Stablecoins: The Growth of Digital Currencies

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Table of Contents

What are Stablecoins?

Since their inception with Bitcoin in 2009, cryptocurrencies have had a huge problem when it comes to being used for purchases; volatility. The rapid changing of pricing in the crypto market makes it very difficult for users to spend their cryptocurrencies reliably, your $100 in Bitcoin for online shopping might be $85 tomorrow. The solution to this is Stablecoins. 

 

Stabecoins are digital assets that fix/peg their price 1:1 to an underlying external asset. The most popular external asset that stablecoins are pegged to is the U.S. dollar but there are many other fiat backed stablecoins and commodity backed stablecoins. Before stablecoins, users had to switch out from cryptocurrencies to fiat every time they wanted to trade. The beauty of stablecoins is that they combine the convenience, privacy and security of cryptocurrencies with the stability and trust of fiat currencies. But its not all sunshine and roses, stablecoins have their fair share of issues.

 

Some examples of stablecoins would be: USDT, DAI, USDC, UST, and BUSD. (These are also the most popular stablecoins). 

How do Stablecoins work?

There are two main types of stablecoins: 

  1. Collateralization: the collateral can be either an external real world asset like the U.S. dollar in Tether’s case or it can be other cryptocurrency assets like the DAI stablecoin. 
  2. Smart Contract Manipulation aka Algorithmic Stablecoins: these stablecoins use sophisticated algorithms to adjust the supply and demand of the coin to keep its peg. 

Collateralization

The most widely used stablecoin in the cryptomarkets is a fiat backed stablecoin: USDT issued by the company Tether. In Tether’s case, the company claims to have $1 US for every USDT issued and in circulation, it’s important to note that USDT’s market cap is currently $78 billion U.S. There are a few issues with collateralized stablecoins:

  • What’s being collateralized is simply deadweight in a lot of ways as its money that could be reinvested but instead its million or billions of dollars not being used. 
  • Employees can embezzle or steal some of the collateral.
  • It’s extremely difficult to prove the total amount of a company’s collateralized position.

Algorithmic Stablecoins

Algorithmic stablecoins solve quite a few of the issues that plague collateralized stablecoins but they still have their own issues associated with them. For starters, algorithmic stablecoins are far easier to audit as they are based on code so auditors need to simply inspect the code to ensure everything checks out. With that being said, they are more volatile in nature as their supply needs to be constantly adjusted to keep their peg. 

There are 3 main types of Algorithmic Stablecoins:

  1. The amount of coins in everyone’s wallet is adjusted so that the value is $1
  2. Coin printing and bond reward system to adjust the price to $1
  3. Same as #2 except a coupon system is used 
 
  1. This type of stablecoin is called a Rebase token. Essentially the token is self aware of its price and it will adjust its supply across everyone’s holdings so that the value is still pegged to $1. For example, let’s say I buy $100 worth of Rebase token which is equivalent to 100 tokens. Later in the day, the Rebase token loses its peg and the supply is adjusted so that now I have 110 tokens. The value in my wallet will still be $100 but the number of tokens everyone has is changed. With this method you have supply volatility instead of price volatility. 
  2. The second type of algorithmic stablecoin uses something called Seigniorage Supply. Seigniorage is a term used to describe the profit a bank makes by printing money. For example if it costs $0.03 to make $1 then the seigniorage is $0.97. A prime example of a coin that uses this method is Basis Cash.
 
 Basic Cash has 3 coins total: Basis cash, Basis shares and Basis bonds. 
Basis Cash Stablecoin
Obtained from Basis Cash

The first and primary point of contact is Basis Cash. When the price of Basis Cash is over $1, the supply is increased to push the price back to $1. This new supply is converted to basis shares and basis shareholders earn a portion of this. When the price of Basis Cash is below $1 people can spend Basis Cash to acquire Basis Bonds, because people are spending Basis cash, supply is leaving circulation and the price will go back to $1. What incentivizes people to buy Basis Bonds? The next time the price goes over $1, the bond holders get paid first then the shareholders.

In theory, the mechanism described above should work. There’s incentives to drive the price down when it goes above $1 and there’s incentivizes to drive the price up when it’s below $1, but in reality it doesn’t work very well. That’s because stablecoins operate in two separate cycles: expansions and contractions. 

 

During expansionary periods, this method works really well.  A lot of money is flowing into the underlying ecosystem and the stablecoin is able to keep its peg to $1. During contractions, investors begin to trade their stablecoins for other coins and tokens and the price begins to fall dramatically. This dramatic fall turns into what’s called a death spiral where a ton of free coins enter the market and the price of all 3 coins (Cash, Shares and Bonds) goes crazy. In the end, the price of the stablecoin falls to almost $0.

 

 3. An example of the third set of algorithmic stable coins is Empty Set Dollar. ESD is very similar to Basis cash except the Share coin and the stable coin are combined. Users can stake their ESD coins to earn income when the coin’s price is over $1. When the coin goes under $1, holders of the stablecoin can purchase discounted coupons which become redeemable only after the coin goes back above $1. Unfortunately for ESD, this method has the same flaws as Basis Cash where the mechanisms in place begin to fail during contractionary periods.

 

Whiteboard Crypto has an excellent video on how these 3 non-collateralized stablecoins work, make sure to check it out!

The Risk of Stablecoins

Centralization

One of the hallmarks of cryptocurrencies is decentralization, the act of taking away power from centralized authorities by distributing  a network. USDT is the biggest stablecoin and is backed by the central authority Tether. This means USDT has many points of failure:

  • Tether the company can go out of business
  • Tether can be regulated
  • All of Tether’s assets can be seized
  • Tether’s claim of backing USDT with $1 U.S, can be proven to be false

Any of the above scenarios can lead to a collapse in USDT thereby wiping out USDT’s $78 billion market cap. Incidentally, Tether has had its fair share of scrutiny and battles with authorities, an excellent timeline and in depth look at this can be found here. 

Inflationary Issues

Stablecoins being pegged to fiat currencies means they have the same issues as fiat currencies: inflation. Inflation has plagued fiat currencies for decades but in recent times has become progressively worse with all time low interest rates across the world. Simply holding onto stablecoins would be the same thing as holding onto a fiat currency, your purchasing power would go down year over year. If you are holding onto stablecoins while waiting for the crypto market to recover or you’re waiting for the perfect buy opportunity, make sure to stake your stablecoins in protocol like Anchor. You can learn more about Anchor Protocol in our fundamental analysis post of Terra Luna.

 

Lack of Regulation

 

Most people would assume that regulation would be a negative aspect for the crypto space in general but proper regulation is necessary to protect investors. If you give a bank your money and it is stolen you are insured through the FDIC (Federal Deposit Insurance Corporation). Proper insurance is not yet established in defi just yet although projects like Terra Luna are implementing their own insurance protocol called Ozone. Nonetheless, regulation of cryptocurrencies across the world is in this gray area where investors are not protected from malicious activity and failure of an entity. 

What's next for Stablecoins?

Stabelcoins have been rapidly growing in their adoption and market capitalizations since early 2021. Fiat-backed stablecoins and commodity-backed stablecoins are less popular now with the rise of algorithmic stablecoins but there is still a variety of well designed coins to be used in the market. The main thing holding back stablecoins from being used in everyday purchases is the lack of adoption from real world merchants and defi applications still being in development. This will begin to change in 2022 and the years to come as the adoption curves ramp up, in the meantime investors can lend out and stake their stablecoins on various exchanges and defi protocols to earn some passive income. Don’t know what exchange to use?

Check out our analysis of 1inch exchange and Kucoin

For more Crypto news and analysis click here.

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