Cryptographic Proof: Oracles & Stablecoins

Exploring the role of decentralized oracles in securing external data for blockchains and maintaining the price pegs of stablecoins.

Defining the Web3 term stablecoin from the broadest perspective is rather straightforward. Stablecoins are crypto assets which maintain a stable spot price, pegged to the spot price of a given non-crypto asset. USDC tracks the spot price of the US dollar, and Paxos Gold’s (PAXG) price is pegged to the price of one ounce of gold, for instance. Investors are thus able to gain exposure to either asset while benefiting from the liquidity of crypto exchanges and blockchain technology.

Since stablecoins make up a substantial amount of value circulating in DeFi applications, they require the same security guarantees of blockchains and the dApps on which they’re used. The interconnectedness, or composability, of Web3 demands that stablecoins be as robust as any other component of the ecosystem. 

Effectively, this means that oracles must be decentralized and have several layers of cryptographic security. This provides transparency and trust to the users of these stablecoins, as they can be sure that their wealth is conserved digitally rather than double-spent, inflated away with fractional reserve issuance or lending, or otherwise misused by stablecoin issuers. With SupraOracles, price pegs can be maintained to the highest degree of certainty since refresh rates take place in a matter of seconds.

Digging deeper, there are two main categories of stablecoins: directly collateralized and algorithmic. Stablecoins which are directly collateralized tend to be held by a centralized third-party which backs their stablecoins with a 1:1 ratio of stablecoins to pegged assets. 

On the other hand, algorithmic stablecoins are dynamically minted or burned in real-time to adjust the circulating supply of issued stablecoins in accordance with the demand, thus adjusting the price upwards or downwards to maintain a stable price peg to the given asset.

Decentralized Web3: Cryptographic Truths & Transparency

Blockchain technology and Web3 more broadly has transformed the expectations people have regarding transparency and accountability when it comes to finance. That is, with transparent and immutable shared ledgers in the forms of blockchains, users expect to know that they can trust the solvency of the entities responsible for their assets.

Bitcoin was, of course, the supernova which exploded into existence in 2009, introducing immutability, transparency, decentralization, and strict rules governing the issuance of new Bitcoins on the blockchain. 

Of course, it’s important to note that transactions made on the blockchain can’t be reversed even if the payment is made accidentally or funds are sent to the wrong address. Therefore, a greater amount of care and responsibility must be taken since one cannot call the bank and ask them to step in and correct such mistakes.

Since blockchain transactions are irreversible, and without central custodians to take responsibility for users’ assets, there can be no room for error. With fiat banks, fraud can take place, but infrastructure exists to either revert or freeze the stolen funds and make the defrauded user whole again.

The bank serves as the trusted entity which can step in to manipulate their ledger if needed. This cannot be done on the blockchain since the ledger is shared by all nodes on the network and therefore immutable since one cannot rewrite the ledger history without the consensus of network participants.  

Regardless of the sort of stablecoin under examination, all require accurate pricing data from decentralized oracles. Oracles are needed to constantly fetch the spot prices of various commodities and currencies and refresh the on-chain prices accordingly to maintain their price pegs, even for stablecoins simply backed 1:1 with fiat banknote deposits.

Without tamper-proof and robust oracles, entire blockchain ecosystems could be compromised, causing trades to execute based on false or stale price data. After all, the value of fiat currencies fluctuate in relationship to one another as well as other commodities all the time. 

Thus, Web3 is an Internet of decentralization, accountability, network consensus, and cryptographic proof. That is, financial agreements and transactions online must adhere strictly to cryptographic primitives, on-chain transparency, and the immutability of blockchains. SupraOracles will play a major role in securing these characteristics, particularly with regards to auditing tokenized assets and stablecoins.

Stablecoin Issuance: DeFi vs. CeFi

Stablecoins may be issued from a centralized custodian which holds the collateralized assets in an off-chain account, or otherwise issued by a decentralized protocol, with collateral for the assets held on a blockchain’s ledger. Each option presents unique pros and cons, and calls for different methods of auditing in order to verify the stablecoins are indeed backed by exactly the collateral value which they purport to represent. 

For instance, centralized custodians which hold fiat US dollars in a bank account, for instance, must make use of oracles to provide transparency through proof of reserve audits. Such issuers of stablecoins require a layer of trust in the given custodian, hence the need for a third party to increase transparency of the custodian and issuer of the coins. 

That is, oracles must regularly seek the US dollar deposits in a given custodian’s account and ensure the amount is in accordance with the number of stablecoins issued and in circulation. A notable example of this is Coinbase’s USDC, which pegs its value to the dollar and is backed 1:1.

Alternatively, decentralized issuers of stablecoins are overcollateralized by crypto-assets which can be audited on-chain. This is possible since all assets on public blockchains are transparently verifiable, providing constant accountability in the form of on-chain audits. This removes the necessity for depositors to ‘trust’ third parties to honestly report and maintain appropriate collateral for issued stablecoins, hence the term trustless has come to be associated with decentralized protocols. 

