By tying value to a reserve asset, stablecoins provide a less volatile alternative to other types of digital assets. DeFi users can receive interest in exchange for lending out stablecoins on a variety of platforms.

In this article, we review what stablecoins are, the different types of stablecoins, and the controversies surrounding stablecoins. Then, we’ll explain how to earn yield by lending stablecoins.

What are stablecoins?

Stablecoins are digital assets that’s prices are pegged to a “stable” reserve asset—usually another currency, commodity, or financial instrument, making them less volatile than other digital assets. Stablecoins can be used as a store of value or put to work generating yield through lending or providing liquidity. There are three main types of stablecoins:

• Algorithmic: Algorithmic stablecoins rely on algorithms that automatically expand or contract the number of tokens in circulation in order to meet a specific price target. These algorithms feed into smart contracts, making algorithmic stablecoins decentralized. Algorithmic stablecoins are typically undercollateralized, meaning distributors don’t have independent assets in reserve to back the value of their stablecoins. Instead, they are backed by another digital asset. For example, FRAX is backed by FXS, Frax Finance’s governance token, and UST was backed by LUNA, Terra’s governance token.

• Crypto-Collateralized: Crypto-collateralized stablecoins, like MakerDAO’s DAI and Inverse Finance’s DOLA, are overcollateralized, meaning the value of the digital assets used as collateral exceeds the value of the loan. Crypto-collateralized stablecoins are  decentralized. Ethereum (ETH) or other Ethereum-based digital assets like USDC, wBTC or COMP are deposited into the crypto-collateralized stablecoin’s smart contracts. The smart contracts use these assets as collateral in maintaining the stablecoin’s peg to the US Dollar. New collateral options can be proposed through the overseeing protocol’s governance, but no one entity controls the issuance of crypto-collateralized stablecoins.

• Fiat-Collateralized: Fiat-backed stablecoins are overcollateralized by fiat reserves, meaning that distributors have cash or cash-equivalent assets in their reserves. For every USDC or USDT coin, there is a dollar in a bank held by the tokens’ distributors. In contrast to algorithmic or crypto-collateralized stablecoins, fiat-collateralized stablecoins are centralized stablecoins. Regulated financial institutions hold reserves in USD that back each USDC and USDT coin.

Controversies with Stablecoins

DeFi users should be aware of the crises and controversies that plagued stablecoins in the last quarter. These controversies surround algorithmic stablecoins, specifically TerraUSD (UST). UST was pegged 1:1 to the US dollar and backed by Terra’s native token, LUNA. Burning 1 LUNA issued 1 UST.

On May 9, 2022, UST lost its peg to the US Dollar, plummeting 100% to a fraction of a cent, where the price remains today. This was largely due to an exploitation of the unique risks inherent to algorithmic stablecoins; because of large withdrawals in a short period of time, the burn-and-mint relationship between LUNA and UST was exploited. UST holders saw the depeg and were prompted to redeem their UST for LUNA (thereby minting LUNA and burning UST), decreasing the supply of UST and increasing that of LUNA. As the supply of LUNA increased, its price fell as well, creating massive losses for holders of both UST and LUNA.

The collapse of UST calls into question the future of algorithmic stablecoins. Critics of algorithmic stablecoins highlight the risk that algorithmic stablecoins could fail in the face of massive withdrawals, due to their lack of reserve assets. Within digital assets, stablecoins have been a particular focus for regulators and governments around the world. Regulatory response to the collapse of this algorithmic stablecoin is expected; in the United States and the United Kingdom, legislation that requires stablecoins to be backed by real assets subject to regular audits of those reserves is in motion.

Generating Yield on Stablecoins

Lending

DeFi users can earn stablecoins by staking them, providing liquidity for stablecoin pairs, or by lending stablecoins. Earning yield on stablecoins via lending happens through a series of steps:

• Stablecoin holders deposit stablecoins to a lending platform. Popular decentralized platforms include Aave, Compound, and Maker.

• The lending platform provides the lender with native tokens to the protocol, such as interest-bearing cTokens for Compound. The tokens represent the total of the principal deposited and interest earned, and they can usually be redeemed at any time.

• A borrower requests a loan in digital assets on one of these lending platforms in exchange for collateral in digital assets. To account for the volatility of the digital asset market and unique risks and expenses associated with it, these loans are usually overcollateralized. The collateral is locked up by the lending platform until the loan is repaid.

• Smart contracts on the lending platform automatically facilitate the funding and management of the lending process. Lenders themselves are not involved in this process.

• Often on a predetermined basis, the lender can redeem the native tokens given to them in exchange for their digital assets lent, plus interest, called “yield.”

• Liquidation of the collateral is automatic. Once they repay the entirety of their loan plus interest, the borrower receives back their collateral. Conversely, if they fail to repay the loan, they lose their collateral to the lending platform and it is used to compensate lenders whose lent assets were lost.

Providing Liquidity

Providing liquidity (LPing) for stablecoins allows users to improve the ease with which tokens can be swapped to other tokens and earn yield from fees generated by trading activity. To contribute to a liquidity pool with stablecoins, users follow a series of steps:

• Once a liquidity pool is created on an automated market maker (AMM) such as Uniswap or Curve, a user deposits stablecoins. In most DEXs, liquidity providers (LPs) must provide an equal value of all tokens in the pool. For example, the DAI/USDC pool on Uniswap requires equal deposits of DAI and USDC.

• LPs receive LP tokens representing the amount of liquidity they have provided. They can withdraw liquidity anytime they want from liquidity pools.

• LP token holders earn a share of DEX trading fees associated with the liquidity pool into which they deposited, proportional to the percentage of liquidity they provided to the pool. Usually, this yield is in the form of the underlying assets in the pool; it may also be in the form of the protocol’s governance tokens.

What is Index Coop?

Index Coop is a decentralized autonomous organization (DAO) that powers structured decentralized finance (DeFi) products and strategy tokens using smart contracts on the blockchain. We offer a suite of sector structured products, leverage and inverse products, and yield-generating products. We aim to create products that are simple to use, accessible to everyone and secure. Our products are built on Set Protocol, a twice-audited, self-custodial DeFi tool that allows for the creation and management of Ethereum-based (or ERC-20) tokens. Among users, partner protocols, and our composable products, Index Coop maintains one of the largest partnership networks in the DeFi ecosystem.

How to buy Index Coop products with fiat currencies:

• First, you’ll need to create an Ethereum wallet like Argent, Metamask, Gemini, or Rainbow.

• Next, you’ll set up your new wallet and connect your bank account.

• Once you’ve deposited fiat currency in your wallet you can exchange it for Index Coop products like the

  Interest Compounding ETH Index (icETH)

  .

You can also earn or buy Index Coop products directly via your favorite decentralized exchange or on the Index Coop App.

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