AAVE’s native stablecoin is officially launched, exceeding collateralization+algorithm has become a new paradigm for stablecoins.

AAVE's stablecoin launched, with collateralization+algorithm as a new paradigm.

LianGuai reporter Jessy

On July 16th, the stablecoin GHO of decentralized lending protocol AAVE officially launched on the Ethereum mainnet.

In the first few years of stablecoin’s birth, the industry roughly classified stablecoins into three types: centralized stablecoins collateralized by real-world assets. Initially, centralized stablecoins only served as a tool for trading other cryptocurrencies and preserving asset value. In addition to stablecoins pegged to the US dollar, there are also stablecoins pegged to other real-world tokens or assets, such as the Chinese yuan. The second type is stablecoins pegged to on-chain assets, such as Bitcoin and Ethereum.

Algorithmic stablecoins are considered the industry’s pearls. Algorithmic stablecoins are cryptocurrencies based on algorithms that maintain price stability, rather than relying entirely on the anchoring of certain reserve assets.

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However, after the collapse of Luna, the algorithmic stablecoin that was once ranked third, and its value directly dropped to zero, algorithmic stablecoins without external asset support have been questioned. Currently, over-collateralization, multiple asset collateral, and algorithm fusion seem to be a more reliable form of stablecoin development.

When interviewed earlier this year, Shenyu mentioned that stablecoins are still in the early stage, perhaps only completing around 30-40% of progress.

In the view of LianGuai reporter, currently, centralized stablecoins still dominate the industry. However, as the industry’s demand for anti-censorship increases, the demand for decentralized stablecoins will also grow. The industry’s development path for decentralized stablecoins has shifted from focusing on algorithmic stability to the current combination of over-collateralization, multi-asset collateral, and algorithms.

There is more than one lending protocol that issues native stablecoins. In addition to AAVE, there are Maker Dao, Curve, Synthetix, and others. For Defi products, launching their own stablecoins can enrich their ecosystem and also resist centralized scrutiny. Currently, the stablecoins launched by these protocols are mostly a combination of over-collateralization and algorithmic stability, and it is difficult to categorize them into a specific type of stablecoin.

From algorithmic stability to over-collateralization

Algorithmic stablecoins were once considered the industry’s pearls.

The purest form of algorithmic stablecoin is UST. Luna and the stablecoin UST are created together. UST can always be exchanged for 1 US dollar worth of Luna, and UST and Luna maintain a relationship of two-way destruction and minting. The arbitrage mechanism between UST and Luna keeps UST at 1 US dollar. In terms of market capitalization, UST once reached over $18 billion, surpassing BUSD and becoming the world’s third-largest stablecoin.

This design is simple and exquisite, but it has problems during a liquidity crisis. Last May, a large amount of UST was intentionally sold, breaking the balance and decoupling UST from the US dollar. Many people exchanged UST for Luna, causing Luna to plummet. Eventually, the prices of both almost went to zero.

There are various mechanisms designed for algorithmic stablecoins, but none of them have effectively helped these stablecoins escape the “death spiral.” This refers to the situation where the stablecoin mechanism fails to work when the price of the stablecoin is below $1, leading to further price declines. This risk of anchoring failure increases, especially during a liquidity crisis.

After the Luna incident, the industry started to reflect on algorithmic stablecoins. Since 2017, from the earliest Basis and Havven to the present, it is necessary to consider the core algorithm’s design. This includes selecting which tokens to anchor to as underlying assets and determining the mortgage (burning) parameters that balance security and capital efficiency. For example, choosing mainstream cryptocurrencies like BTC as underlying collateral assets will lead to lower capital utilization. In terms of reducing the collateral ratio and releasing collateral liquidity, GHO accepts various types of collateral through the AAVE protocol. Among them, AAVE has a collateral ratio of 400% and accounts for no more than 25% of the total reserves. The facilitator uses different types of collateral assets for collateral and non-collateral issuance. Thirdly, it is important to consider the demand for stablecoins, the order of minting, and how to regulate them. Taking GHO as an example, it achieves price anchoring through the minting-market arbitrage approach.

