Module 9: DeFi Deep Dive
Stablecoins in DeFi
Chapter 7 of 14 · about 6 minutes
7.1 The weekend a stablecoin slipped
In March 2023, a US bank that held part of the reserves for USDC, one of the largest dollar stablecoins, collapsed. Over a weekend, USDC traded as low as about $0.88. Other stablecoins that relied partly on USDC in their own reserves slipped too. When the US government announced that the bank's depositors would be protected, USDC returned to $1 within days.
"So even the 'safe' stablecoins can wobble," said Mint.
"And because DeFi is built on stablecoins, a wobble in one can ripple everywhere," said Hash. "Module 1, Chapter 5 introduced the types of stablecoins. This chapter looks at how they actually work inside DeFi, and how their peg holds, or doesn't."
7.2 Stablecoins as DeFi's base layer
Stablecoins are the most used assets in DeFi. They're the main trading pair on DEXs, the main asset borrowed in lending protocols, the base for yield strategies, and the unit for measuring returns. Their stability is something nearly everything else depends on.
7.3 How fiat-backed stablecoins hold their peg
Fiat-backed stablecoins hold cash and short-term government bonds in reserve (Module 1, Chapter 5). Their peg is maintained by arbitrage with redemption:
| Situation | Arbitrage | Effect |
|---|---|---|
| Stablecoin trades below $1 | Buy it cheaply, redeem with the issuer for $1 | Buying pressure lifts the price |
| Stablecoin trades above $1 | Deposit $1 with the issuer, mint a new token, sell it above $1 | Selling pressure lowers the price |
This works as long as redemption is available and reserves are trusted. In March 2023, redemptions were disrupted over a weekend, and doubts about the reserves broke the peg temporarily.
7.4 Crypto-collateralised stablecoins
Crypto-collateralised stablecoins are minted against crypto collateral through smart contracts, often called collateralised debt positions (CDPs).
How a CDP works:
- A user deposits collateral, such as ETH.
- The user mints stablecoins against it, up to a maximum set by a minimum collateral ratio.
- The user pays a stability fee, an interest rate on the minted amount.
- To get the collateral back, the user repays the stablecoins.
- If the collateral ratio falls below the minimum, the position is liquidated.
Example. A user deposits ETH worth $15,000, with a minimum collateral ratio of 150%.
| Value | |
|---|---|
| Collateral value | $15,000 |
| Maximum stablecoins mintable | $15,000 ÷ 1.5 = $10,000 |
| Amount minted (conservative) | $6,000 |
| Collateral ratio | $15,000 ÷ $6,000 = 250% |
| Collateral value at liquidation | $6,000 × 1.5 = $9,000 |
| ETH fall needed for liquidation | 40% |
This is very similar to borrowing on a lending protocol (Chapter 5), except the stablecoin is newly created rather than borrowed from lenders.
7.5 How CDP stablecoins hold their peg
| Situation | Who acts | Effect |
|---|---|---|
| Stablecoin trades below $1 | CDP holders buy it cheaply to repay their debt at face value | Buying pressure lifts the price |
| Stablecoin trades above $1 | Users mint more against collateral and sell above $1 | Selling pressure lowers the price |
| Persistent deviation | Governance adjusts the stability fee or savings rate | Changes incentives to mint or hold |
Many CDP stablecoins also use a peg stability module (PSM): a contract that lets users swap the stablecoin one-for-one with another stablecoin, like USDC. This tightens the peg considerably, but it means the stablecoin partly depends on that other stablecoin. That dependency is exactly why some CDP stablecoins slipped when USDC did in March 2023.
"So stablecoins backing other stablecoins creates a chain," said Node.
"A very common pattern in DeFi," said Hash. "Chapter 12 is about those chains."
7.6 Savings rates
Some stablecoin protocols offer a savings rate: holders can deposit the stablecoin into a contract and earn interest, funded by stability fees and the protocol's reserve income. Raising or lowering the savings rate is a tool to influence demand and the peg.
7.7 Synthetic dollars
Synthetic dollars are tokens designed to be worth $1 without being backed by dollars or by overcollateralised crypto loans. A common design uses the delta-neutral basis trade from Module 7, Chapter 12: the protocol holds crypto, such as ETH or staked ETH, and shorts an equal amount of perps. The combined position is roughly stable in dollar terms, and the funding received when funding is positive provides yield.
| Feature | Synthetic dollar based on the basis trade |
|---|---|
| Backing | Crypto plus short perp positions |
| Yield source | Staking rewards and positive funding |
| Main risks | Negative funding for long periods, exchange or custody failure where hedges sit, perp liquidation, depegs of collateral assets, smart contract risk |
These products can offer attractive yields when funding is high. But their yield falls, and can turn negative, when funding drops, and they depend on centralised exchanges and custodians for the hedge.
7.8 Yield-bearing and tokenised treasury stablecoins
Another growing category is tokens backed by short-term government bonds, passing the interest through to holders. They aim to give stablecoin holders the yield that fiat-backed issuers normally keep. These are often treated as securities and may be restricted to certain users or jurisdictions (Module 1, Chapter 14). This matters more because the US GENIUS Act bans payment stablecoin issuers from paying yield directly to holders, pushing yield-seeking demand toward tokenised treasuries and similar products (Module 10, Chapter 6).
7.9 Comparing stablecoin designs
| Type | Backing | How the peg holds | Main risks |
|---|---|---|---|
| Fiat-backed | Cash and bonds held by an issuer | Redemption arbitrage | Issuer, banking partners, regulation, freezing |
| Crypto-collateralised (CDP) | Excess crypto in smart contracts | Arbitrage, fees, savings rates, PSMs | Crypto crashes, liquidation failures, dependency on other stablecoins |
| Synthetic (basis trade) | Crypto plus short perps | Hedged value, redemption | Negative funding, exchange risk, liquidation |
| Algorithmic | Incentives and a sister token | Mint-and-burn arbitrage | Confidence spirals, as with TerraUSD in 2022 |
Many fiat-backed stablecoin issuers can also freeze tokens at specific addresses, for example in response to theft or legal orders. That's a consideration for anyone relying on them in DeFi.
7.10 Try it yourself
Pick one fiat-backed stablecoin, one crypto-collateralised stablecoin, and one synthetic dollar. For each, find: what backs it, how users can redeem or mint, whether it can be frozen, and its lowest price in the past two years. Then check what share of the crypto-collateralised stablecoin's backing is held in other stablecoins.
Key takeaways from this chapter
- Stablecoins are DeFi's base layer; their stability supports nearly everything else.
- Fiat-backed stablecoins hold their peg through redemption arbitrage, which depends on reserves and banking access.
- CDP stablecoins are minted against excess crypto collateral and hold their peg through arbitrage, fees, savings rates, and peg stability modules.
- Peg stability modules tie some stablecoins to others, creating dependency chains, as seen in March 2023.
- Synthetic dollars use delta-neutral basis trades; their yield depends on funding and exchange infrastructure.
- Treasury-backed tokens pass through bond yields but may be restricted.
- Every stablecoin design has distinct risks, including freezing by issuers.