Decentralization Ratio

November 21, 2023 - Around 2 mins mins to read

Understanding the Decentralization Ratio

The Decentralization Ratio (DR) is a metric that measures the proportion of collateral value that is decentralized compared to the total supply of stablecoin backed by those assets. It provides insights into the level of risk associated with an asset and indicates the extent to which its value is derived from decentralized sources. Unlike other metrics that only consider assets within a protocol’s system contracts, the DR takes into account all underlying components of collateral that the protocol has claims on.

The DR is particularly useful in evaluating the off-chain risk of a stablecoin. Collateral with high off-chain risk, such as fiatcoins, securities, and custodial assets like gold or oil, are considered to have 0% decentralization. Off-chain risks may include government interference, asset freezing, or the requirement of Know Your Customer (KYC) procedures. For example, if the Securities and Exchange Commission (SEC) prohibits the transfer of USDC to non-KYC’d entities, it would be classified as having 0% decentralization. Additionally, the DR also takes into account risks associated with the base currency underlying the assets, such as US Dollar inflation for USDC. On the other hand, assets like Ethereum and reward tokens such as CVX and CRV are considered to be 100% decentralized.

Let’s use the FRAX3CRV LP token as an example to understand how the DR is calculated. The FRAX3CRV LP token consists of 50% FRAX and 50% 3CRV. Since FRAX cannot back itself, only the 3CRV portion is considered. The 3CRV is further composed of 33% USDC, 33% USDT, and 33% DAI. Among these, USDC and USDT are fully backed by fiatcoins, while DAI is 60% backed. Therefore, each $1 of FRAX3CRV LP token derives approximately $0.066 ($1 x 0.5 x 0.33 x 0.4) or 6.6% of its value from decentralized sources.

Author: Travis Moore, CTO of Frax Finance.

Travis Moore is an angel investor, programmer, entrepreneur, and the CTO of Frax, the world’s first fractional algorithmic stablecoin that is partially backed by collateral and stabilized algorithmically. Frax is an open-source and permissionless project that aims to bring a truly trustless, scalable, and stable asset to the decentralized finance ecosystem. Moore is also a co-founder of Everipedia, a blockchain-based knowledge base. He holds a triple-major from UCLA in Neuroscience, Biochemistry, and Molecular, Cell, & Developmental Biology. Moore’s primary interests lie in artificial intelligence and blockchain technology, which he believes will have the most significant impact on the world in the coming decade.