EXPLAINED: The 7 Tenets of a Decentralized Stablecoin

Stablecoins play a vital role in the crypto market. As a means of reducing volatility, they are designed to allow people to reliably store value.

Yet, while the cryptocurrency movement has been built around the idea of decentralization, many popular stablecoins are not truly decentralized. As proven by recent events, stablecoins that are not decentralized present significant risks for holders and the broader crypto community. 

Here are the 7 tenets of a truly decentralized stablecoin.

What is a Decentralized Stablecoin?

Decentralized stablecoins are a way of storing value outside of the control of any central authority. At the same time, they allow users to avoid the volatility associated with traditional cryptocurrencies.

While the prices of other cryptocurrencies are often prone to price dips and hikes, stablecoins are designed to maintain a stable value. To do so, their value is pegged against other assets. 

Most often, stablecoins are pegged to fiat currencies such as the US dollar or physical commodities. Ultimately, the goal of a stablecoin is to maintain a stable value that is directly tied to the asset or commodity the coin is pegged to.

In the crypto market today, some of the largest cryptocurrencies by market cap are stablecoins. They currently enjoy a wide variety of use cases such as serving as a store of value, powering decentralized ecosystems, being used for remittances and payments, and playing a key role in decentralized lending platforms.

The 7 Tenets of Decentralized Stablecoins

Much in the same way that we can evaluate projects based on whether or not they follow the first principles of crypto and blockchain, there are 7 tenets that we can use to identify truly decentralized stablecoins.

In order to be decentralized, a stablecoin should:

1. Exist on a Decentralized Blockchain

One of the most immediate prerequisites for a stablecoin to be decentralized is that its underlying technology must be decentralized as well.

Blockchain technology was first outlined in Bitcoin’s whitepaper, but not all blockchains implementations in the world today prioritize decentralization in the same way as Bitcoin’s creator(s). In fact, many blockchains are entirely controlled by companies, teams, and other middlemen.

Decentralized blockchains are those which operate on a peer-to-peer basis. They allow users to interact directly with one another without the presence of any centralized authorities. Being built on a decentralized blockchain is the very first step in identifying a decentralized stablecoin. 

2. Be Generated By an Immutable and Governance-Free Smart Contract

Smart contracts are transparent self-executing computer programs that allow ecosystems to function without middlemen. They enable a true peer-to-peer transfer of value between participants.

Some projects, however, are not built around governance-free smart contracts. Instead, they give project creators control and may even retain admin keys. This is particularly concerning, as admin keys are the ultimate risk to decentralized finance. Essentially, they allow their holders to take back control of the network.

As long as admin keys are out there, a project cannot be immutable; its owners could one day decide to manipulate the ecosystem. As such, decentralized stablecoins need to make use of an immutable and governance-free smart contract without generating or retaining admin keys.

3. Not Be Censorable or Blacklistable

A project cannot be decentralized when a central authority has the ability to censor transactions and blacklist users. 

When an authority has the ability to engage in censorship or blacklist wallet addresses, it signifies that the network itself is not decentralized. For asset holders, this can place them at significant risk of one day being locked out of their own funds.

The idea of a central authority being able to seize your holdings is entirely antithetical to the core principles of the crypto movement. If someone can lock you out of accessing your coins, are they really yours to begin with?

4. Be Fully Collateralized at All Times

Stablecoins are often pegged to fiat currencies and participants within the network place faith that they can convert their coins to fiat whenever they so choose.

Unfortunately, the fact of the matter is that several prominent stablecoins have been accused of not having enough collateral to pay out holders.

For individual users, insufficient collateral means that you may not be able to cash out your stablecoins at times when there is insufficient liquidity. For the broader market, this can create panic as people race to convert their stablecoins to fiat currencies.

In order to prevent these scenarios, decentralized stablecoins must always be fully collateralized. 

5. Have Transparent Collateral

In order to mitigate user fears and uphold the values of the cryptocurrency movement, decentralized stablecoins should have transparent collateral.

At all times, it should be possible for both internal and external audits to prove that users’ funds are truly backed by assets or commodities.

Especially in decentralized ecosystems, this transparency is crucial. Without transparency, users are stuck blindly placing their faith—which is little better than the financial systems that the crypto movement was designed as an alternative to.

6. Be Community Owned and Created

The peer-to-peer ecosystems in which decentralized stablecoins exist should always serve their users. A great way to ensure that this is the case is for decentralized stablecoins to be created and owned by the community.

By maintaining a community-first approach, stablecoins are able to serve as a tool of the people rather than simply as a product that is marketed to them.

For this reason, an important tenet of decentralized stablecoins is letting the community itself dictate the ecosystem’s future.

7. Have Direct Redemptions

Redemptions are the process in which users can redeem their stablecoins for the assets and commodities that they are backed by.

Just about every stablecoin on the market today claims that users can redeem their tokens, but what some projects fail to disclose is that this process can be needlessly difficult or even intentionally inaccessible.

For a decentralized stablecoin to have real value and serve the interest of its holders, there needs to be a direct and accessible way for users to redeem their coins. 

What Happens When Stablecoins Do Not Meet These Tenets

In the past, stablecoins failing to uphold these tenets has led to significant consequences for network participants and even the broader crypto market.

One of the most famous examples is TerraUSD, a stablecoin which was at one point pegged 1:1 with the US dollar. When its sister network, Luna, collapsed, an estimated $60 billion USD was wiped out of the crypto market. 

TerraUSD is what is known as an algorithmic stablecoin, which means it was not pegged to an asset or commodity. Since the stablecoin’s collapse, many articles have attempted to cover the litany of factors that contributed to its downfall. Importantly, TerraUSD failed to uphold most of the tenets on this list.

While less significant in scale, other popular stablecoins have also been subject to concern for failing to meet these tenets. One such example is USDC, which recently made the controversial decision to block transactions associated with a decentralized application known as TornadoCash.

The fact that USDC’s issuer, CENTRE, was able to blacklist these addresses has been a concern for proponents of the decentralization movement. In addition, it has also raised concerns for a decentralized stablecoin known as Dai, as a portion of its collateral is provided by USDC. 

For a deep dive into Dai, read our article on the 6 risks of Dai and MakerDAO.

Overall, stablecoins have cemented themselves as a crucial part of the crypto market. It is important for users to realize, however, that not all stablecoins are created equal. By following these 7 tenets, it becomes easier to identify the stablecoins that are truly decentralized.