(Un)stablecoins

May 25, 2022

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What are stablecoins and why do we need them?

In a market characterized by high volatility, stablecoins offer crypto investors security and represent an escape from the volatility of crypto markets. Over the past few years, stablecoins have shown tremendous growth, see Illustration 1, and as of writing increased their total market capitalization up to $158.99b with three of them trading in the top ten with regard to market cap. Despite making only a fraction of the overall crypto market cap (~12%), they are among the most traded coins in the entire crypto space, with USDT and USDC frequently hitting top daily trading volumes. From a more macro perspective though, they still only represent a tiny fraction of the world’s money supply.

Illustration 1: Total supply of the most important stablecoins
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SOURCE: THE BLOCK, BITCOIN SUISSE RESEARCH

Stablecoins aim to maintain a peg to a government-issued currency or commodity like gold. Besides commodity-backed, crypto-backed, or algorithmic stablecoins, most of them are collateralized off-chain with the corresponding fiat currency, such as USD, EUR, or CHF. Leveraging blockchain technology, they are easily transferable between cryptocurrency exchanges as they offer near-instantaneous 24/7/365 trading without relying on conventional payment systems or custodial holdings of fiat currency balances. This enables a more efficient arbitrage of the markets. Today, stablecoins are mostly used for trading, lending, and borrowing crypto assets. They offer attractive yields in various DeFi applications that enables the mitigation of inflation. Their on-chain nature is crucial for DeFi platforms such as Aave, Curve, or Compound. In a portfolio, they also act as volatility cushion and dry powder to react to given market opportunities. With growing adoption, they might lead to more inclusive payment and financial systems and open up tokenized financial markets. On the flipside, they pose various risks such as centralization, collateral mix, transparency for off-chain assets, operational risks, liquidity, and stability risks. Moreover, in light of recent events, tighter regulation is expected. In the EU, stablecoins fall under the Regulation on Markets in Crypto Assets (MiCA) while in the U.S., a working group recommended prudential regulation on stablecoins. According to US Treasury Secretary Janet Yellen, the situation is real-time proof that lawmakers’ concerns about the stablecoin industry are justified.

The stablecoin taxonomy

While all stablecoins offer the promise of price stability, not all can achieve this outcome. By design, Stablecoins are using various sorts of collateralization and price stabilization mechanisms to ensure their peg. They come in several different flavors, but can generally be represented in three major types, see Illustration2.

Illustration 2: Properties of the most important stablecoin classes
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SOURCE: A16Z, BITCOIN SUISSE RESEARCH

Off-chain collateralized stablecoins (e.g. USDT, USDC, BUSD):

typically backed by bank deposits, which are regularly audited (including Tether as of this year), and minted by a centralized entity that maintains these reserves. They keep their peg to fiat currency by trust in that entity to always honor creation and redemption requests of tokens versus bank deposits. USDT and USDC offer different risk profiles as USDC is 100% backed by cash and U.S. treasuries whereas USDT has ~28.47% in commercial papers, a form of unsecured debt, that comes with a higher risk profile. This category usually offers high stability and convenient capital efficiency, as the stablecoins are always backed 1:1 by collateral. They also come with several risks and disadvantages such as centralization as governments and entities can freeze funds and transparency issues as the collateral is off-chain and requires trust. Overall, they are historically not precarious, yet inherit trust from collateral backing.

 

On-chain collateralized stablecoins (e.g.: DAI, MIM, aUSD):

minted permissionlessly [LC1] through DeFi protocols by depositing collateral. The peg is maintained by high collateralization ratios that are liquidated for the protocol’s stablecoins if the threshold is hit. This class offers high decentralization, and convenient stability but lacks capital efficiency since they require significant over-collateralization to compensate volatility risk of crypto assets. If poorly designed, the liquidation thresholds may be set too low, causing untimely liquidation. Moreover, they pose smart contract risks, oracle risk, and risk of a protocol failure the stablecoin is operating on. Additionally, they inherit the risks associated with custodial stablecoins if part of their collateral consists of stablecoins such as USDT or USDC. Overall, they are historically not precarious, yet might come with protocol-specific risk.

