when the market is bearish, stablecoins rise to prominence and enjoy a bull market. People want to be sure their assets are safe and can be redeemed anytime. The fall of Terra Luna after the much-hyped success has also dampened confidence in algorithmic stablecoins that are not backed by tangible assets. Attention is fast shifting towards over-collateralized stablecoins. Over-collateralization (OC) means the provision of locking up assets as collateral worth more than enough to buffer potential losses in the event of a default. It is used to manage risk effectively and entails using an asset as collateral on a loan where the asset's value exceeds the loan’s value. Before looking at the impact of dual collateral-backed and over-collateralized stablecoins in uncertain times, it is necessary to unpack these concepts for more clarity.

What are Dual Collateral-Backed and Overcollateralized Stablecoins?

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Stablecoins are crypto assets linked to a specific currency, i.e the US dollar. They are broadly classified into two types: centralized and decentralized. Centralized stablecoins are digital assets fully backed by fiat and issued and controlled by centralized companies or custodians. Examples include Tether's USDT and Circle's USDC, which account for most of the market share.

Decentralized stablecoins, on the other hand, are typically classified as either over-collateralized or non-collateralized. Specifically, in a dual collateral-backed stablecoin, two coins exist. One is the pegged coin, and the other is a secondary coin used to absorb the volatility of the pegged coin. Therefore, dual collateral-backed and overcollateralized stablecoins are often crypto-collateralized. The values are pegged to that of other cryptocurrencies. The fact that the underlying asset, in this case, is also a cryptocurrency makes it not generally safe and may also be highly unstable. This reality gave rise to the term "over-collateralization." It implies that a relatively large amount of reserve cryptocurrencies may be required to issue even a small number of tokens.

Why Over-collateralization?

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There are some factors responsible for the drive towards over-collateralization. The recent happenings in the crypto industry have shown some stablecoins may not really be stable when storms arrive in dark skies. In 2021, the IRON token, a partially backed stablecoin, experienced a large-scale ‘bank run,’ a situation similar to what often leads to the collapse of banks when people fear and rush over to the bank to pull out their money in a short period. The problem arose because the token was not fully or over-collateralized.

If it were for just stability, centralized stablecoins would have been sufficient. The purpose of centralized stablecoins is to deposit a dollar and keep it safe in a bank account for every dollar that a user trades for a stablecoin. The approach has been the industry standard since the rise of stablecoins and continues to be so today. However, centralized stablecoins are increasingly subject to scrutiny by regulators. This regulatory uncertainty affecting centralized stablecoins such as Tether gave rise to the demand for decentralized stablecoins that are not affected by regulatory pressure. The two options in this regard are algorithm-backed stablecoins or over-collateralization. The ability to scale fast and increase supply to meet demand initially favored algorithmic stablecoins such as Terra Luna. However, the flaws in the protocol and the eventual crash are driving adoption and traction for over-collateralized stablecoins.

Essential Concepts in Dual Collateral-backed and Overcollateralized Stablecoins

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Dual collateral-backed and overcollateralized stablecoins such as DAI, LUSD, and agEUR operate a minting system based on creating a collateralized debt position (CDP). This system refers to the locking of some of the acceptable crypto assets as collateral. Some of the essential concepts in this system are discussed below.

Collateralization Ratio:

The value of locked crypto assets as collateral divided by the total value of the circulating supply of a stablecoin is referred to as the collateralization ratio of the stablecoin. One of the popular overcollateralized stablecoins, Dai currently has over 165 percent assets in value (USDC, ETH, etc.) that are locked as collateral for the value of DAI in circulation. The collateralization ratio provides a basis for comparing the overcollateralized stablecoins or CPD.

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Collateral Quality:

Dual collateral-backed and overcollateralized stablecoins are created to provide a buffer against volatility. Since minting stablecoins means having excess in the asset deposited as collateral, when the collateral experiences a severe downturn, many of the CDP created will be at the risk of liquidation. In this case, the stablecoin can lose its backing if not adequately liquidated. This experience has led some over-collateralized stablecoins to prioritize the quality of collateral used for the backing. For example, after the March 2020 crisis, DAI opted for adding a large part of USDC as collateral.

Impact of Dual Collateral-backed and Overcollateralized Stablecoins in Uncertain Times

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The uncertainty that followed the fall of Terra Luna's algorithm-backed stablecoins piqued the interest of many users in over-collateralized stablecoins. These stablecoins grow in demand and adoption. Therefore, it is pertinent to look at some of the impacts of dual collateral-backed and overcollateralized stablecoins:

1. Rekindling hope and confidence in crypto:
uncertain times in the crypto space are characterized by fear and dumping of assets. The mechanisms put in place by the creators of overcollateralized stablecoins to protect against volatility generally rekindle people's hope in crypto. It provides a safe option to control the negative vibes in uncertain times.

2. Safer option to keep assets:
Overcollateralized stablecoins are a safer option to keep assets in the crypto ecosystems during uncertain times.

3. Competitiveness:
Overcollateralized stablecoins are more competitive during uncertain times than other crypto tokens because they address the pain points of users and businesses while also offering stability.

4. Payment alternative:
Dual collateral-backed and overcollateralized stablecoins can be used for payments at a low cost during uncertain times. The government can use it for conditional cash transfers or monetary aid in emergencies.

Last Thoughts

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The intrinsic nature of cryptos makes them consistently more vulnerable to volatility than other asset classes. This factor is responsible for over-collateralization of this category of stablecoins. The quality of the collateral is also very crucial. A high collateralization ratio creates a problem of capital efficiency for overcollateralized stablecoins. A scalability problem that makes it difficult to increase supply in response to demand. However, The decentralization of dual collateral-backed and overcollateralized stablecoins provide safety from being easy targets of regulators looming over the stablecoin industry. This category of stablecoins rekindles hope and provides a safer option to keep assets in uncertain times, other things being equal.

Author: Gate.io Observer: M. Olatunji

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* This article represents only the views of the observers and does not constitute any investment suggestions.

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