What are Stablecoins?

What are Stablecoins?

In this article we explain the different types of stablecoins, what they are and what the future holds

Introduction

Crypto is a volatile asset class. Whether you view that as a feature or a bug, you cannot deny that the inherent volatility of cryptocurrencies creates challenges when it comes to mainstream adoption as a payments solution. In addition to payments, volatility in cryptocurrencies poses adoption challenges even for trading/investing purposes. Imagine losing 20% of your intended capital due to price fluctuations in the time it took for you to execute a trade. While optimists  hope that one day everything will be denoted in ETH or BTC, we still have a long way to go before that happens. 

In the meantime, a type of cryptocurrency has emerged to fill that gap, one that doesn’t have volatility but still possesses the technological benefits of blockchain technology: stablecoins.

What are Stablecoins?

Stablecoins are cryptocurrencies that aim to maintain a peg to an underlying asset; most commonly, fiat currencies such as the US dollar. In layman terms: 1 USDT (an example US Dollar stablecoin) = 1 USD. This removes the volatility that other cryptocurrencies have but since the asset is built on a blockchain, it has similar benefits such as seamless transfers between addresses. The lack of volatility makes stablecoins the preferred option when it comes to executing trades. Stablecoins are involved in 85-90% of trading volume according across exchanges and the top 3 trading pairs on DEXs in 2021 by Smart Money have stablecoins as one side of the pairing. 

Source: Nansen’s State of the Crypto Industry 2021 report

It’s important to note that while they all have the same overarching goal of maintaining their peg to the chosen underlying currency,  not all stablecoins are built the same way. Different stablecoins have different underlying mechanisms to maintain their peg and these mechanisms can vary drastically. 

Types of Stablecoins

Fiat-Backed Stablecoins

Fiat-backed stablecoins are essentially tokenized versions of the underlying currency. They are backed by an equivalent amount of cash or cash equivalents in a bank. Fiat-backed stablecoins currently make up the majority (over 90%) of the entire stablecoin market capitalization, with the top 3 stablecoins all falling under this category. They’re largely regarded as the safest type of stablecoins and are typically more resilient in holding their peg during turbulent market conditions. 

USDT, launched by Tether in 2014, is one of the first and is currently the largest stablecoin. USDC, launched by Circle in collaboration with Coinbase in 2018, is the second largest overall but has overtaken USDT as the preferred stablecoin for on-chain transactions. The rise of USDC came on the back of USDT facing heavy regulatory scrutiny and a lack of transparency and clarity on the composition of fiat-like assets that they hold. By being regulated and having regular audits, USDC has managed to gain the trust of the masses and capitalize on the regulatory issues USDT faced in 2021. Checking out smart money holders on Nansen, we see that USDC has 1961 smart money wallets holding the token compared to USDT’s 1565 wallets. We also see a steady uptrend in the number of wallets holding on to USDC while USDT’s looks to be tapering off since October 2021.

USDC Smart Money Holders

Source: Nansen's Token God Mode

USDT Smart Money Holders

Source: Nansen's Token God Mode

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Being backed by fiat currencies in a bank is a double edged sword. Backing is the primary factor behind this class of stablecoins’ stability and security, but it’s also the main con of the category. Having assets in banks leaves these stablecoins at the mercy of decisions made by banks and regulators. Because they are bank-controlled they are at risk of bank censorship and can often be frozen, infringing on the censorship-resistance provided by most blockchains. 

Overcollateralized Asset Backed Stablecoins

The next generation of stablecoins built on the idea of issuing stablecoins backed by assets, with one small tweak. Instead of being backed by fiat currencies, these stablecoins are backed by cryptocurrencies. In most cases, a user deposits assets into the protocol and an amount of stablecoin is then minted to be withdrawn by the user. Due to the volatile nature of cryptocurrencies, these protocols require the stablecoins minted to be overcollateralized - e.g. $1000 worth of ETH deposited only entitles you to withdraw $600 worth of a stable, with varying reserve ratios depending on the project.  

DAI is the most successful in this category of stablecoins and is created by the protocol MakerDAO. MakerDAO is a lending protocol that gives out loans in DAI at a predetermined interest rate. Similar to the example above, users would deposit ETH as collateral and receive an amount of DAI, with each DAI being worth 1 USD. If the value of the collateral falls below the required amount to support the loan, users would have to pay the amount they borrowed plus a fee to get back their collateral. Inversely, if the value of the collateral rises, users are allowed to borrow more DAI. Magic Internet Money (MIM) is another example of such a stablecoin but relies on interest bearing assets as collateral. 

Taking a look at Nansen’s Token God Mode dashboard, we see that the number of smart money wallets holding DAI has been relatively constant at 1.35K. The top addresses that hold DAI are bridges or stablecoin liquidity pools suggesting that DAI is actively used across multiple chains and holders are generating yield on it. 

