Decentralised Stablecoins Explained: How Crypto-Backed and Algorithmic Stablecoins Work

Decentralised stablecoins represent one of the most ambitious and technically challenging problems in DeFi: creating a price-stable cryptocurrency that tracks a fiat currency (almost always the US dollar) without relying on a centralised issuer holding actual dollars in a bank account. The motivation is clear: stablecoins are essential infrastructure for DeFi protocols, providing the stable unit of account and medium of exchange that makes lending, trading, and yield generation functional, but centralised stablecoins like USDC and USDT reintroduce the exact counterparty risks and censorship vulnerabilities that DeFi is designed to eliminate. A truly decentralised stablecoin that maintains its peg reliably while remaining uncensorable and non-custodial would be foundational infrastructure for the entire DeFi ecosystem. Achieving this in practice has proven extremely difficult, as demonstrated by the catastrophic failure of TerraUSD (UST) in May 2022 and the persistent challenges facing algorithmic stablecoin designs.

How Crypto-Backed Stablecoins Work

The most established approach to decentralised stablecoins is over-collateralisation with crypto assets. MakerDAO’s DAI (now rebranding to USDS) is the longest-running and most battle-tested implementation of this model. To create DAI, a user deposits collateral assets (originally only ETH, now including WBTC, USDC, and various DeFi liquidity provider tokens) into a Maker Vault smart contract and borrows DAI against that collateral at a collateralisation ratio that must remain above the minimum threshold (typically 150-200% depending on the collateral type). The over-collateralisation is the key mechanism that keeps DAI backed: if a user deposits AUD 200 worth of ETH, they can borrow at most AUD 133 worth of DAI (at 150% collateralisation), meaning there is always more collateral value than outstanding DAI value.

The peg maintenance mechanism in crypto-backed stablecoins relies on arbitrage incentives that operate automatically through smart contracts. When DAI trades below US$1 (e.g., US$0.98), it is profitable to buy cheap DAI and use it to repay MakerDAO debt (which is always valued at exactly US$1 by the protocol), closing Vaults and removing DAI from circulation; this buying pressure pushes the price back up. When DAI trades above US$1 (e.g., US$1.02), it is profitable to open new Vaults, borrow DAI, sell it, and repay later (earning the US$0.02 premium per DAI); this selling pressure pushes the price back down. The DeFi protocols governance parameters (stability fees, which are interest rates on borrowed DAI, and debt ceilings for each collateral type) are adjusted by MKR governance token holders to maintain peg stability through changing market conditions.

Liquidation is the critical safety mechanism that ensures crypto-backed stablecoins remain solvent during market downturns. If the value of collateral in a Vault falls below the minimum collateralisation ratio (due to a price drop in the collateral asset), the Vault becomes eligible for liquidation: external participants (called keepers) can liquidate the Vault by purchasing the collateral at a discount (the liquidation penalty, typically 13-15%) and using the proceeds to repay the outstanding DAI debt, closing the position. This mechanism keeps the total outstanding DAI always backed by sufficient collateral, but creates risk for Vault owners who are not monitoring their positions: a rapid price drop in ETH can trigger unexpected liquidations with substantial penalties. Managing collateralisation ratios above the minimum threshold is essential risk management for anyone minting DAI or similar decentralised stablecoins.

Defi Tax Implications

The DeFi tax implications of crypto-backed stablecoin minting are significant for Australian users and not straightforward. The ATO’s position on whether opening a MakerDAO Vault and minting DAI constitutes a taxable disposal of the ETH collateral is not definitively resolved: arguments exist both that it is a loan (creating no CGT event at the time of deposit) and that it is a disposal (triggering CGT at the collateral’s market value at deposit). The stability fee (interest) paid on DAI debt is likely deductible if the borrowed DAI is used for income-producing purposes. Liquidation events (where collateral is sold to repay debt) are clearly taxable disposals of the collateral at the liquidation price. Consulting a crypto tax specialist familiar with DeFi tax treatment before significant Vault activity is strongly recommended.

