Celo: a Stablecoin Ecosystem for the Real-World DeFi

The following report was written by Messari Hub Analyst(s) and commissioned by Celo, a member of Messari Hub. For additional information, please see the disclaimers following the article

Stablecoins are like snowflakes: they all look the same but no two are alike. Although stablecoins share the common goal of price stability, they each approach stability through different mechanisms.

The differences between these mechanisms matter. The infamous algorithmic stablecoin project Iron Finance recently crashed to literally zero due to low quality reserve assets and poorly designed stabilization mechanisms. Stablecoin design is more important than ever and proper due diligence on what lies under the hood of a one dollar token is becoming increasingly challenging.

Most of the stablecoin transaction volume is related to trading activities. However, some projects like Celo create their stablecoins mainly for peer-to-peer payment purposes. Celo aims at making their stablecoins a sound and reliable alternative to cash especially in emerging countries where access to banking is limited. As far as stablecoin design, the Celo stability mechanism relies on a combination of algorithms and over-collateralized on-chain and cross-chain reserves. A deeper dive into the main features of each stablecoin type is needed to understand how these mechanisms compare to one another.

The stablecoin market

Stablecoins can be divided into fiat-backed, crypto-backed and algorithmic. Fiat-backed stablecoins are the most popular among the three categories and their dominance shows no sign of abating. On the other hand, the growth curve of algorithmic stablecoins is much steeper.

The three types of stablecoins are different in many aspects:

Fiat-backed: these aretokens whose price is linked to the value of a particular fiat currency. Most of these tokens are backed by the promise of the stablecoin issuer that 1 fiat-backed stablecoin can be exchanged for 1 unit of fiat if necessary. This requires the issuer to hold sufficient amounts of cash and cash-equivalents on the balance sheet, which is hard to verify (and impossible to do so in real time) and therefore requires trust. From a design standpoint, fiat-backed stablecoins are relatively simple to understand. However, the peg monitoring and management requires the intervention of a centralized party (e.g., the treasury of the issuing firm/protocol) that adjusts the reserve asset balance according to the market demand for the token. Furthermore, fiat-backed stablecoins need to be audited by a third partyto ensure that tokens remain fully collateralized by high-quality reserve assets.The ability of such assets to be readily liquidated during market turmoil is what defines the quality of non-cash reserves.

Crypto-backed: these stablecoins operate in the same way that a fiat-backed stablecoin does but, instead of using fiat-denominated assets as collateral, they have cryptocurrencies locked up as collateral. A crypto-backed token usually relies on an overcollateralized reserve to compensate for the volatility of the cryptocurrencies used as collateral. This means that each one dollar token is usually backed by more than one dollar worth of collateral. The MakerDAO stablecoin, DAI, is the largest crypto-backed stablecoin by market cap with $ 6.5 billion DAI in circulation. Originally, DAI was minted using ETH as the only collateral, but can now be minted using around 20 different collateral types.

Thanks to their on-chain nature, crypto-backed stablecoins don’t need either custodians or external auditors as the reserve values can be publicly verified in real time. However, achieving peg stability is more complex than for fiat-backed stablecoins since cryptocurrencies locked as collateral show wider and less predictable price fluctuations.

Algorithmic: algorithmic stablecoins aim at achieving higher capital efficiency than collateralized stablecoins. Indeed, instead of having collateral set aside, these protocols manage the peg through dynamically controlling supply and demand of the stablecoin. The protocol acts as a “central bank”, increasing supply when token demand increases, and reducing it when demand weakens. Usually the adjustment of stablecoin demand and supply is done through the use of a second token used to allow arbitrage when the stablecoin price deviates from the parity. In the case of Terra UST, the largest algorithmic stablecoin by market capitalization, the LUNA token can be exchanged for a corresponding amount of UST through the protocol itself. This allows arbitrageurs to buy (sell) a dollar worth of LUNA, swap it for one UST and sell (buy) UST in the open market whenever the UST price is above (below) the parity. The rules for doing so are embedded in a smart contract and changing them is only possible through social consensus or more formal governance votes tied to a governance/seigniorage token.

