Crypto-Backed Stablecoin

A crypto-backed stablecoin is a stablecoin whose tokens are created when users lock other cryptocurrencies, such as ether or wrapped bitcoin, into a smart contract and borrow against them. Because crypto prices swing sharply, the locked collateral must be worth more than the stablecoins issued. If its value falls too far, the system sells it automatically to repay the debt. The best-known example is Dai, launched by MakerDAO in 2017 and now run by the Sky protocol alongside its successor token USDS.

Crypto-backed coins are a branch of the collateralized stablecoin family. They differ from a fiat-backed stablecoin in that no company holds bank reserves and there is usually no one to redeem from; the collateral is visible on the blockchain and managed by code. They also differ from an algorithmic stablecoin, which has little or no real collateral. They are a core building block of decentralized finance.

Think of a pawnbroker who only lends you half what your item is worth. You leave a guitar worth $1,000 and walk out with $500. If guitar prices crash and yours is suddenly worth only $600, the pawnbroker sells it before it drops further, keeps the $500 plus a fee, and gives you what is left.

A crypto-backed stablecoin system is that pawnbroker, run by a computer program in public. You lock up crypto and receive dollar tokens worth well under the value of what you locked. Anyone can see every locked item and every loan, and if prices fall too far, the program sells the collateral without asking.

Each loan sits in its own position, often called a vault or collateralized debt position. The key number is the collateralization ratio:

• $Q$ is the quantity of collateral locked, for example the number of ether.
• $P$ is the current market price of one unit of collateral, supplied by a price oracle.
• $D$ is the stablecoin debt outstanding on the position.

The protocol sets a minimum ratio. Rearranging gives the price at which a position becomes eligible for liquidation:

Example: a user locks 10 ether at $3,000 each, worth $30,000, and mints 15,000 stablecoins. The ratio is $30{,}000 \div 15{,}000 = 2$, or 200%. If the minimum is 150%, the liquidation price is $15{,}000 \times 1.5 \div 10 = 2{,}250$. Should ether fall below $2,250, the position can be liquidated. This buffer is the idea of overcollateralization; minimum ratios differ by protocol and collateral type.

Without a company that pays out $1 per token, these systems use several tools to hold the price near $1:

• Liquidations. Under-collateralized positions are auctioned or sold, and the proceeds retire the debt; see forced liquidation. A penalty fee discourages borrowers from letting this happen.
• Interest rates. A borrowing fee, often called a stability fee, makes minting more or less attractive. Raising it shrinks supply when the coin trades below $1; lowering it does the opposite. Some systems also pay a savings rate to holders who lock the coin.
• Redemption against collateral. Some designs let any holder swap one coin for $1 of collateral taken from the riskiest positions. Liquity's LUSD, launched in 2021 with a 110% minimum ratio and ether as its only collateral, is a well-known example.
• Peg stability modules. Maker added a module that swaps the coin one-for-one with USDC. It tightened the peg but meant a large share of Dai came to be backed by a fiat-backed coin.

Arbitrage traders link all of these to the market: when the coin trades away from $1 on a decentralized exchange or a centralized exchange, minting, repaying or redeeming becomes profitable until the gap closes.

Someone has to decide which assets count as collateral, the minimum ratios, fees and oracle sources. In most systems these settings are voted on by holders of a governance token through a decentralized autonomous organization; Maker used MKR, and Sky now uses SKY. Over time several protocols added tokenized Treasury bills and other real-world assets as collateral to earn steady income, which made them less purely crypto-backed and more dependent on traditional custodians. Lending markets such as Aave have also issued their own overcollateralized stablecoins, blurring the line with a decentralized lending protocol.

• Sharp market falls. On 12 March 2020 ether fell steeply, network congestion disrupted Maker's liquidation auctions, and some collateral was sold for almost nothing, leaving the system short; Maker covered the gap by minting and selling MKR.
• Oracle and code risk. A wrong price feed or a bug in the contract can trigger wrongful liquidations or let attackers mint unbacked coins.
• Capital inefficiency. Locking $2 to borrow $1 limits how much stablecoin the system can supply.
• Hidden centralisation. Reliance on USDC or tokenized Treasuries reintroduces issuer and freeze risk; see stablecoin freezing.
• Regulatory fit. Laws such as the US GENIUS Act and EU MiCA are written around an issuer holding fiat reserves. Coins with no identifiable issuer are not permitted payment stablecoins under the US Act, and their treatment remains unsettled.

Like any stablecoin, a crypto-backed coin can lose its peg under stress; see depegging. The broader topic of what backs a coin is covered under stablecoin collateral, and the token mechanics under stablecoin minting and burning.

• Sky (formerly MakerDAO)
• Liquity