 

Algorithmic stablecoins (e.g.: UST, USDN):

aim to maintain peg through dynamically controlling supply and demand of the stablecoin by the protocol. The protocol acts similar to a central bank, increasing supply when the token shows a deflationary tendency, and reducing it when the purchasing power of the stablecoin drops. The rules for doing so are embedded in a smart contract and changing them is, given sufficient decentralization, only possible through social consensus or more formal governance votes tied to a governance/seigniorage token. As algorithmic stablecoins are completely uncollateralized and use algorithms to maintain peg. These are optimized to incentivize market participants to arbitrage and manipulate circulating supply. By design, there are various mechanisms available to achieve that:

  • Rebase: manipulate the base supply to maintain the peg. The protocol mints or burns supply from circulation in proportion to the coin's price deviation from the peg.
  • Seigniorage: multi-coin system, with one coin's price, is designed to be stable and at least one other coin is designed to facilitate that stability. Like rebase, they also typically leverage a combination of protocol-based mint/burn mechanisms and arbitrage mechanisms.

This class has an outstanding capital efficiency and convenient decentralization, depending on the project as each class offers a spectrum. However, as history proves, they often lack the most important trait which is stability. Overall, they are historically precarious due to the significant number of failed projects and it is hard to build trust in such a system.

When it comes to non-custodial, decentralized approaches, there is a rather new category that combines algorithmic mechanisms with on-chain collateral:

 

Hybrid or fractional stablecoins (e.g.: FRAX, USN)

a mix of on-chain collateralized and algorithmic stablecoin with a collateralized element, but also an algorithmic element to cover under-collateralization. The aim to maintain peg by combining the best mechanisms from pure algorithmic stablecoins and their collateralized counterparts.

A closer look at the most important stablecoins

When it comes to custodial stablecoins, the major three representatives are USDT, USDC, and BUSD. Besides having the highest trading volumes, they also are the most trusted and adopted stablecoins. Not all of them contain the same level of trust or provide the same level of transparency though.

 

USDT

First issued in 2014, Tether was among the very first stablecoins. USDT was developed by BitFinex and is the largest stable coin by market cap, and the most widely available. At the same time, it's also the most controversial as after years there is still a lack of transparency, with U.S. regulators even fining Tether $41m last year. Due to marginal returns, an issuer of stablecoins might focus on riskier and less liquid investments. Untransparent structures further increase this danger.

 

USDC

USD Coin is the second largest stablecoin and is fully backed by assets in reserve. USDC is governed by a membership-based consortium known as Centre, which formed between Coinbase & Circle (backed by Goldman Sachs). This body sets technical, financial, and policy standards for the stablecoin. They announced in late August that Circle's reserves had expanded beyond cash and cash equivalents. Moreover, USDC is regulated on a comparable footing to major payment companies such as PayPal, Venmo, or Apple Pay.

A current breakdown of the respective reserves is found in Table 1. As we mentioned above, due to USDT’s reserves and its anticipated audit, it is perceived as riskier compared to USDC which is also mirrored by the recent supply shift from USDT to USDC.

Table 1: Reserves breakdown of USDT and USDC
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SOURCE: TETHER, CIRCLE, BITCOIN SUISSE RESEARCH

BUSD

Binance USD is natively available on the Binance exchange platform. BUSD is issued in partnership with Paxos Trust Company, which is responsible for holding the USD collateral in reserve that backs BUSD.

The most important representatives of non-custodial, decentralized stablecoins are DAI and MIM.

 

DAI

DAI is the first decentralized, collateral-backed cryptocurrency. It is collateralized and backed by a diversified, overcollateralized portfolio of crypto assets (primarily USDC and ETH) locked in smart contracts. As such, DAI maintains its value not by being backed by USD custodied by a centralized entity, but by using collateralized debt denominated in various crypto assets. MakerDAO, a decentralized autonomous organization (DAO) manages DAI. As USDC makes a major share of DAI collateral, see Illustration 3, it mitigates the aspect of decentralization, and USDC centralized properties are now baked into the protocol design as well.

Illustration 3: Collateral breakdown of generated DAI and MIM on Ethereum
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SOURCE: DAISTATS, MIM, BITCOIN SUISSE RESEARCH

MIM

MIM is very similar to DAI yet comes with a more diversified and riskier collateral basket, as shown in Illustration 3. As the collateralization ratio for DAI is 161.76%, MIM’s ratio is considerably lower at ~120%. Therefore, MIM is considered to come with a higher risk profile yet higher yield. The staking yield comes from the interest, occurring alongside with MIM minting. SPELL is their governance token and sSPELL is the staking certificate. As of writing, MIM is working on its analytics page to bring more transparency. However, as MIM is running on the blockchain, all data is out there.