The main advantages of algorithmic stablecoins are the absence of collateral and the transparency that makes them easily auditable when the smart-contracts are open source. The higher decentralization level compared to the asset-backed stablecoins comes at the expense of ensuring that market participants trust the protocol to achieve peg stability over time. Because of the lack of collateral reserves, algorithmic stablecoins rely on the community to be the lender of last resort. However, some projects have chosen an hybrid design that combines algorithmic stabilization mechanisms with collateral reserves. This hybrid mechanism reduces the reliance of the peg stability on market expectations.

Peg stability during market turmoil

Stablecoins have price fluctuations that stay within a certain range during normal market phases. When volatility spikes and prices move downward, many trades are voluntarily closed to cut losses or automatically liquidated by lending protocols in case collateral falls below a certain level. Either way, money moves abruptly from volatile assets to stablecoins. The deviation from the peg during market crashes is a good stress test measure to assess whether stability mechanisms work in extreme conditions. For almost all stablecoins the term peg refers to a soft peg against a fiat anchor currency. This means that the value of the stablecoin can deviate from the anchor currency for short amounts of time or within certain ranges. To measure deviation from the peg in a distress scenario, we gather daily highest, lowest and closing prices on May 19, 2021, a day in which the cryptocurrency market has wiped out $ 700 million market capitalization. We then compute two indicators:

• the difference between highest and lowest daily prices (high-to-low gap)
• the deviation between the closing price and one dollar

These charts show that neither asset-backed nor algorithmic stablecoins have been immune to fluctuations around the parity. The former have shown relatively wider price ranges whereas the latter have closed the day at prices slightly further from the parity.

Celo: DeFi for unbanked as a mission

Celo is a platform designed to make global payments with cryptocurrencies accessible to anyone from a mobile phone. Given the breadth of this ambitious goal, Celo relies on decentralized application (dApp) developers to build solutions on top of it leveraging smart contract compatibility. The use cases of dApp built on top of Celo range from traditional remittances to contributions for universal basic income in communities with extreme poverty.

The main pillars for Celo to achieve global adoption among financially excluded communities are stablecoins as medium of exchange and mobile phone wallets as means of payment. In adaptation to mobile usage Celo has adjusted its Proof-of-Stake blockchain to optimize block headers for mobile-phone synchronization. Furthermore, gas fees can be paid in multiple currencies to accommodate for users endowed with a wide variety of assets.

The Celo stablecoins & stability

The Celo stability mechanism relies on two different types of tokens.The first one is represented by elastic supply stablecoins pegged to fiat currencies such as Celo Dollar (cUSD), Celo Euro (cEUR) and others. The second one value is CELO, the fixed supply governance and utility token of the system with floating value. The dual-token system has been designed to allow Celo stablecoins to maintain their peg with fiat currencies through adjusting the supply and demand of the CELO token.

To provide an additional safety buffer, Celo also employs a basket of diversified cryptocurrencies held as reserves to support the peg. This stability mechanism can thus be defined as a hybrid crypto-collateralization / seigniorage-style model. The reserve is currently equal to 8 times the outstanding stablecoin amount issued by Celo and it is composed of CELO tokens for 76% whereas the remaining portion is composed of BTC, ETH, other stablecoins like DAI and nature-backed assets like cMCO2, a tokenized version of carbon credit. By allocating a fraction of the reserve assets to natural capital, the reserve can create an incentive mechanism that aligns demand for stablecoins with the protection of natural capital and act as a large-scale carbon sink.

Market participants can contribute in maintaining the Celo Dollar (or cEUR) price aligned to the parity by taking profits whenever deviations occur. This mechanism, called Mento, allows CELO token holders to exchange a dollar worth of CELO for one Celo Dollar. When demand for the Celo Dollar rises and the market price is above the target, an arbitrage profit can be achieved by swapping a dollar worth of CELO for one Celo Dollar and selling that Celo Dollar for the market price.