Central banks around the world have also begun issuing their own stablecoins, also called digital currencies (CBDCs), backed by sovereign governments and their local fiat currencies, each with their own collateralization and auditing requirements. These may or may not be as transparent as decentralized or private stablecoin issuers depending on local circumstances and the nature of their financial reporting and regulatory agencies. 

After all, collateralization levels of fiat-to-debt issuance at central and commercial banks do not match the 150%+ levels of their crypto counterparts. In the US, fractional-reserve lending allows fiat banks with less than $16.3 million in assets to issue debt without any reserve requirement. Larger banks with more assets are only required to hold between 3%-10% of the debt they issue in fiat reserves.

Proof of Reserve Audits & Rebasing Algo-Stablecoins with Decentralized Oracles

As mentioned, stablecoins maintain their peg to commodities or fiat currencies by using direct collateral or algorithmically, using an elastic supply that is burned or minted on-chain. In order to provide depositors with confidence that stablecoins are indeed backed by assets of equal value, decentralized oracles must constantly monitor the reserves of the stablecoin issuer to provide verifiable and transparent on-chain proof that their reserves and circulating stablecoin supply are in order.

The mechanism of verifying the reserves of a stablecoin or other crypto asset is called a Proof of Reserves (PoR) audit. Oracles fetch the data needed for stablecoin issuers to maintain a high degree of accuracy as to the true collateralization of the stablecoins they’ve issued into circulation.

PoR reference feeds can be operated autonomously by decentralized networks of oracles. Since the transparent auditing of collateral is constantly being conducted in real-time, users’ funds are protected from fraudulent activity, black swan security breaches, fractional reserve trickery, or other misuse of deposits coming from stablecoin issuers.

Paxos uses an oracle-based PoR auditing system for their USD stablecoin Paxos Standard (PAX) and their gold-backed token, PAX Gold (PAXG). However, the refresh rate of their oracle’s price feeds may not be fast enough if the USD or Gold spot prices experienced elevated volatility. 

As mentioned, some algorithmic stablecoins maintain their peg by burning or minting coins in relation to the collateral which backs them, relying on oracles to constantly relay spot prices back to the stablecoin issuers so that the peg is maintained as close to the spot price as possible. MakerDAO is an example of a decentralized protocol which uses oracles and adjustable interest rates, issuing a US dollar stablecoin known by its ticker symbol DAI. 

MakerDAO, a decentralized stablecoin protocol, maintains its peg by having users lock up collateral into smart contracts via overcollateralized debt positions. The smart contract allows users to borrow a minted stablecoin, known as DAI, at fixed interest rates depending on which tier of overcollateralization users choose. For instance, higher interest rates go along with overcollateralized Ethereum deposits of 130% of the DAI borrowed, with better rates offered for deposits reaching 170% overcollateralization.

Protocols which use oracles to provide live PoR audits provide transparency for users as they prove the true backing of the tokens that they hold. These oracle-based audits also provide collateralization data on the pegged assets, increasing the transparency of stablecoins. This also encourages healthy incentives for lenders and borrowers of these tokens since Web3 overcollateralization standards increase accountability for all of the participants.

Web3 Composability: Oracles Essential to Stability

Oracles are absolutely essential for fetching and validating external data for stablecoin issuers, smart contract platforms, NFT marketplaces, and more. Without a high throughput oracle to keep the data faucet on full throttle, DeFi’s usefulness and risk of slippage will be negatively impacted without paying high gas, driving up the cost of operations and creating further network congestion as they do on other blockchains. Thus, oracles bear the responsibility of fostering trust in crypto assets by adding layers of verifiable cryptographic randomness and decentralization to the Web3 ecosystem. 

Perhaps due to the novelty of digital assets and DeFi in particular, the legitimacy necessary for stablecoin issuers to gain further adoption will inevitably come down to gaining the trust of depositors through transparency and demonstrations of healthy reserves. Oracles will thus increase stability across the digital asset ecosystem as global adoption takes place in the coming years and traditional assets find themselves moving back and forth from Web3 protocols. 

Given the composability of blockchains, dApps, and crypto assets, SupraOracles adheres strictly to the principles of decentralization and verifiable randomness in order to secure digital assets and the liquidity between traditional and Web3 assets. For stablecoin issuers that maintain off-chain fiat or commodity reserves, recurring PoR audits by SupraOracles will provide transparency and accountability for the issuer and monitor the health of their reserves and Web3 protocols more broadly.

References

1. CB Insights Research Report. (2022, 25 Jan.). What are stablecoins? CB Insights. 
2. GeoEconomics Center. (2021, 20 Apr.) The rise of central bank digital currencies. Atlantic Council.
3. Maxwell, A. (2021, 19 Oct.). The world of cryptographic proof. World Magazine.
4. Prathap, M. (2021, 24 Dec.). Top 6 stablecoins in the crypto market — what are they, how they work and why they have governments worried. Business Insider India. 
5. Robinson, D. (2021). Stablecoins and oracles [Lecture 9 PDF]. Stanford Computer Science: 251.

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