Liquity Protocol represents a more capital-efficient second-generation approach to crypto-backed stablecoins. Liquity’s LUSD stablecoin requires only 110% collateralisation (compared to Maker’s 150%+) while maintaining robustness through innovative mechanisms: the Stability Pool (where LUSD holders deposit their stablecoins to absorb liquidations, earning ETH at a discount), the Redemption Mechanism (where LUSD can always be redeemed directly for ETH at face value from the riskiest Vaults), and a flat one-time borrowing fee rather than ongoing interest. The mathematical elegance of Liquity’s design (which has been formally verified by security researchers) and its significantly higher capital efficiency compared to Maker represent meaningful innovations, but LUSD has not achieved the scale of DAI and operates only with ETH as collateral. Understanding the different design approaches helps DeFi investors evaluate the stablecoin risks specific to each implementation.

Algorithmic Stablecoins and the Risks of Uncollateralised Design

Algorithmic stablecoins attempt to maintain price stability through supply adjustment mechanisms rather than collateral backing, offering the appeal of capital efficiency (no locked collateral) at the cost of significantly higher fragility. The pure algorithmic model operates through: when the stablecoin price is above peg, the protocol mints new stablecoins to increase supply and drive the price down; when the price is below peg, the protocol burns stablecoins or offers discounts on companion tokens to reduce supply and drive the price up. This model is elegant in theory but relies entirely on market participants having confidence that the mechanism will maintain the peg, creating a circular dependency: the peg is maintained by confidence, and confidence depends on the peg being maintained.

The failure of TerraUSD (UST) in May 2022 is the definitive case study for algorithmic stablecoin collapse and illustrates what is now called the “death spiral” failure mode. UST’s peg was maintained through a burning mechanism: users could always exchange US$1 of LUNA (Terra’s companion token) for 1 UST, or 1 UST for US$1 of LUNA, providing arbitrage pathways that theoretically maintained the peg. This worked during normal market conditions and periods of growing confidence but was fatally vulnerable to coordinated selling: when large UST holders began exiting simultaneously (triggered by a large withdrawal from the Anchor Protocol yield source), LUNA had to be minted at an accelerating rate to absorb the UST selling, diluting LUNA’s value, which reduced confidence in UST’s backing, which caused more UST selling, which required more LUNA minting. This death spiral destroyed an ecosystem with peak market capitalisation of AUD 60+ billion in less than a week, causing cascading contagion across DeFi protocols and centralised exchanges that had exposure to the Terra ecosystem. The risks of algorithmic stablecoins are not theoretical: this is a documented systemic collapse.

Frax Finance developed a hybrid approach (partially algorithmic, partially collateralised) that has demonstrated more resilience than pure algorithmic designs while achieving higher capital efficiency than pure over-collateralisation models. Frax’s stablecoin adjusts its collateral ratio dynamically based on market conditions: when demand is high and the peg is solid, the collateral ratio decreases (more algorithmic, more capital efficient); when market conditions deteriorate, the collateral ratio increases (more collateralised, more robust). The fractional reserve model means that FRAX is not fully backed by collateral at all times, which introduces some algorithmic fragility, but the dynamic adjustment mechanism has helped Frax maintain its peg through multiple market stress events that destroyed purely algorithmic competitors. Frax represents the current state of the art in hybrid designs, though it is not immune to the fundamental confidence-dependency that affects all algorithmic elements.

Defi Risk Assessment Framework

The DeFi risk assessment framework for evaluating any stablecoin should always distinguish between mechanism type (fully collateralised, over-collateralised crypto-backed, partially collateralised, or pure algorithmic) and track record under stress. A stablecoin that has maintained its peg through the FTX collapse (November 2022), the March 2023 banking crisis that temporarily depegged USDC, and multiple sharp crypto market corrections has demonstrated meaningful resilience. A new algorithmic stablecoin with no track record beyond a bull market should be treated with extreme scepticism regardless of the elegance of its mechanism design. Australian DeFi investors using stablecoins in DeFi strategies should understand the failure mode of each stablecoin they hold, since stablecoin depegs in DeFi positions can cause losses far beyond the initial stablecoin position if used as collateral for borrowing.