Source: Nansen's Token God Mode

Having all assets on-chain removes the risk associated with being reliant on banks and overcollateralization makes the system more resilient against bank runs. However, it removes liquidity from the overall crypto markets. The more collateral is staked into the system, the less these tokens can be used for other areas in crypto. The higher the overcollateralization, the safer the protocol is with regards to maintaining the peg but the less capital efficient it gets. Stability of the protocol is heavily tied to the types of collateral allowed into the system. Proper screening and assessing of which assets are allowed to act as collateral is vital to reduce the risk of a collapse of the system. 

Algorithmic Stablecoins

Algorithmic stablecoins are stablecoins that are not fully backed by any asset and maintain their peg via certain mechanisms embedded within the protocol. In their ideal state, these stablecoins aim to maintain their peg without having any external collateral, making them the most capital efficient and scalable stablecoin of the bunch. 

Prior to its collapse on the week of 9 May 2022, UST, created by Terraform Labs on the Terra blockchain, was the poster child of the category. UST’s peg to the US dollar was maintained by a swapping mechanism between the protocol’s LUNA token and UST. Users were able to swap the LUNA token for an equivalent value of UST and vice versa, with UST being taken as 1 USD regardless of the current market price for UST. This created an arbitrage opportunity for users whenever UST decoupled from its USD peg. In such situations, users were incentivized to do swaps in the direction of arbitrage, maintaining the peg. 

Users swap LUNA for UST whenever 1 UST > 1 USD and sell the UST for USD, earning the difference. In the reverse situation (1 UST < 1 USD), users swap UST for LUNA, essentially buying an equivalent amount of LUNA for less than its USD value.

The exact mechanisms of other algorithmic stablecoins will vary but most if not all of them involve a burn/mint mechanism that’s similar to UST. This category of stablecoins are the riskiest of the bunch, with their peg largely backed by collective faith in the system, in addition to market forces. Once faith is eroded, they can quickly fall into a death spiral as users all rush to exit their positions on both the stablecoin and the main token used for the swaps, leading to cascading price drops on both assets. 

The consequence of a death spiral? Well, the charts below say it all.

Commodity Backed Stablecoins

Commodity backed stablecoins are backed by real world commodities, such as rare metals, real estate or oil. The most common commodity used is gold. They are usually backed 1:1 and allow users who hold a certain minimum amount to redeem an equivalent amount of physical gold. This is the smallest category of stablecoins so far, Paxos Gold (PAXG) the category leader has a market capitalization of only 608M.  

How Stable are Stablecoins?

The stability of stablecoins vary from token to token with fiat-backed stablecoins typically being the most stable and algorithmic stablecoins being the least stable. The ability for a stablecoin to maintain it’s peg largely depends on the protocol’s ability to allow redemptions for an equivalent amount of assets (fiat, crypto, commodities) or enough users willing to do the necessary swaps to restore the peg in the case of an algorithmic stablecoin. While stablecoins aim to be stable assets, they have an added layer of risk compared to the underlying asset that they are pegged to. 

Top Stablecoins

The top stablecoins today are predominantly fiat-backed stablecoins with USDT, USDC, BUSD taking the lead. 

Market Cap of ETH Stablecoins

In wake of UST’s implosion, non-fiat backed stablecoins have taken a huge hit and investors are generally more cautious about their choice of stables. DAI is the only non-fiat backed stablecoin in the top 5. Its resilience can be attributed to a few factors - age of the protocol, ability to maintain its peg during the entire saga, overcollateralization.  Other upcoming stablecoin protocols that are worth diving deeper into but not covered in this article are: Frax and Fei USD. 

The Future of Stablecoins

Stablecoins have the potential to change how existing real world payments are carried out and help bring crypto to the masses. Projects such as Solana Pay, which is a digital payments solution similar to that of Venmo/CashApp or GrabPay, leverage stablecoins such as USDC to allow consumers to make real world purchases using. As the UI/UX improves over time, consumers might not even realize that they’re interacting with a blockchain and just view it as a normal digital payment platform. 

Beyond real world localized payments, stablecoins, just like other cryptocurrencies, are a more efficient way to do cross border transfers compared to the current banking system. Cross border transfers via banks take hours if not days to process and typically come with fees attached, even if it’s to send money to your own accounts. Transferring stablecoins to anyone, anywhere around the world, takes anywhere from a couple of seconds to a few minutes and transaction fees cost a couple of cents to a few dollars depending on the blockchain. The only set up required is a crypto wallet which is similar to a digital wallet used to store crypto currencies. 

Conclusion

Stablecoins today come in numerous shapes and sizes, from highly centralized but stable versions such as fiat-backed stablecoins to decentralized and wildly experimental algorithmic stablecoins. They are by far the preferred medium of exchange used in crypto trading and their growth over the last two years is a strong indicator of the demand for non-volatile cryptocurrencies. Integrating them into payment systems for retail merchants and real world items help bring blockchain to the masses and improve adoption of the technology. While not necessarily the most exciting category in the crypto space, there’s huge potential for innovation and growth of stablecoins and it’s definitely worth keeping an eye on new innovative ones. 

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