Cryptographic Proof: Oracles and Stablecoins

Explore the role of decentralized oracles in securing data external to the blockchain and maintaining stablecoin price pegs.

Table of contents

• Decentralized Web3: Encrypted Truth and Transparency

• Stablecoin issuance: DeFi vs. CeFi

• Proof of Reserve Audits and Rebasing of Algorithmic Stablecoins Using Decentralized Oracles

• Web3 composability: Oracles are critical to stability

• References

Defining the Web3 term stablecoin in the broadest sense is fairly simple. Stablecoins are crypto assets that maintain a stable spot price, pegged to the spot price of a given non-crypto asset. USDC tracks the spot price of the U.S. dollar, and for example, the price of Paxos Gold (PAXG) is pegged to the price of an ounce of gold. Investors are therefore able to gain exposure to both assets while benefiting from the liquidity of cryptocurrency exchanges and blockchain technology.

Since stablecoins constitute a large amount of the value circulating in DeFi applications, they need to provide the same security guarantees to the blockchain and the dApps that use them. The interconnectedness or composability of Web3 requires stablecoins to be as strong as any component of the ecosystem.

In practice, this means that oracles must be decentralized and have multiple layers of cryptographic security. This provides transparency and trust to users of these stablecoins, as they can be certain that their wealth is held digitally and not double-spent, inflated through fractional reserve issuance or loans, or otherwise abused by stablecoin issuers. With SupraOracles, the price peg can be maintained with the highest degree of certainty, as the refresh rate occurs within seconds.

At a deeper level, stablecoins fall into two main categories: directly collateralized and algorithmic. Directly collateralized stablecoins are often held by a centralized third party that backs their stablecoins at a 1:1 ratio of stablecoins to the underlying asset.

Algorithmic stablecoins, on the other hand, are dynamically minted or destroyed in real time to adjust the circulating supply of issued stablecoins based on demand, thereby adjusting the price upward or downward to maintain a stable price peg to a given asset.

Decentralized Web3: Encrypted Truth and Transparency

Blockchain technology and Web3 more broadly change expectations around financial transparency and accountability. That is, through a transparent and immutable shared ledger in the form of a blockchain, users expect to know they can trust the solvency of the entities responsible for their assets.

Bitcoin, of course, was the supernova that went off in 2009, introducing immutability, transparency, decentralization, and strict rules governing the issuance of new bitcoins on the blockchain.

Of course, it is important to note that transactions made on the blockchain cannot be reversed, even if an accidental payment is made or funds are sent to the wrong address. Therefore, greater caution and responsibility must be exercised, as one cannot call a bank and ask them to step in and correct such errors.

Since blockchain transactions are irreversible and there is no central custodian responsible for a user’s assets, there is no room for error. With fiat banks, fraud can occur, but the infrastructure exists to recover or freeze stolen funds and make the defrauded user whole again.

“Without tamper-proof and robust oracles, the entire blockchain ecosystem could be compromised, resulting in transactions being executed based on false or stale price data.”

The bank, as a trusted entity, can step in to manipulate its ledger when needed. This cannot be done on a blockchain because the ledger is shared by all nodes on the network and is therefore immutable as the ledger history cannot be rewritten without the consensus of the network participants.

Regardless of which stablecoin is examined, accurate pricing data from a decentralized oracle is required. The oracle needs to constantly fetch spot prices for various commodities and currencies and update the on-chain price accordingly to maintain its price peg, even for stablecoins that are simply backed 1:1 with fiat paper deposits.

Without tamper-proof and robust oracles, the entire blockchain ecosystem could be compromised, causing transactions to be executed based on false or stale price data. After all, the value of fiat currencies fluctuates all the time in relation to each other and other commodities.

Web3 is therefore an internet of decentralization, accountability, network consensus, and cryptographic proofs. That is, online financial protocols and transactions must strictly adhere to cryptographic primitives, on-chain transparency, and the immutability of the blockchain. SupraOracles will play an important role in protecting these characteristics, especially in auditing tokenized assets and stablecoins.

Stablecoin issuance: DeFi and CeFi

Stablecoins can be issued by centralized custodians who hold collateral assets in off-chain accounts, or by decentralized protocols that provide collateral for assets held on the blockchain ledger. Each option has unique advantages and disadvantages and requires different audit methods to verify that stablecoins are indeed backed by the value of the collateral they claim to represent.

For example, a centralized custodian that holds fiat dollars in a bank account must use oracles to provide transparency through proof of reserve audits. Such stablecoin issuers require a certain level of trust in a given custodian, so a third party is needed to provide transparency to both the custodian and the issuer.