The Australian regulatory treatment of stablecoins is evolving alongside global regulatory frameworks. ASIC and the Australian Treasury have been monitoring the stablecoin space closely since the UST collapse, and regulatory proposals for stablecoin issuers operating in Australia (covering reserve requirements, disclosure obligations, and redemption guarantees) are progressing through consultation processes. The Australian crypto regulation framework will likely require stablecoin issuers targeting Australian retail users to meet prudential standards similar to those applied to bank deposit products. Decentralised stablecoins operating without a centralised issuer present a regulatory challenge: there is no legal entity to apply requirements to, which may result in regulatory treatment focusing on interfaces (exchanges and wallets that provide access) rather than the protocol itself. Monitoring the regulatory developments affecting Australian crypto users is important for anyone holding significant positions in decentralised stablecoins.

Using Decentralised Stablecoins in Your DeFi Strategy

DAI and USDS occupy a specific niche in DeFi strategies where decentralisation of the stablecoin itself is a priority. For Australian DeFi participants using DeFi lending protocols or liquidity pools where stablecoin positions may be subject to censorship risk (for example, if USDC’s issuer Circle can freeze individual addresses, as they demonstrated in the Tornado Cash aftermath), using DAI or LUSD instead of USDC provides protection against censorship at the asset layer. However, this censorship resistance comes with trade-offs: DAI’s peg management mechanism adds complexity, the stability fee represents an ongoing cost, and the over-collateralisation requirement locks up capital that could otherwise be deployed productively. The decision between centralised and decentralised stablecoins depends on the specific risk profile of the DeFi strategy and the user’s weighting of censorship risk versus capital efficiency.

Yield opportunities on decentralised stablecoins exist across multiple DeFi protocols. DAI deposited in Aave or Compound earns variable lending interest; DAI in Maker’s DSR (DAI Savings Rate module) earns protocol-determined interest; DAI in liquidity pools on Uniswap or Curve earns trading fees; and various yield farming strategies can compound these base yields through additional token incentives. The DSR rate (set by MKR governance) provides a useful reference rate for DAI yield: when it is higher than lending rates on third-party protocols, depositing in the DSR is the most capital-efficient base option. Understanding the yield landscape for decentralised stablecoins requires tracking multiple protocols simultaneously, which is a normal part of active DeFi participation.

Risk management for decentralised stablecoin positions requires monitoring both the DeFi protocol holding the stablecoins and the stablecoin mechanism itself. A DAI position in Aave carries both Aave protocol risk (smart contract failure in Aave’s contracts) and DAI mechanism risk (a systemic failure in Maker’s collateral system that causes DAI to depeg). Concentration in a single decentralised stablecoin compounds these risks: if DAI depegs while you are holding it in Aave, you face simultaneous protocol risk and stablecoin risk. Diversifying stablecoin exposure across multiple types (some centralised for stability, some decentralised for censorship resistance) with position limits on each reduces the impact of any single stablecoin failure. The DeFi risk framework for stablecoins applies position sizing principles to stablecoin allocation across different stability mechanisms.

For Australian users, the tax treatment of income earned on decentralised stablecoins follows the same general principles as other DeFi income: interest earned through the DSR or lending protocols is assessable income in the income year it is received, denominated in AUD at the exchange rate at time of receipt. The stability fee paid when using Maker Vaults is a deductible expense if the borrowed DAI is used for income-producing activities. Any capital gains tax events triggered by swapping between stablecoins or redeeming stablecoins for other assets must be recorded accurately. The ATO’s crypto data matching program now captures many on-chain DeFi interactions, making accurate record keeping of all decentralised stablecoin activity a non-negotiable compliance requirement for Australian DeFi participants.

The future trajectory of decentralised stablecoins is shaped by ongoing protocol research, regulatory developments, and market competition from well-regulated centralised alternatives. MakerDAO’s transition toward including real-world assets as collateral (treasury bonds, mortgage-backed securities) has introduced off-chain counterparty risk into what was previously a purely on-chain system, creating new risk dimensions that were not present in the original design. New decentralised stablecoin research is exploring novel collateral types, more efficient peg mechanisms, and better regulatory compliance while maintaining meaningful decentralisation. For Australian DeFi investors tracking this space, Shepley Capital membership provides ongoing analysis of developments in decentralised stablecoins and their implications for Australian DeFi strategies, including tax and regulatory compliance guidance specific to the Australian context.

