Stablecoins have become a cornerstone of the DeFi economy since their introduction. Without stablecoins, DeFi would not operate in its current form. While USDT and USDC are the most widely used stablecoins today, there are actually 75 different stablecoins active in the DeFi ecosystem as of this writing.
Despite the variety, stablecoins often receive less attention compared to trending sectors like derivatives, privacy, or blockchain gaming. In a competitive market, the recent introduction of the 4pool has sparked concerns about the future of DAI. This article explores DAI’s underlying mechanisms and how the 4pool might affect its trajectory.
Although stablecoins gained significant traction around 2020, the concept dates back further. In 1996, E-Gold was created as a digital currency fully backed by gold and silver—making it arguably the first stablecoin. In 2006, Liberty Reserve emerged as a centralized digital currency service enabling anonymous currency exchanges between users. However, it wasn't until 2020 that stablecoins truly entered the mainstream.
Why Did Stablecoins Become Popular?
Issues with Traditional Finance and the Rise of DeFi
The global financial system is a foundational pillar of modern society, enabling value exchange and incentivizing productive activities. However, traditional finance relies heavily on centralized authorities, creating risks such as mismanagement, fraud, and systemic corruption.
The Great Recession exposed critical flaws in this centralized model, where problems at a few major institutions triggered a domino effect leading to global economic turmoil. This catalyzed the development of DeFi—an open, permissionless, and transparent financial ecosystem operating without central intermediaries.
As DeFi grew, so did the demand for stablecoins. These digital assets combine the stability of fiat currencies with the liquidity and utility of cryptocurrencies. They are typically pegged to fiat currencies like the US dollar, making them ideal for storing value and facilitating trades within volatile crypto markets.
Stablecoins serve four primary functions:
- A stable store of value resistant to market fluctuations
- A medium of exchange for peer-to-peer transactions
- A unit of account with predictable pricing
- A standard for deferred payments and debt settlement
The Emergence of Decentralized Stablecoins
The crypto community, always pushing for innovation, sought alternatives to centralized stablecoins like USDT and USDC. They desired a truly decentralized stablecoin.
The Rise of DAI
DAI became the first decentralized stablecoin to successfully maintain its peg. Earlier attempts, such as Empty Set Dollar (ESD) and Dynamic Set Dollar (DSD), had failed.
Launched in 2017, DAI started as the Single Collateral DAI (SAI) system, where users could borrow DAI using only ETH as collateral. The supply of DAI depended on the total value of collateral and the collateralization ratio. As a collateralized debt position (CDP) stablecoin, outstanding loans played a crucial role in maintaining the peg.
When DAI traded above its dollar peg, borrowers were incentivized to take more loans against their collateral and sell DAI on the market. This increased the circulating supply, pushing the price back down. Conversely, when DAI traded below the peg, borrowers could buy DAI at a discount to repay loans, creating buying pressure and reducing supply.
In 2019, Multi-Collateral DAI (DAI) was introduced, allowing multiple assets as collateral. This diversification was intended to strengthen the peg by providing better backing for minted DAI.
The Role of the 3Pool and Peg Stability Module
Despite these mechanisms, DAI still experienced significant volatility. Its stability improved notably after the deployment of the 3pool on Curve Finance and the introduction of the Peg Stability Module (PSM) in December 2020. The 3pool—consisting of DAI, USDC, and USDT—provided deep liquidity, while the PSM allowed users to mint DAI using USDC at a 1:1 ratio without fees.
These developments suggest that DAI’s stability relies heavily on its integration with centralized stablecoins like USDC and USDT rather than solely on decentralized collateral.
Other decentralized stablecoins, such as TerraUSD (UST) and Frax (FRAX), also depended on the 3pool for liquidity. UST was fully algorithmic, while FRAX used a hybrid model. Both offered substantial bribes to incentivize liquidity, highlighting the pool’s importance for peg stability.
Key Insight: DAI’s success as a stablecoin is closely tied to the 3pool and PSM, raising questions about its decentralization.
Is DAI Truly Decentralized?
To assess DAI’s decentralization, we must examine the 3pool and PSM.
The 3pool Mechanism
The 3pool on Curve Finance enables efficient, low-slippage trading between DAI, USDC, and USDT. With over $3.54 billion in total value locked (TVL), it ensures deep liquidity for DAI, effectively anchoring it to USDC and USDT.
MakerDAO’s Peg Stability Module
The PSM allows users to mint DAI using USDC as collateral at a 100% ratio. As of now, 52% of DAI is backed by USDC through the PSM. This direct linkage to a centralized stablecoin further challenges DAI’s decentralized narrative.
Key Insight: DAI functions largely as a proxy for USDC and USDT, relying on them for stability.
Will the 4pool Replace DAI?
The recent proposal for a 4pool—adding UST and FRAX to the existing 3pool assets—threatens to disrupt this equilibrium. The 4pool aims to become the primary stablecoin pool on Curve Finance, potentially draining liquidity from the 3pool.
FRAX and UST are the largest contributors to the 3pool’s TVL. If they migrate to the 4pool, other assets may follow, especially given the incentives offered by the 4pool alliance—including BadgerDAO, OlympusDAO, and Tokemak.
This group collectively controls over 62% of the vote-locked CVX (vlCVX) through Convex Finance, giving them significant influence over Curve’s governance. Historical data shows that FRAX and Terraform Labs (TFL) have been top bribe contributors on Votium, suggesting strong motivation to shift liquidity.
Key Insight: The 4pool could successfully attract liquidity away from the 3pool, destabilizing DAI’s primary support mechanism.
Conclusion
The 3pool’s potential decline poses a significant risk to DAI. If liquidity migrates to the 4pool, DAI may struggle to maintain its peg, leading to cascading effects across the DeFi ecosystem. While the outcome remains uncertain, stakeholders should monitor these developments closely.
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Frequently Asked Questions
What is DAI?
DAI is a decentralized stablecoin pegged to the US dollar. It is backed by collateralized debt positions and operates on the Ethereum blockchain.
How does the 4pool affect DAI?
The 4pool may drain liquidity from the 3pool, which is critical for DAI’s stability. This could challenge DAI’s ability to maintain its peg.
Is DAI fully decentralized?
While DAI aims to be decentralized, it relies heavily on centralized stablecoins like USDC through mechanisms like the Peg Stability Module.
What are the main uses of stablecoins?
Stablecoins serve as a store of value, medium of exchange, unit of account, and standard for deferred payments in decentralized finance.
How does Curve Finance help stablecoins?
Curve provides liquidity pools with low slippage, enabling efficient trading and peg stability for stablecoins like DAI.
What risks does DAI face?
DAI faces risks from liquidity shifts, reliance on centralized assets, and competition from new pools like the 4pool.