What are Stablecoins?

What are Stablecoins?

So what exactly are stablecoins? 

Stablecoins are cryptocurrencies whose prices are supposed to reflect an underlying asset’s value. As the name suggests, stablecoins are supposed to be stable with the underlying asset. That is to say, the price of the coin is not meant to be volatile. For example, one stablecoin representing one US dollar should always equal $1 USD. We call this 1:1 ratio a ‘peg’ as the value of the stablecoin is ‘pegged’ to the dollar.

While the value of the stablecoin might not EXACTLY be 1:1 at all times due to overall market volatility, it should be extremely close. Deviations should be within fractions of a cent or out to the third or fourth decimal place.  

Most stablecoins currently represent fiat currencies. You have likely already come across some stablecoins, such as USDC, USDT, UST, or DAI. 

Why is there a need for Stablecoins?

Stablecoins bridge the gap between fiat currencies and cryptocurrencies in the crypto space. They can be used to on or off-ramp your fiat or to be held as cash-on-hand in your wallet. They are popular for sending instantaneous payments as the value remains stable and all users can send and receive it easily. 

In some cases, it can even be used as a store of value. For countries with high inflation, citizens can choose to convert their native fiat currency and store it as a stablecoin such as USDC, to prevent their purchasing power from reducing in a high inflation environment. 

Early 2022 was termed “stablecoin season” because the high APRs on stablecoin farms were marketed as “risk-free” and became incredibly popular. There were protocols promising double-digit APYs on stablecoins, which is a great deal compared to the typical savings account. It was no surprise that participants flocked to these heavily advertised farms. However, fast forward half a year later and things did not end well when the source of the yield was revealed.

Types of Stablecoins

There are a few types of stablecoins, namely Fiat-Backed, Crypto-Backed, and Algorithmic.  

Fiat-Backed Stablecoins

A fiat-backed stablecoin is entirely backed by fiat assets in its treasury. For every $1 of stablecoin minted, there is $1 of fiat collateral in their treasury.

Some popular examples of Fiat-Backed stablecoins are USDC, USDT, and BUSD.

Let’s take a look at  USDC’s reserves:

As of 26th August 2022, we can see that there is $52.3B USDC in circulation while there is $52.4B in fiat in their reserves. This means that there is more money in their reserves than total USDC in circulation and so they are slightly over-collateralized. 

This is a good thing! In the worst-case scenario, every USDC holder could attempt to redeem their token for USD. Because of USDC’s collateralization, this would not be a problem.

Note that fiat-backed stablecoins such as USDC (Circle) and USDT (Tether) are centralized because their reserves belong to and are managed by business organizations and their reserves are denominated in a centralized currency, the United States Dollar.

Crypto-Backed Stablecoins

Similar to fiat-backed stablecoins, crypto-backed stablecoins have assets sitting in their treasury. The difference being crypto-backed assets use cryptocurrencies as collateral and crypto-backed assets are typically decentralized. Crypto-backed stablecoins are generally over-collateralized to account for the price volatility of the cryptocurrencies used as collateral. 

Some popular examples of crypto-backed stablecoins are DAI and MIM.

As an example, DAI is a stablecoin pegged to USD that is over-collateralized with crypto assets. Users who would like to mint $DAI need to deposit collateral worth more than the amount they would like to borrow. As seen below, with 10 ETH (worth $15.9k) as collateral, the user can only borrow up to $9.3k worth of DAI. 

Being over-collateralized reduces the likelihood that the price volatility in the collateral assets will cause the stablecoin to de-peg.

To illustrate this imagine if you could mint 2,000 DAI for one ETH when ETH was at $2,000!

Because crypto-backed stablecoins have treasuries that are managed by a DAO, and their collateral is denominated in a variety of cryptocurrencies, we call these stablecoins decentralized.

Algorithmic

Algorithmic stablecoins are decentralized and not backed by anything! They rely on algorithms and markets to maintain peg (or at least try to). There are a few types of algorithmic stablecoins. 

