How do stablecoins work?

Mainstream stablecoins use a variety of peg mechanisms to maintain value stability. The most common mechanisms are collateralized debt positions, arbitrage, and elastic supply.

The approach taken by the decentralized stablecoin protocol MakerDAO is to allow users to lock their collateral in smart contracts. The smart contract then generates a stablecoin called DAI as overcollateralized debt with flexible interest rates. To maintain a one-to-one relationship between DAI and the U.S. dollar, the MakerDAO smart contract automatically adjusts the interest rate, prompting borrowers to pay off their debts or borrow more stablecoins. The total supply of DAI can be increased or decreased by adjusting the interest rate, thus affecting the price of DAI. Value rises when supply and interest rates are low, and falls when supply and interest rates are high.

The stable currency index DeFiDollar uses an arbitrage mechanism. DeFiDollar includes multiple stablecoins such as DAI, USDC, USDT, and sUSD to keep pace with the USD. For example, if the price of one of the reserve stablecoins (such as USDT) exceeds $1, and the index price of DUSD is less than $1, the smart contract will sell USDT for DUSD to bring the DUSD price back 1. The Chainlink oracle provides a reference price feed for the DUSD smart contract to calculate how to rebalance the stablecoin index.

How DeFiDollar leverages Chainlink oracles to trigger stablecoin indices to rebalance

Ampleforth (AMPL) is a decentralized algorithmic stablecoin that uses an elastic supply mechanism to anchor the current Consumer Price Index (CPI). The CPI is an index published by the Bureau of Economic Analysis that reflects the current value of the U.S. dollar in 2019, adjusted for inflation. When the AMPL price is high, the wallet balance will increase; when the AMPL price is low, the wallet balance will decrease. Automatic changes in supply affect market prices, a mechanism known as "rebasing". The total issuance of AMPL is adjusted daily to track the current Consumer Price Index (CPI), an index published by the Bureau of Economic Analysis for the current value of the U.S. dollar after adjusting for inflation. AMPL’s volume-weighted average price (VWAP) and CPI index are both transmitted to the Ampleforth protocol by Chainlink oracles.

Stablecoin applications connected to Chainlink oracles

Although stablecoins vary in architecture and design, they all require accurate price feeds to maintain pegs in decentralized applications. Since the exchange rate is always changing, stablecoin applications need to input real-time price feeds. In addition, since stablecoins are usually collateralized by other encrypted assets or off-chain bank reserves, a tamper-proof mechanism must be used to transmit data in order to ensure the security and stability of the system.

Blockchain oracles like Chainlink can connect the blockchain ecosystem to the off-chain world. The amount of stablecoins locked in DeFi applications is very large, so it needs to have security and reliability comparable to the underlying blockchain. That is, the oracle that feeds the price of the stablecoin needs to have a strong and robust decentralized architecture with multiple layers of security in place to maintain a 1:1 relationship with the value of the anchored asset. In this way, stablecoin users will also have a higher sense of transparency and trust, and can be sure that the stablecoin assets in their hands have end-to-end security without any single point of failure, and can reflect the real economic value.

Stablecoins are usually collateralized by another asset, the most common collateral being fiat currencies such as US dollars. The oracle machine can not only provide price feeds to stable coins and maintain the peg price, but also provide the current asset mortgage rate. One example is TrueUSD (TUSD), which connects to Chainlink oracles to obtain collateral rate data, and users can clearly check whether the asset collateral rate is sufficient. In this way, DeFi users can verify the real mortgage rate of all TUSD tokens in real time, and the protocol can also automatically protect user funds to avoid risks such as insufficient mortgage rate or black swan events.

TrustToken is connected to Chainlink Reserve Proof to provide smart contracts with off-chain legal currency reserve proof of TUSD stablecoin

This mechanism for verifying asset reserves is called Chainlink Reserve Proofs. These on-chain reference price feeds provide smart contracts with the data needed to calculate off-chain reserve collateralization rates for any on-chain asset. These reference price feeds are run by the decentralized oracle network in the Chainlink network, which can automatically audit the collateral in DeFi applications in real time, ensure the safety of user funds, and prevent the reserve ratio not meeting the requirements or off-chain custodian fraud. .

Paxos is a leading financial market infrastructure and cryptocurrency trading platform that integrates Chainlink oracles to provide highly usable and tamper-proof real on-chain price feeds for DeFi smart contracts, including the USD-collateralized stablecoin Paxos Standard ( PAX) and the gold-collateralized stablecoin PAX Gold (PAXG), these two stablecoins refer to Chainlink for price feeds when performing key on-chain functions. In addition, Chainlink also provides proof of reserves for Paxos tokens, allowing DeFi applications to quickly verify on the chain whether the token’s USD and gold asset mortgage rates are sufficient. These collateral assets are hosted off-chain by Paxos.

How Paxos Uses Chainlink Proof of Reserves to Verify Off-Chain Asset Collateralization

Another stablecoin protocol that uses proof-of-reserves is Neutrino USD, an algorithmic stablecoin collateralized with cryptocurrencies, pegged to the U.S. dollar fiat currency. Chainlink nodes continue to ping the USDN contract on Ethereum and the off-chain API of Waves to obtain the current balance. Once the balance deviation exceeds a certain threshold, Chainlink oracles automatically update the balance in the Proof of Reserves reference contract.

The use of Chainlink Proof of Reserves for stablecoins can improve transparency for users, who can verify the true collateral level of the token. Chainlink Proof of Reserves can also be customized to provide collateralization rate data for any pegged asset, including fiat currencies like GBP or commodities like gold. This helps to improve the transparency of the stablecoin protocol.

Central bank digital currency (CBDC) may anchor an off-chain asset, so it is also necessary to obtain relevant asset price feeds. Chainlink can provide price feeds for government-issued stablecoins, guarantee their price stability, and transmit current mortgage rate data for them.

Since many stablecoins are collateralized by fiat currency in off-chain bank accounts, data must be transmitted to the blockchain to guarantee the true value of the asset. If the stablecoin is collateralized by off-chain reserves, it can be connected to the Chainlink oracle to achieve on-chain audit. This will greatly improve the transparency and health of reserve assets.