The flaws of algorithmic stablecoins

UST was the most famous algorithmic stablecoin until it collapsed to $0 in May 2022 after its flawed peg mechanism resulted in hyperinflating LUNA from ~300m to ~6t circulating supply within hours. UST began depegging on May 7, as large withdrawals Anchor began. These had a domino effect on Curve’s UST pool. UST, which is linked to LUNA by design, is supposed to be pegged 1:1 with the USD, yet it fell sharply below the $1 mark down to an ATL of $0.045. As soon as the LUNA price started falling as well, the price of both assets started collapsing quickly. Trapped in a downward spiral induced by their peg mechanism, UST holders kept minting LUNA, not only massively diluting Luna but also putting significant sell pressure on the token and therefore leading to even more supply minting. UST was designed to maintain its peg to USD by burning or minting a second token, called LUNA. Basically, their algorithm works like that:

  • If UST >$1, the protocol incentivizes users to burn LUNA and mint UST
  • If UST<$1, the protocol incentivizes users to burn UST and mint LUNA

With that, 1 UST can always be burned for 1 USD worth of newly minted LUNA and vice versa regardless of the price of either asset. Under normal circumstances and therefore trust in the mechanism, the design creates arbitrage incentives in both directions to keep the price of 1 UST close to 1 USD. Extreme volatility and panic unveiled, that the mechanism is seriously flawed and couldn’t even be saved by LFG’s reserve assets, see Illustration 4.

Illustration 4: LFG reserves before and after the LUNA/UST crash
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SOURCE: LFG RESERVES, BITCOIN SUISSE RESEARCH

The LFG was building a significant reserve basket on top of their peg algorithm to be able to defend UST’s peg. All their reserves were drained trying to defend the USD peg though that also put significant sell pressure on e.g. BTC. Due to the hyperinflation of LUNA, its underlying blockchain PoS consensus was also in danger of being easily attacked. Venus Protocol and Blizz Finance announced that their protocols were exploited due to Chainlink pausing the LUNA oracle.

Several new algorithmic stablecoins that mirror the seigniorage model used by UST, such as Waves’ Neutrino USD (USDN) already suffered depeg. As history proves, designing an algorithmic stablecoin that maintains its peg is very challenging – it requires well-balanced protocol incentives, a credible stability mechanism, and trust. Among the algorithmic stablecoins that depegged already are USDN, DEI, UST, BAC, ESD, and FEI. “Built to Fail: The Inherent Fragility of Algorithmic Stablecoins” published by the University of Calgary demonstrates how algorithmic stablecoins are inherently fragile. They argue that this stablecoin class relies on a consistent minimum level of demand for the coin, independent actors who are incentivized to stabilize the price, and reliable price information at all times without interruption. That poses problems as none of these variables are certain and typically deteriorate when prices start falling.

A promising hybrid approach seems to be semi-algorithmic stablecoins that are backed on-chain by other crypto collateral such as FRAX or USN. These may come with better capital efficiency yet have to be battle tested first. USN running on NEAR for example operates similarly to UST with a few key differences. According to Decentral Bank DAO, which manages USN's reserve fund, it is a NEAR native semi-algorithmic stablecoin that is soft-pegged to the dollar. At launch, USN is 2:1 overcollateralized by USDT and NEAR.

USN minting works via a smart contract, but the NEAR is not burned but used by the DAO for staking. It, therefore, improves the baseline security of NEAR’s underlying blockchain and will in case of a USN depeg not fundamentally affect NEAR’s security as happened with LUNA. By minting USN, the NEAR supply is not changed and is actually decoupled from the stablecoin. It generates attractive stablecoin rewards from the staking APR, compared to rewards that were offered for UST in Anchor. As a result, there is no risk of a death spiral for NEAR. Similar to LUNA’s peg mechanisms, the USN smart contract enables on-chain arbitrage to keep the peg (1 USN can always be mined for NEAR worth 1 USD if USN>USD, or NEAR worth 1 USD can always be redeemed for 1 USN if USN<USD).

Conclusion and Outlook

With the recent growth, adoption, and anticipated regulation, stablecoins might become established as a means of trading vehicle and payment even outside of the crypto and DeFi ecosystem as they offer a viable alternative for remittances and cross-border payments. As DeFi is a main driver of stablecoin growth, its robustness toward highly volatile markets is essential. With the recent collapse of LUNA and the structural risks posed alongside, regulatory and legal scrutiny will likely increase regardless of how the issue is trying to be resolved. Moreover, new approaches in designing algorithmic stablecoins with superior capital efficiency might result in a reliable mechanism design to offer unique benefits enabled by decentralized technology.

Bitcoin Suisse