The most important aspect of stablecoins is security. Avoiding the death spiral should be the core proposition of algorithmic stablecoins. However, this is not an easy problem to solve, even in the traditional financial field, and it is not easily avoidable in the crypto field. Currently, the industry tends to combine collateral and algorithms, with collateral assets being mainly mainstream cryptocurrencies and some real-world assets.

GHO’s Specific Logic

Taking GHO on AAVE as an example, we can see that it introduces the concept of collateral, with multiple cryptocurrencies being used as collateral. Similar to GHO, there is Maker Dao’s stablecoin Dai, which is collateralized by a combination of ETH, USDC, BTC, and other cryptocurrencies. The inspiration for GHO essentially comes from Dai. The operation of GHO is roughly “deposit collateral -> mint $GHO, burn $GHO -> recover collateral”.

GHO is different from Dai in that the collateral assets in GHO can generate interest income, and the minting of GHO has an upper limit. The minting of GHO incurs a certain interest rate, and all decision-making power is held by Aave Governance. Due to E-Mode, stablecoin holders can also access GHO at a nearly 1:1 ratio.

And in practice, it borrows from the practice of frax finance and deploys an AMO-type system. Entities included in the whitelist can mint and burn GHO without trust.

In terms of specific mechanism design, holding and pledging AAVE tokens can earn stAAVE, which can reduce the overall cost of minting GHO (i.e. lower interest rates). This helps alleviate the selling pressure of AAVE on the secondary market and ensures the security of the AAVE protocol. The interest fees generated by GHO lending will be sent to the DAO treasury. If GHO reaches the market value of DAI, estimated at an average interest rate of 3.5%, AaveDAO can earn nearly $150,000 per day, which benefits the price growth of AAVE and makes GHO more secure.

Currently, stablecoins that utilize over-collateralization include GHO, crvUSD, and dpxUSD. They ensure price stability to a large extent by establishing over-collateralization based on existing liquidity. At the same time, some over-collateralized stablecoin projects achieve cold start through innovative models, such as HOPE, which uses locked reserve assets and the DeFi ecosystem to maintain stablecoin price stability through the establishment of reserve pools and use cases.

Characteristics of GHO

AAVE’s stablecoin GHO is essentially consistent with the core logic of Maker Dao, both of which mint stablecoins through over-collateralization at a certain collateral ratio. The act of collateralizing and minting stablecoins is entirely a market behavior.

However, a relatively innovative concept introduced by AAVE is the introduction of a “central bank,” which it calls a “facilitator.” According to the official statement, this facilitator can be a protocol or an entity (elected). In practice, AAVE Dao should play the role of this facilitator in the early stages. The facilitator can generate and burn GHO without trust. It can be imagined that the central bank will intervene when the stablecoin is unanchored.

This means that there is both a highly market-oriented aspect and a centralized aspect of “central bank macro-control” in the issuance and burning of GHO.

There are also certain restrictions on the “facilitator,” called “buckets,” which specify the upper limit of GHO that a specific facilitator can generate.

Specific to the borrowing interest rate and repayment period of GHO, they are determined through Dao governance. From this, we can see that the issuance of GHO actually plays an important role in enhancing the governance attributes of AAVE Dao.

A highly imaginative aspect is that using GHO in AAVE can achieve layer-2 nesting, where users can convert their virtual assets into GHO and then swap GHO for other virtual assets. The entire process can be done without any slippage and exchanged for other stablecoins.

But we should also see the other side of this design. The facilitators in AAVE have the right to mint GHO without any collateral, which is too centralized. Once someone with ill intentions intervenes, it may cause the risk of GHO becoming unanchored. Although AAVE has set up bucket mechanisms to limit the amount of GHO generated by facilitators, both are elected through AAVE voting. If there is collusion of interests, governance will become increasingly centralized. In fact, the Dao is currently controlled by large holders, and ordinary retail investors have little say.

Finally, for holders who can obtain a large amount of AAVE at a very low cost, GHO is equivalent to a perpetual motion machine of benefits, and there is a risk that a large amount of AAVE will be cashed out using GHO, which may trigger a collapse of the AAVE market value in the future.

