Undercollateralized Stablecoins

Undercollateralized Stablecoins, also called Algorithmic, usually have exceeding stablecoin emissions in comparison to the collateral they own. The debt of the protocol, acquired by minting stablecoins, is covered by the protocol's own equity token to make up for the lack of collateral. One could argue that emissions are collateralized by the equity of the project but this is only sustainable as long as the market capitalization of the equity token is greater than the stablecoin's circulating supply. What allows the mint/burn process, that keeps the peg, to happen is a process called Seigniorage. It works this way: - When a dollar pegged stablecoin is minted it requires $ 1 worth of a mix of collateral and equity. - When a stablecoin is burnt it's redeemed for 1$ worth of a mix of collateral and equity. This allows an arbitrage opportunity to take place: - If the price of the stablecoin is lower than 1$ → buy the stablecoin, redeem the collateral + equity, sell the collateral + equity for profit. - If the price of the stablecoin is over 1$ → buy collateral + equity, mint the stablecoin, sell the stablecoin for profit. What we just described is the Frax Finance's model for Fractional Reserve that partially backs emission with collateral and partially with equity and determines the % of collateralization in hard assets (tokenized securities aka USDC, or 3CRV LP tokens to be more specific) vs the equity proportion with their CR (Collateral Ratio) that is rebalanced accordingly to the shifts in demand and liquidity depth for both their stablecoin and their equity. They aren't just the biggest players in this category but also first movers and innovators. They managed to achieve sustainability in such a terrible market downturn as the one we are currently experiencing thanks to the responsible way in which they conducted their business. Luna was another major exponent of this category but their model was far more risk-prone and their redemption mechanism was also far less fair. They were almost entirely equity backed, fully collateralized by debt or, so to speak, completely undercollateralized. Their reserves of decentralized collateral weren't posted on-chain, managed in a centralized fashion and their redemption mechanism, also, wasn't allowing the repayment of decentralized collateral to each user. The market has already demonstrated their model was unsustainable so we are not going to focus on that anymore.

Fundamentals of the Undercollateralized Model:

USERS: acquire CREDIT, in the form of stablecoins, that they can exercise against the protocol with redemptions. PROTOCOL: acquires DEBT with stablecoin emissions and has to stay solvent to meet redemptions.

In the Undercollateralized Model the Users are LONG on the Peg

1.01 Expansion phase = The equity is under buy pressure while its supply contracts (it's being burned to mint new stablecoins) so its price increases. This drives a lot of growth in both market share and user base, also makes it easy to subsidize yields with the treasury holdings. 0.99 Contraction phase = The equity is sold while its supply is expanding (it's being minted to fulfill redemptions and repeg the stables) so its price crashes and so does the market share. If the protocol has acquired too much debt it's at solvency risk. PRO: Great incentives alignment for fast adoption and growth. CONS: The more it scales the less secure and the more the risk of bankruns and Negative Depegs grows. Locked liquidity can help you maintain the solvency status though.