Overcollateralized Stablecoins

Overcollateralized stablecoins are issued in circulation by Money Markets, also known as Lending Markets or Debt Markets. For the purpose of backing the stablecoins value these Debt Markets normally hold more collateral than what they produce as emissions.

What generates these emissions and keeps the stablecoins value pegged is CDPs or Collateralized Debt Positions: Users apply for a loan, denominated in the stablecoin (e.g 1000 DAI), they put up collateral overcollateralizing the debt position (e.g. 2000$ worth of ETH), the protocol charges Interest Rates (IRs) on the position which will increase or decrease according to market demand for the stablecoin (buy pressure/sell pressure = demand for contraction/expansion for the stablecoin's supply) and liquidates every position under a specific liquidation threshold that will guarantee at least 100% collateral to be recovered. This way these protocols practically outsource the solvency risk to borrowers. Maker DAO is not only the most prominent exponent for this type of decentralized stablecoin, they also were the absolute first movers that gave birth to the sector and, right now, also the first one closer to attaining real world adoption.

Fundamentals of the Overcollateralized Model:

USERS (CDP owners): acquire DEBT when minting stables, they need to stay solvent on the value of their collateral to avoid liquidation PROTOCOL: acquires CREDIT (aka future cash flow that will be exercisable through liquidations/IRs)

In the Overcollateralized Model the Users are SHORT on the Peg

1.01 Expansion phase = IRs are lowered to incentivize the opening of new CDPs and organic growth of the Total Value Locked (TVL) inside the Money Market. The growth in the demand for leverage usually happens when the value of the collateral is appreciating and the market momentum is bullish but demand for stability (new stables) is scarce in this context. If, for any reason, the demand for stability picks up and the stablecoin undergoes high buying pressure in a bearish downturn of the market, while demand for leverage and for new loans is still at the lows, IRs would have to go negative, which isn't very sustainable as a solution. This risks to cause a positive depeg (1.01) of the stablecoin and a great damage to the organic user base of the protocol: Borrowers. For this reason Maker has introduced the Price Stability Module (PSM) to effectively provide an arbitrage opportunity to mint stablecoins under the market price and dilute supply in a scenario like the one described above, through what we might acknowledge as a seigniorage process at 100% CR with stable collateral (USDC). This demand for stability vs demand for leverage problem (users vs buyers), plus the collateralization requirements far exceeding the minting capacity of the protocol to protect the solvency status, cause growth and the adoption rate to suffer. 0.99 Contraction phase = IRs are raised to force repayments, borrowers have to pay to avoid liquidation and the protocol profitability grows but only relatively to a shrinking TVL and market share. This problem can be identified as a conflict of interest between the governance of the protocol, that wants to stay profitable with IRs, and the organic adoption from borrowers (users) that open new CDPs and increase protocol's TVL and the market share of the stablecoin when the market dynamics turn in their favor and the relative profitability of the governance is low. Conditions are hardly favorable for both sides simultaneously. PRO: Highest security standards and solvency guarantees at scale. CONS: Scaling is hard because of the governance (profitability) vs users (adoption) conflict of interest and the capital inefficiency inherent to the protocol, due to the need for overcollateralizing its emissions.