Similarly, when demand for the Celo Dollar falls and the market price is below the target, an arbitrage profit can be achieved by purchasing Celo Dollars at the market price, exchanging it with the protocol for one US Dollar worth of CELO, and selling CELO to the market. This allows market participants to maintain the Celo Dollar price aligned to $ 1 with minimal intervention from the protocol. It is worth mentioning that the Mento mechanism has a variant, called Granda Mento, which is employed when the protocol needs to exchange large amounts of CELO for Celo stable tokens without incurring in excessive slippage.

Coexistence of multiple stablecoins

Platforms and projects having the ambition to provide products and services with a global reach should be flexible enough to meet customer needs from all over the world. A stablecoin pegged to the US dollar could be unsuited for payments in countries that adopt different fiat currencies. Therefore, Celo allows the creation of multiple stablecoins for users. The stablecoin pegged to the Euro, cEUR, has been launched in early 2021 and other stablecoins can be added in the future to track, among others, Japanese Yen or Brazilian Real.

The stability of each stablecoin is managed on a standalone basis through a specific Mento mechanism. New stablecoins are introduced via a governance process to ensure platform sustainability. To avoid a new asset having a negative impact on the stability of the other tokens (e.g. if it has high volatility) Celo uses a proof-of-bonded-stake model to vote on new introductions. Celo holders are then expected to vote in favor of a new stablecoin only if they think such stablecoin could experience a stable and sustainable growth with no harm for the ecosystem.

Lastly, it’s worth noting that the reserve pool doesn’t need to be the same for all stablecoins. Reserves could be created based on the specific characteristics of the stablecoin and the use cases this stablecoin will be employed for. For instance, in the context of stablecoins used by local communities for remittance payments, some of the local reserve currency could get distributed to local inhabitants, which would allow them to benefit from the adoption of the local stablecoin, acting like a social dividend in the process.

Mobile phone wallets for a global reach

Wallets are an essential tool to manage cryptocurrency payments. Most of them are certainly not as immediate as a smartphone can be and not easily accessible for communities with scarce access to personal computers. Celo aims at broadening its customer base and improving the user experience when it comes to pay with cryptocurrencies by introducing a phone-number based identity system. This mechanism ties a phone number to a Celo address and, when a payment is instructed, the phone number acts as a wallet address. This approach does not compromise the user’s privacy since a hash plus a pseudorandom pepper of the phone number is stored on the blockchain without need to share the actual phone number. The Celo public address allows the user to attach multiple phone numbers to the same address, change associated numbers and/or revoke them at any time.

Mobile phones are not the only tool at the user’s disposal since any device that can receive secure messages could be employed such as IP addresses or bank routing and account numbers. Finally, attaching phone numbers to Celo addresses enables capturing reputation (like a credit score). Celo employs EigenTrust, a decentralized algorithm where a phone number’s score is defined by the number of other phones who trust it weighted by their reputation scores (similar to how PageRank works). Whereas payments among a small group of known people do not create particular trust issues, when it comes to executing transactions with people outside of a direct circle of contacts, it is useful for a user to be able to aggregate the trust signals of those in their network to make purchase, payment, and credit decisions.

The regulatory stance on stablecoins

Stablecoins are the representation of fiat currencies on the blockchain. It is not surprising that financial and monetary regulatory authorities have intensified their efforts in understanding potential impacts of stablecoin usage on consumer protection and financial stability. The U.S. Treasury Department recently met with several industry participants to discuss the risks and benefits posed by stablecoins. The two main concerns coming from regulators are the following:

• “Bank run” scenario: if, at a certain point in time, a large number of customers wants to redeem their stablecoins in exchange for the underlying fiat currencies, stablecoin issuers may not be able to serve all customers if reserves are not sufficient or not readily available.
• Monetary policy effectiveness: there could be a significant disconnection between the rate of return of one dollar in the real economy and one dollar on the blockchain. In some cases, the return of these fiat currencies is even negative.This discrepancy could lead people to move their savings away from traditional financial institutions, making monetary policy much less effective. The risk of this scenario materializing has been clear when Coinbase announced the introduction of its Lend feature aimed at allowing USDC depositors to earn a 4% annual percentage yield. Coinbase’s chief legal officer wrote that the SEC threatened to sue the company if it launched such a product. According to Brian Armstrong, Coinbase’s CEO, the SEC informed the company that the lend feature would be considered a security, meaning it would be regulated as an investment. Regardless of being a security or not, it’s quite clear that stablecoin deposit yields represent a serious threat to banks’ retail funding composed of customer deposits with a current remuneration rate close to zero.

