The Foundation of DeFi

You can’t do finance with assets that swing 10% daily. That’s why stablecoins exist-cryptocurrencies designed to maintain a stable value, usually pegged to $1 USD.

Stablecoins are the bridge between volatile crypto and usable money.

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Why Stablecoins Matter

Problem	Stablecoin Solution
Crypto volatility	Stable value for pricing
Fiat on-ramps	Hold USD on-chain
DeFi operations	Lending, borrowing, trading
Cross-border payments	Fast, cheap transfers

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Types of Stablecoins

1. Fiat-Backed

Each stablecoin is backed by $1 in a bank:

Stablecoin	Issuer	Backing
USDC	Circle	USD in banks (audited)
USDT	Tether	USD + other assets
BUSD	Binance/Paxos	USD (regulated)

User deposits $100 → Issuer mints 100 USDC
User redeems 100 USDC → Issuer burns, returns $100

Pros: Simple, intuitive backing Cons: Centralized, can be frozen, regulatory risk

2. Crypto-Backed

Overcollateralized by crypto assets:

Deposit 1.5 ETH ($3,000)
→ Borrow up to 2,000 DAI ($2,000)
→ 150% collateralization ratio

Stablecoin	Protocol	Collateral
DAI	MakerDAO	ETH, WBTC, stablecoins
LUSD	Liquity	ETH only
sUSD	Synthetix	SNX

Pros: Decentralized, transparent, no freeze risk Cons: Capital inefficient, liquidation risk

3. Algorithmic

Supply adjusts automatically to maintain peg:

Price > $1 → Mint more (increase supply, lower price)
Price < $1 → Burn/incentivize removes (decrease supply, raise price)

Stablecoin	Mechanism	Status
FRAX	Fractional-algorithmic	Hybrid
UST	Algorithmic	Collapsed

Pros: Capital efficient, scalable Cons: Death spiral risk (UST proved this)

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How DAI Maintains Its Peg

1. **DAI > $1**: Users open vaults, mint DAI, sell for$1+ profit
2. DAI < $1: Users buy cheap DAI, repay debt at discount
3. Liquidation: Undercollateralized positions are liquidated

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The Risks

De-peg Risk

Stablecoins can lose their peg:

Event	Stablecoin	Impact
2023 USDC de-peg	USDC	Briefly $0.88 (SVB exposure)
2022 UST collapse	UST	$1 →$0.02
2022 Tether FUD	USDT	Briefly $0.95

Regulatory Risk

Fiat-backed stablecoins can be:

• Frozen (blacklisted addresses)
• Regulated out of existence
• Required to hold only government bonds

Smart Contract Risk

Crypto-backed stablecoins rely on code:

• Bugs can cause loss
• Oracle failures affect liquidations
• Governance attacks

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Analyzing Stablecoin Safety

Question	Safe Answer
What’s the backing?	Clear, audited reserves
Can it be frozen?	For fiat-backed, yes
Regulatory status?	Compliant, licensed
Audit history?	Regular, public attestations
Peg stability?	<1% deviation historically

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Practice Exercises

Exercise 1: Compare Stablecoins (Beginner)

Look up on CoinGecko:

1. Market cap of USDC, USDT, DAI
2. Which is largest?
3. Has any de-pegged recently?

Exercise 2: DAI Vault Math (Intermediate)

You deposit 2 ETH at $2,000 each ($4,000 collateral). Liquidation threshold: 150%

1. Maximum DAI you can mint?
2. At what ETH price are you liquidated?

Answer

1. $4,000 / 1.5 = 2,666 DAI max
2. If you mint 2,666 DAI: Liquidation when collateral = 2,666 × 1.5 = $4,000 But you have 2 ETH, so:$4,000 / 2 = **$2,000 per ETH** (current price-no margin!) Safe borrowing: 2,000 DAI → liquidation at$1,500 ETH

Exercise 3: Research (Advanced)

Research how FRAX’s fractional-algorithmic mechanism differs from UST’s approach. Why did one survive and one collapse?

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Knowledge Check

1. What’s the difference between fiat-backed and crypto-backed stablecoins?

2. Why do crypto-backed stablecoins need overcollateralization?

3. What went wrong with UST?

4. Can USDC be frozen?

5. How does DAI maintain its peg?

Answers

1. Fiat-backed = USD in banks. Crypto-backed = crypto locked in smart contracts.

2. Volatility. If collateral drops in value, overcollateralization provides buffer before liquidation.

3. Death spiral. When UST de-pegged, LUNA minting caused hyperinflation, destroying both assets.

4. Yes. Circle can blacklist addresses, making their USDC unusable.

5. Arbitrage. When DAI > $1, users mint and sell. When DAI <$1, users buy to repay debt cheaply.

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Summary

Type	Backing	Pros	Cons
Fiat-backed	USD in banks	Simple, stable	Centralized, freezable
Crypto-backed	Over-collateralized	Decentralized	Capital inefficient
Algorithmic	Supply adjustment	Capital efficient	Death spiral risk

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What’s Next?

🎯 Continue learning:

• Crypto Wallet Types - Securing your stablecoins
• Yield Farming Basics - Earning with stablecoins

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You now understand the foundation that makes DeFi usable. 💵