Comparing Decentralised and Centralised Stablecoins for DeFi Use

Centralised stablecoins (USDC, USDT, BUSD) maintain their peg through fiat reserves held by a centralised entity, audited periodically (though with varying frequency and rigour), and redeemable directly for fiat currency by verified users of the issuing platform. This direct backing with real dollars makes the peg maintenance mechanism simple and robust: there is no algorithmic complexity, no liquidation cascade risk, and no dependence on crypto market conditions for peg integrity. The trade-offs are: censorship risk (the issuer can freeze individual addresses), counterparty risk (the issuer could become insolvent or the reserves could be insufficient), and the off-chain trust dependencies that make centralised stablecoins fundamentally inconsistent with the trustlessness goals of DeFi.

For most DeFi liquidity provision and yield farming strategies, the practical difference between centralised and decentralised stablecoins is primarily the censorship risk factor. For most retail Australian DeFi investors who are not in categories likely to face address freezing (sanctioned entities, crime-linked addresses), the censorship risk of USDC is relatively low and the robustness advantages of its direct fiat backing make it the more practical choice for large stable value positions. The preference for decentralised stablecoins is more relevant for DeFi protocols themselves (whose liquidity pools and collateral systems should not be vulnerable to single-entity censorship), for users in jurisdictions where fiat on-ramps are restricted, and for ideologically committed DeFi participants who value decentralisation as a first principle regardless of the practical risk differential.

Stablecoin diversification across both types represents the practical risk management approach for most Australian DeFi participants with meaningful positions. Holding some USDC (for liquidity and peg robustness) alongside some DAI or LUSD (for censorship resistance and on-chain trustlessness) provides a blend of stability mechanisms that reduces dependence on any single design’s vulnerabilities. The weighting between centralised and decentralised stablecoins depends on position size (larger positions warrant more censorship risk concern), the specific DeFi protocols being used (some protocols have specific stablecoin preferences that affect yield), and the individual investor’s assessment of the relative risks. Shepley Capital membership provides stablecoin analysis and allocation guidance to help Australian DeFi investors build well-structured stablecoin positions within their broader DeFi portfolio.

Frequently Asked Questions

What are decentralised stablecoins?

How Crypto-Backed Stablecoins Work?

The most established approach to decentralised stablecoins is over-collateralisation with crypto assets. MakerDAO's DAI (now rebranding to USDS) is the longest-running and most battle-tested implementation of this model. To create DAI, a user deposits collateral assets (originally only ETH, now including WBTC, USDC, and various DeFi liquidity provider tokens) into a Maker Vault smart contract and borrows DAI against that collateral at a collateralisation ratio that must remain above the minimum threshold (typically 150-200% depending on the collateral type).

What are the Australian tax implications of minting a stablecoin?

The DeFi tax implications of crypto-backed stablecoin minting are significant for Australian users and not straightforward. The ATO's position on whether opening a MakerDAO Vault and minting DAI constitutes a taxable disposal of the ETH collateral is not definitively resolved: arguments exist both that it is a loan (creating no CGT event at the time of deposit) and that it is a disposal (triggering CGT at the collateral's market value at deposit). The stability fee (interest) paid on DAI debt is likely deductible if the borrowed DAI is used for income-producing purposes.

Why are algorithmic stablecoins so risky?

How should you assess a stablecoin's risk?

How do decentralised stablecoins fit a DeFi strategy?

DAI and USDS occupy a specific niche in DeFi strategies where decentralisation of the stablecoin itself is a priority. For Australian DeFi participants using DeFi lending protocols or liquidity pools where stablecoin positions may be subject to censorship risk (for example, if USDC's issuer Circle can freeze individual addresses, as they demonstrated in the Tornado Cash aftermath), using DAI or LUSD instead of USDC provides protection against censorship at the asset layer. However, this censorship resistance comes with trade-offs: DAI's peg management mechanism adds complexity, the stability fee represents an ongoing cost, and the over-collateralisation requirement locks up capital that could otherwise be deployed productively.

How do decentralised and centralised stablecoins compare?

What are the risks associated with Decentralised Stablecoins?

Decentralised stablecoins trade issuer risk for mechanism risk, and the mechanism can fail: uncollateralised algorithmic designs have collapsed completely, wiping out holders within days. Over-collateralised designs are more robust but expose users to liquidation if the collateral falls sharply. For Australian users there is a further complication, since minting against collateral may itself be a CGT event depending on the mechanism, which is not how most users think about taking out a loan.