What are the regulatory measures that are most likely to be employed to address these two issues? A recent paper called “Taming wildcat stablecoins”, published by two Federal Reserve economists, could provide some frames to understand what the backbone of the incoming regulatory framework for stablecoins could be:

• Treat stablecoins as bank deposits: this would force stablecoin issuers to conduct their business within a licensed bank. The stablecoin issuer could become a licensed bank itself, or it could choose to conduct its stablecoin activities through a partnership with a licensed bank (as Facebook is reportedly planning to do with its stablecoin, Diem). If the stablecoins are sold to retail customers, that would be the equivalent of accepting retail deposits, and the bank then also would be required by law to carry FDIC insurance.
• Designate stablecoins as “systemically important payment instruments”: this would allow Fed to impose stricter controls and closer monitoring on risk management activities carried out by stablecoin issuers. The authors posit that the “Federal Reserve could then require stablecoins to be issued from FDIC-insured banks or require stablecoin issuers to hold cash reserves at the Federal Reserve one-for-one (i.e., transform stablecoins into public money).
• Replace stablecoins with public digital money in the form of Central Bank Digital Currencies (CBDC): one of the main purposes of CBDC is to protect the US dollar from the competition of private forms of digital currencies.

Being forced to ensure full compliance to the Federal Reserve will effectively tie down stablecoins to U.S. monetary oversight. A potential way out from this scenario could be represented by the retaliation of other countries. China, Russia and the European Union have all taken steps or voiced concerns to move past the dollar-dominant financial system. These three countries have also actively regulated cryptocurrencies or started building their own digital currency. It is very likely that if Treasurys-backed stablecoins emerge, these countries will issue stablecoins backed by their own currencies into the wider cryptocurrency market. CBDCs, private and public-private stablecoins denominated in different currencies could emerge as a counter to U.S.-centered regulation of stablecoins.

Poised to withstand regulatory challenges?

When it comes to predict how harmful the impact of regulation will be on stablecoins, the characteristics that put Celo in a favorable position can be summarized as follows:

• Low reliance on stablecoin reserves: algorithmic stablecoins could theoretically remain out of the regulatory loop. For instance, according to the EU Markets In Crypto Assets (MiCA) Regulation, algorithmic stablecoins “should not be considered as asset-referenced tokens, provided that they do not aim at stabilising their value by referencing one or several other assets.”. The hybrid nature of the Celo stability mechanism could however put its stablecoins in a middle ground that makes the regulatory treatment more uncertain. On the other hand, the smart contract that underlies Celo stablecoins is easier and cheaper to audit than it is to evaluate the credit risk of a bank holding collateral for other stablecoins.
• Decentralized governance: an algorithmic stablecoin is a representation of what true decentralization looks like, without any regulatory bodies to maintain or watch over the proceedings, as the code is responsible for supply and demand adjustments around the target price. Celo has a decentralized stablecoin governance structure that ensures the absence of an accountable entity for regulators.
• Stablecoin diversification: the stablecoins exposure to different fiat currencies allows Celo to operate in countries with a more accommodative regulatory stance on stablecoins and cryptocurrencies and avoid excessive concentration under US watchdogs scope.
• Low dependence on traditional DeFi uses: since Celo stablecoins are mainly used for payment purposes, the impact deriving from a potential shutdown of decentralized exchanges or lending platforms would be limited compared to asset-backed stablecoins.

The evolution of stablecoins can no longer ignore supervisory authorities and their attempts to limit their reach to preserve the status quo. The chance of observing a clear bifurcation between highly centralized and highly decentralized stablecoins cannot be excluded. While the latter undoubtedly have great innovation potential, they have to establish trust to gain traction and stop being considered as speculative assets in disguise.

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