Crypto-collateralized stablecoins lock crypto-assets such as ETH as collateral — with a significantly higher value — to back their stable tokens. This way, whenever the backing crypto-asset loses value to lower levels than the value of stable tokens, the peg is broken and the system collapses as a consequence. Accordingly, many people believe stablecoins of the kind are like ticking bombs and can be detonated at any moment.
However, a brief review of market prices during the last year reveals that the most prominent crypto-collateralized stablecoin, DAI, has firmly maintained its peg even at times when Ether — the crypto-asset backing it — lost value to one-tenth comparing to its peak price. So, the argument presented in paragraph one seems to be far from true.
Are we missing something?
In fact, it is true that crypto-collateralized stablecoins are at risk of breaking their peg, however, the risk is far less than what is generally believed.
Smart contracts issuing crypto-collateralized stablecoins can be viewed as banks issuing loans. As mentioned before, they require collateral with a value that is significantly higher than the loan they are providing. So if the collateral value decreases to lower levels than the value of the loans, the system collapses.
But, that’s not the whole story!
Smart contracts do not remain idle to allow the collateral depreciate value to lower than or even equal to the value of the loans. Once the collateral loses value to less than 1.5 times the value of loans, the smart contract actively puts the collateral in an auction (or simply sells it to for a fixed price) and only accepts native stablecoins in return.
For example, Ether is worth $200, John locks 1 Ether in order to receive $100 worth of stablecoins. Now, suppose Ether price falls to $180, $160 and so on. As soon as price reaches $150, the smart contract puts all collateral Ethers in an auction in order to forcib...