AI-Powered Stablecoins: Enhancing Stability and Trust in DeFi

Among the most promising use cases at the convergence of AI and blockchain technology are AI-powered Stablecoins. This article complements the posts already made for exploring AI-powered credit scoring, yield optimization, and how AI is driving the future of finance across DeFi.

We’ll begin by briefly explaining stablecoins and their role in the crypto industry. We’ll then examine the different kinds, focusing on crypto-backed overcollateralized stablecoins, before ending with an exploration into the role of AI and how it can enhance this dynamic sector.

Stablecoin Fundamentals

Some people reading this may already be familiar with stablecoins and their role in the crypto ecosystem. For those unfamiliar with the term, stablecoins are a type of cryptocurrency tied to the price of a commodity or another currency. Their price remains stable because they are constantly pegged to the same value as the commodity or currency they represent. Stablecoins provide an essential role for several reasons. 

They offer direct, fast, and inexpensive payment rails between parties on a global scale. Compared to the legacy SWIFT system, which is expensive and cumbersome, stablecoins offer a dynamic and cheap alternative. These payment rails are highly effective for companies with a global workforce and provide an easy, standardized payment option.

The same applies to remittance payments. Stablecoins are cutting edge compared to legacy remittance payment providers, which are slow and inconsistent. They instantly provide anyone who uses them with basic banking instruments. In regions where much of the population cannot access bank accounts or where banks are unstable, corrupt, and experiencing high inflation, stablecoins provide a financial lifeline.

Stablecoins also effectively hold positions within crypto markets. While most regions tax crypto gains whenever the tokens get sold, stablecoins provide an intermediary service that can hold traders' positions at a constant price during periods of higher market volatility without triggering a taxable event.

Not all Stablecoins are Created Equal

Stablecoins that maintain an active peg with another currency like $USDT and $USDC do with the U.S. dollar can use different mechanisms to maintain parity with the pegged real-world currency. Fully collateralized fiat-backed stablecoins are the most commonly used, while overcollateralized crypto-backed stablecoins are still popular, with algorithmic stablecoins falling out of favor since the Terra LUNA ecosystem collapse.

Fully Collateralized Fiat-Backed Stablecoins

As previously mentioned, $USDT and $USDC are among the two most recognizable fiat-backed stablecoins, with over $165 billion combined circulation. By being fully collateralized on a one-to-one basis with the currency they represent, they also pose the least risk of all the stablecoins.

The mechanism they use to operate is simple. A user purchases the stablecoin in the equivalent denomination of USD. The stablecoin issuer then deposits that $USD in a bank and issues the equivalent amount of stablecoins to the purchaser. The issuer can then use the depositors' USD within the bank to hold short-term treasury bonds and begin earning interest, while the depositor can take the issued stablecoin and use it anywhere it is accepted.

Over Collateralized Crypto-Backed Stablecoins

Stablecoins were identified early as valuable tools for developing a fully decentralized financial system. Crypto-backed stablecoins were designed to maintain the quality of decentralization by not having a central issuer. In 2014, MakerDAO was formed, and it spent the next three years developing a crypto-backed stablecoin. The original version of its coin, which would later become DAI, was launched in December 2017. 

ETH solely backed this early version. It was known as the Single-Collateral Dai (SAI) but was viewed as having too much risk concentrated under a single cryptocurrency as a backer, so the full Multi-Collateralized Dai (DAI) would launch two years later in 2019.

The concept of a stablecoin collateralized by an unstable asset was an innovative breakthrough for the space. However, given how volatile the crypto market is at any given time, a crypto-backed stablecoin would need a mechanism to protect the issuer from bankruptcy if the underlying asset begins to lose value. DAI found a solution through a series of methods, such as over-collateralizing the issuance of DAI when purchasing and the option to re-collateralize the underlying asset if the underlying value dropped.

DAI is unique in how it is issued. Unlike the centrally controlled, fully collateralized, fiat-backed stablecoins, DAI does not have a central issuer. Anyone can issue more DAI by engaging with any lending protocols issued by MakerDAO (since rebranded to Sky). A user borrows DAI by overcollateralizing the loan with their other cryptocurrencies. The smart contract then issues the borrower a collateralized Debt Position (CDP) and releases the amount of the determined DAI. If the collateralized cryptocurrencies' value dips below the stable DAI's value, the borrower can recollateralize the position by adding more crypto or they may sell off and close out the underlying position

Algorithmic Backed Stablecoins

A number of stablecoin projects have attempted to create fully algorithmic stablecoins that manage the backing of the stablecoin’s supply and demand purely through algorithmic formulas. BitUSD and NuBits were early iterations in 2014, but both ultimately failed due to a lack of diversification and backing of volatile assets. NuBits was backed by Bitcoin and lost its peg when Bitcoin’s price crashed in 2016. The crash left BitUSD lacking capital to maintain the pegged price at $1. BitUSD had a similar experience when it backed its stablecoin solely with BitShares, and lost its peg in 2018.  

However, the most notable algorithmic stablecoin crash came in May 2022 when the Terra ecosystem’s UST stablecoin collapsed. The collapse was prompted by a crisis in confidence of the broader Terra ecosystem, specifically its Anchor savings platform that paid out users up to 20% for depositing their savings. With a lack of confidence that the Anchor protocol would be able to sustain its rates, users began taking out their savings. This reaction caused a decline in the price of the larger ecosystem’s LUNA coin, which was used to stabilize the UST stablecoin. That, in turn, triggered the stablecoin algorithm to issue additional UST. As UST flooded the market, users panicked and withdrew more savings from Anchor in what became a vicious cycle, ultimately causing LUNA to crash and UST to lose its peg to the U.S. dollar.

AI-Driven Improvements

While the history of algorithmic stablecoins may give some pause when considering AI-powered stablecoins, the reality is that AI algorithms are significantly more advanced than those used in earlier iterations. 

In the AI-powered predictive markets article, we explored how AI can overcome these previous shortcomings through more advanced predictive modeling for collateralization and risk detection. More advanced predictive modeling ultimately leads to better treasury management and collateral optimization, leading to a more stable and securely optimized stablecoin. 

Similarly, in the AI-yield optimization piece, we explored how AI’s dynamic reinforcement through real-time data collection could assist in early detection and market adjustments. This leads to a highly optimized and more stable AI stablecoin. Shifts in market prices would be adjustable in real-time, and better anomaly detection could get leveraged for early detection of market manipulators.

The Future of AI-Powered Stablecoins

The potential for an AI-powered stablecoin offers a unique value opportunity to the world of stablecoins. For all their benefits, the fully collateralized fiat-backed stablecoins still have several shortcomings. The USDC’s issuer Circle is based out of the U.S. As such, it is required to operate based on the rules and regulations of U.S. law. 

Crypto-backed overcollateralized stablecoins, while popular, remain a niche avenue for most users. They are inefficient and too volatile for those looking to hold stablecoins as a store of value in the long term.

Despite these challenges, stablecoins are poised to power the next industrial revolution of AI agents. For example, automated AI can execute commands and make payments without any human interaction. For such a future, there will need to be a new category of stablecoin that maintains stability and is uncensorable. This occurs through a fully decentralized AI-powered stablecoin.