Entry of lending protocols changes the classification of stablecoins

For a protocol, issuing its own stablecoin actually increases the complexity of the stablecoin and may even become a carrier for attacks. In recent years, there have been many cases of protocol bankruptcies due to attacks on stablecoins, such as Cashio, Acala, and Bean.

Moreover, the competition for stablecoins is fierce. Some decentralized stablecoins have established a huge moat in terms of on-chain liquidity and cooperation with other protocols. Based on this, it may be difficult for protocol stablecoins to obtain deep liquidity.

Is this a thankless task for the protocol?

In fact, currently, it has become popular for lending protocols to introduce their own stablecoins. This can be easily explained. Stablecoins are a place where you can make the most money, and there is a huge demand and market here. More realistically, stablecoins issued by super applications with a specific user base essentially bypass trust intermediaries and directly form coinage contracts with their users. Protocols can use stablecoins as a way to increase the value accumulation and utility of governance tokens, and stablecoin issuers can establish direct deposit modules with other lending markets or deposit collateral into AMM LP (for example, Maker’s D3M and FRAX AMO).

GHO is an asset that users deposit into the AAVE protocol for over-collateralization minting. Therefore, the growth of GHO demand will encourage more users to deposit assets in AAVE. In addition, stkAAVE holders who participate in the security module staking can obtain discounted interest rates to mint GHO, which further incentivizes more users to participate in staking. At the same time, the rising demand for AAVE makes the price of AAVE more favorable, and the interest generated by GHO also becomes a new source of income for the AAVE protocol. Therefore, for AAVE, launching GHO directly enhances the overall competitiveness of AAVE to a great extent.

By comparing the native stablecoins launched by several lending protocols, we can see their respective characteristics. Maker DAO has introduced RWA, which ultimately will be a combination of on-chain and off-chain collateral asset models. Interestingly, Maker DAO announced the SLianGuairk protocol in May, which aims to enhance the liquidity and profitability of the DAI stablecoin. In other words, DeFi products deployed on Ethereum, centered around DAI, have the supply and borrowing functions of ETH, stETH, DAI, and sDAI, and all DeFi users can use the SLianGuairk protocol. The focus of this protocol will be to reshape DAI as a freely floating asset collateralized by real-world assets.

CRV Finance has launched crvUSD, which is interesting because of its liquidation mechanism. Its lending and liquidation automated market maker algorithm (LLAMMA) is a dynamic lending liquidation algorithm, which means it introduces an automated market maker into the lending and liquidation process. Therefore, it is different from ordinary collateralized stablecoins. It is issued through over-collateralization and adopts a special purpose AMM to replace the traditional lending and liquidation process. When the liquidation threshold is reached, liquidation does not happen all at once, but is converted into a continuous liquidation/de-liquidation process. In this algorithm, collateral will be diversified in different price ranges to reduce losses during liquidation. It generates arbitrage opportunities by having larger price fluctuations than external prices to dynamically liquidate collateral. When the price drops, the collateral becomes crvUSD, and when the price rises, it reverts to collateral. The PegKeeper and Monetary Policy algorithms of the protocol are used by Curve Finance to anchor crvUSD at $1. Although the native stablecoin of CRV Finance still uses over-collateralization, it replaces some traditional methods such as liquidation and price anchoring with several algorithms, making more use of algorithmic practices.

Compared to stablecoins of other DeFi products, we can see that nowadays, each stablecoin has its own characteristics. With the development of the stablecoin track, we can no longer simply classify stablecoins into the three types mentioned at the beginning. Nowadays, stablecoins are collateralized by online and offline assets, combined with algorithms. Some people have also proposed to divide stablecoins into “centralized stablecoins” and “decentralized stablecoins”. However, decentralized stablecoins also have a centralized aspect.

In addition to preserving the value of assets, the biggest use case of stablecoins is within DeFi. Various protocols in DeFi are entering the stablecoin race, and they have unique advantages. The biggest beneficiaries will be the protocols themselves.

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