That is, the oracle must periodically search for USD deposits in a given custodian’s account and ensure that the amount is consistent with the number of stablecoins issued and in circulation. A notable example is Coinbase’s USDC which pegs its value to the US dollar and is backed 1:1.

If stablecoins are to represent real and verifiable value on the blockchain, they must be backed by off-chain assets.

Alternatively, decentralized stablecoin issuers are overcollateralized with crypto assets that can be audited on-chain. This is feasible because all assets on public blockchains are transparently verifiable, providing ongoing accountability in the form of on-chain audits. This eliminates the need for depositors to “trust” a third party to honestly report and maintain appropriate collateral for issued stablecoins, and thus the term “trustless” has become associated with decentralized protocols.

Central banks around the world are also beginning to issue their own stablecoins, also known as digital currencies (CBDCs), backed by sovereign governments and their local fiat currencies, each with their own collateralization and auditing requirements. Depending on the local context and the nature of their financial reporting and regulatory bodies, these may or may not be as transparent as decentralized or private stablecoin issuers.

After all, the collateralization levels of fiat debt issuance by central and commercial banks do not match the 150%+ levels of their cryptocurrency counterparts. In the U.S., fractional reserve lending allows fiat banks with less than $16.3 million in assets to issue bonds without any reserve requirements. Larger banks with more assets only need to hold 3%-10% of the fiat debt they issue in reserve.

Proof of Reserve Audits and Repositioning Algorithmic Stablecoins Using Decentralized Oracles

As mentioned earlier, stablecoins maintain their peg to a commodity or fiat currency using an elastic supply that is destroyed or minted on-chain, either through the use of direct collateral or algorithms. In order for depositors to trust that stablecoins are indeed backed by assets of equivalent value, decentralized oracles must constantly monitor the reserves of stablecoin issuers to provide verifiable and transparent on-chain proof that their reserves and circulating stablecoin supply are in order.

The mechanism for verifying the reserves of stablecoins or other crypto assets is called a Proof of Reserves (PoR) audit. Oracles obtain the data that stablecoin issuers need to maintain a highly accurate understanding of the true collateralization of the stablecoins they have issued into circulation.

The PoR reference feed can be operated autonomously by a decentralized oracle network. Since transparent audits of collateral are constantly happening in real-time, users’ funds are protected from fraudulent activity, black swan security breaches, fractional reserve scams, or other abuses of deposits from stablecoin issuers.

Stablecoin reserve audits that show excess collateral reserve levels both increase investor confidence and promote incentives for stablecoin issuers and custodians to make reasonable decisions.

Paxos uses an oracle-based PoR auditing system for its USD stablecoin Paxos Standard (PAX) and its gold-backed token PAX Gold (PAXG). However, if the USD or gold spot prices experience wild swings, their oracle prices may not update fast enough.

As mentioned earlier, some algorithmic stablecoins maintain their pegs by destroying or minting coins tied to the collateral backing them, relying on oracles to continually relay the spot price back to the stablecoin issuer to keep the peg as close to the spot price as possible. MakerDAO is an example of a decentralized protocol that uses oracles and an adjustable interest rate to issue a USD stablecoin with the ticker DAI.

MakerDAO is a decentralized stablecoin protocol that maintains its peg by having users lock collateral in a smart contract through an overcollateralized debt position. The smart contract allows users to borrow a minted stablecoin, called DAI, at a fixed interest rate, depending on the overcollateralization tier selected by the user. For example, a higher interest rate comes with an overcollateralized Ethereum deposit of 130% to borrow DAI, with a better interest rate for deposits that reach 170% overcollateralization.

Protocols that use oracles to provide real-time PoR audits provide transparency to users as they prove the real-world backing of the tokens they hold. These oracle-based audits also provide collateral data for the pegged assets, increasing transparency in stablecoins. This also encourages healthy incentives for lenders and borrowers of these tokens as the Web3 overcollateralization standard increases accountability for all participants.

Web3 composability: Oracles are critical to stability

Oracles are absolutely necessary to obtain and verify external data for stablecoin issuers, smart contract platforms, NFT marketplaces, etc. Without high-throughput oracles to keep data taps running at full speed, the usefulness and slippage risk of DeFi will be negatively affected without paying high gas fees, driving up operational costs and causing further network congestion as on other blockchains. Therefore, it is the responsibility of oracles to promote trust in crypto assets by adding verifiable cryptographic randomness and a layer of decentralization to the Web3 ecosystem.

Perhaps due to the newness of digital assets and DeFi, the legitimacy necessary for stablecoin issuers to gain further adoption will inevitably come down to gaining the trust of depositors through transparency and proof of healthy reserves. As a result, oracles will increase the stability of the entire digital asset ecosystem as global adoption grows in the coming years and traditional assets find themselves moving back and forth across Web3 protocols.

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