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. In the blockchain and cryptocurrency world, decentralization is a key principle that refers to the distribution of power and control among multiple participants rather than being centralized under a single authority or entity.

The DR provides insights into the level of risk associated with an asset and indicates the extent to which its value is derived from decentralized sources. It is an important metric for evaluating the off-chain risk of a stablecoin. Off-chain risks may include government interference, asset freezing, or the requirement of Know Your Customer (KYC) procedures. By considering the decentralization ratio, investors and users can assess the level of exposure to such risks.

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. This includes both on-chain assets (assets recorded on the blockchain) and off-chain assets (assets held outside the blockchain ecosystem).

For example, let’s consider a stablecoin called FRAX3CRV LP token. This token consists of 50% FRAX and 50% 3CRV. However, since FRAX cannot back itself, only the 3CRV portion is considered for the calculation of the DR. The 3CRV is further composed of 33% USDC, 33% USDT, and 33% DAI. Among these, USDC and USDT are fully backed by fiat currencies, while DAI is 60% backed.

By applying the DR calculation, each $1 of the 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. This means that the remaining value is derived from assets that have lower decentralization, such as fiatcoins or partially backed assets.

The DR is particularly useful for investors and users who want to evaluate the risk associated with a stablecoin or any other asset backed by collateral. It provides a quantitative measure of decentralization and helps assess the stability and trustworthiness of the underlying assets.

It’s important to note that assets like Ethereum and reward tokens, such as CVX and CRV, are considered to be 100% decentralized. These assets are native to the blockchain ecosystem and do not have off-chain risks associated with them. On the other hand, stablecoins backed by fiat currencies or other off-chain assets would have a lower decentralization ratio.

The decentralization ratio also takes into account risks associated with the base currency underlying the assets. For example, if a stablecoin like USDC is backed by US Dollars, there is a risk of US Dollar inflation impacting the stability of the stablecoin. Such risks are considered in the calculation of the DR, providing a more comprehensive assessment of the asset’s decentralization and off-chain risks.

By understanding and considering the DR, investors and users can make informed decisions about the stability and risks associated with stablecoins and other assets. It allows for a better understanding of the underlying collateral and helps in managing the overall risk exposure.

The concept of decentralization is an important aspect of blockchain technology and the broader decentralized finance (DeFi) ecosystem. It aims to reduce reliance on centralized intermediaries and create a more transparent, trustless, and resilient financial system. The Decentralization Ratio is just one of the metrics that contribute to assessing the level of decentralization in the blockchain and cryptocurrency space.

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.