Part 2. The Architecture of Trust: Dissecting Stablecoin Models and Lessons from Failures 📉
Stablecoins aim for ‘stability,’ but the way they secure that stability—the ’trust mechanism’—varies drastically by model. This difference determines each model’s strengths and weaknesses.
Centralized Stability: Fiat-Collateralized Model
The most intuitive and market-dominant approach is using fiat currency as direct collateral. In this model, a centralized issuer deposits one dollar in cash or equivalent safe assets in a bank account for every stablecoin token issued. Users maintain confidence in the token’s value because they can redeem their stablecoins with the issuer at a 1:1 ratio for actual fiat currency anytime.
- USDC (USD Coin): Issued by Circle, it prioritizes regulatory compliance and transparency. Reserves mainly consist of cash and short-term U.S. Treasury bonds, regularly audited by global accounting firms and publicly disclosed. This approach has earned high trust from institutional investors and rapidly expanded market share.
- USDT (Tether): The largest by market cap but historically controversial due to reserve transparency issues. Tether states its reserves include not only cash but also commercial paper, secured loans, corporate bonds, precious metals, and even Bitcoin, indicating potentially higher risk compared to USDC.
Trust in this model relies entirely on faith in the issuer and external auditors, with the greatest risk being counterparty risk. If the issuer mismanages reserves or goes bankrupt, the stablecoin can lose value.
Decentralized Robustness: Crypto-Collateralized Model
More faithful to decentralization philosophy, this model minimizes reliance on centralized issuers or traditional financial systems. A prime example is DAI, issued by the MakerDAO protocol.
- How it works: Users deposit volatile crypto assets like Ethereum (ETH) as collateral into smart contract vaults. They can then issue (borrow) DAI up to a certain percentage of the collateral’s value. The key is over-collateralization, maintaining collateral value significantly above debt value (e.g., 150% or more) to buffer against price drops.
- Automated Liquidation: If collateral value falls below a predefined liquidation ratio, smart contracts automatically sell the collateral on the market to repay the loan. This mechanism is the last line of defense for the system’s solvency.
Trust here comes from transparent, auditable smart contract code and mathematical algorithms. No need to trust a centralized party; anyone can verify the code’s operation. However, main risks include smart contract vulnerabilities (bugs or hacks) and systemic risk from cascading liquidations during sharp market crashes.
Ambitious but Collateral-Free: The Death of Algorithmic Stablecoins
The most ambitious and experimental model tried to peg value to $1 solely by algorithmically adjusting supply without physical collateral. This system typically used two tokens: a stablecoin (e.g., UST) and a sister coin absorbing price volatility (e.g., LUNA).
- 2022 Terra-Luna Collapse: The Terra ecosystem algorithmically guaranteed that 1 UST could always be exchanged for $1 worth of LUNA. If UST price dropped, arbitrageurs bought UST cheaply and exchanged it for $1 worth of LUNA, burning UST and reducing supply to restore the peg. However, in May 2022, massive UST sell-offs pushed its price well below $1. To restore the peg, the algorithm began issuing exponentially more LUNA, causing LUNA’s price to crash and spreading fear that LUNA could no longer back UST. This triggered a massive ‘bank run’ on UST holders, and both tokens’ values collapsed to near zero within days.
- The ‘Death Spiral’: The Terra-Luna incident proved that collateral-free algorithmic stablecoins rely on unrealistic assumptions of perpetual market trust and demand for the sister token. In crises, trust evaporates, and the algorithm accelerates collapse. Since then, the market has almost entirely lost faith in this model, with many experts likening it to a Ponzi scheme.
Each stablecoin model reveals a fundamental trade-off among stability, decentralization, and capital efficiency—the ‘stablecoin trilemma.’ Fiat-collateralized models sacrifice decentralization for stability; crypto-collateralized models accept capital inefficiency for decentralization; algorithmic models tried to achieve all three but lost stability and failed. The market’s overwhelming preference for fiat-backed models like USDC and USDT clearly shows users value practical stability and ease of use over pure decentralization.
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