Rebasing Model
  • Rebasing controls the circulating supply to try to maintain the peg. This means that there is no fixed total supply for the token. When the price of the token is > $1, the total supply is increased by minting more tokens and distributing them to holders. When the price of the token is >$1, supply is decreased by reducing the total supply by burning them and reducing the number of tokens. This generally helps to maintain the peg but the total supply will face frequent drastic changes.
  • Ampleforth ($AMPL) is a stablecoin that uses this rebasing model. AMPL rebases every 24hrs to try to maintain its $1 peg. Yes, that means that holders could have an initial 100 tokens,  wake up to 150 tokens the next day, and 75 tokens the day after. While the number of tokens may change, the value remains unchanged. 
Seigniorage Model
  • A seigniorage model employs bonds to maintain a peg. When the value of the stablecoin is above the peg, more stablecoins are printed and awarded to those who staked their stablecoins. When the value of a stablecoin is below the peg, bonds can be bought with the stablecoins, the coins are then burned to reduce the circulating supply. These bonds can then be used to redeem for more stablecoins when the peg is re-established. Popular protocols that use this variation are UST/Luna Terra and Empty Set Dollar (ESD).
  • Another variation of this model involves three tokens: stablecoins, shares, and bonds. In this variation, instead of awarding more stablecoins to those who staked their stablecoins, they are awarded to the shareholders. Shareholders purchase shares for the sole purpose of receiving more stablecoins when the stablecoin is above the peg. When below peg, bonds are issued to burn and reduce supply and can be redeemed for stablecoins when the peg is re-established. Popular protocols that use this variation are Basis Cash and Tomb Finance.  

Partially Collateralized Algorithmic Model

As the name suggests, these stablecoins are only partly collateralized, often with a combination of other stablecoins and governance tokens. It also relies on an algorithm to maintain its peg. 

FRAX from Frax Finance is an example of a partially collateralized stablecoin. It is minted with USDC and FXS, their governance token. There is a collateral ratio (CR) that decides the amount of USDC and FXS needed. The amount of USDC required is equal to CR, while the amount of FXS required is 1 – CR.

For easy visualization, examples as below:

Collateral RatioAmount of USDC required ($1/USDC)Amount of FXS required (in $)Number of FRAX minted 
100%1000100
80%8020100
60%6040100

The algorithmic part dynamically adjusts the CR. When the price of FRAX is above $1, the CR is decreased so less USDC is required and when the price of FRAX is below $1, the CR will be increased so more USDC is required. 

The system relies on arbitrage to keep the price of FRAX stable. When the price of FRAX is above $1, users can deposit $1 to mint every new FRAX and sell it on the open market, thus creating sell pressure that pushes the price of FRAX downwards. When the price of FRAX is below $1, users can purchase FRAX off the open market and redeem it for $1 for every FRAX, thus creating buy pressure and reducing circulating supply, and pushing the price of FRAX upwards.

Stablecoin Risks

Now you might be thinking, what risks are there if all it does is equal $1?

Theoretically, stablecoins are on the lower end of the risk spectrum because they are designed to have little or no price volatility. However, there are many recent examples that prove this to be incorrect. The peg is only as good as the system that maintains it. The risks involved are still very real.

Smart Contract Risk

As with all blockchain products, there are smart contract risks involved. Exploits can occur and contracts can have bugs.

De-pegging Risk

While the purpose of a stablecoin is to simply maintain a 1:1 peg, this is easier said than done. In theory, many of the above models sound feasible but history has shown us that models behave differently when they enter the real world. Algorithmic stablecoins are particularly vulnerable as they have no collateral in case of crisis. Once de-pegged, they typically “death-spiral” and can not be recovered. UST is currently the most recent and notorious example.

Centralization Risk

Recently, there have been concerns over certain stablecoins that are centralized because the centralized authority has full control. Centralized entities face government regulation and must abide by the regulations set by their native government. This may result in censorship issues, as evidenced by the recent Tornado Cash controversy. Recent USA regulation of Tornado Cash has resulted in all addresses that have interacted with Tornado Cash being blacklisted. This poses a grave threat to DeFi’s efforts to achieve truly decentralized finance.

Conclusion

While there are many risks and advantages to stablecoins, their convenience and utility ensure that they will be a key asset in the future development of DeFi. Gone are the days when it took hours or even days to send money to overseas parties. Payments can be made at a stable price only because of stablecoins. The technology may not be perfect yet, but stablecoins are beginning to stabilize the chaotic crypto space.

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