Stablecoins Algorithmic Gamble: Stability Versus Scalability.

Stablecoins have emerged as a cornerstone of the cryptocurrency ecosystem, offering a bridge between the volatility of digital assets and the stability of traditional currencies. They aim to provide a more predictable and reliable value, making them essential for various applications, from everyday transactions to decentralized finance (DeFi). Understanding stablecoins, their mechanisms, and their risks is crucial for anyone navigating the world of crypto.

What are Stablecoins?

Definition and Purpose

Stablecoins are cryptocurrencies designed to maintain a stable value relative to a specific reference asset, most commonly the US dollar. Unlike Bitcoin or Ethereum, which can experience significant price fluctuations, stablecoins aim to offer a more predictable value, making them suitable for:

• Facilitating faster and cheaper cross-border payments.
• Providing a stable medium of exchange in volatile crypto markets.
• Enabling participation in DeFi protocols without exposing users to excessive price risk.
• Offering a more stable store of value compared to other cryptocurrencies.

Different Types of Stablecoins

Stablecoins achieve price stability through various mechanisms, resulting in different categories:

• Fiat-Collateralized Stablecoins: These are backed by reserves of traditional fiat currencies like the US dollar, euro, or British pound. The issuer holds an equivalent amount of the reserve asset for each stablecoin in circulation. Examples include Tether (USDT) and USD Coin (USDC).
• Crypto-Collateralized Stablecoins: These stablecoins are backed by other cryptocurrencies. Since crypto assets are volatile, they are typically over-collateralized, meaning more crypto collateral is held than the value of the stablecoins issued. Examples include Dai (DAI) and sUSD (Synthetix USD).
• Algorithmic Stablecoins: These stablecoins use algorithms and smart contracts to automatically adjust the supply of the stablecoin in response to changes in demand, aiming to maintain its peg. They don’t rely on holding reserves of fiat or crypto. Examples include (formerly) TerraUSD (UST) and FRAX.
• Commodity-Collateralized Stablecoins: Backed by tangible assets like gold, silver, or other commodities. Pax Gold (PAXG) is an example.

Key Characteristics of Stablecoins

Regardless of their type, stablecoins share some common characteristics:

• Price Stability: Their primary goal is to maintain a stable value, usually pegged to a specific asset.
• Transparency (Ideally): The reserves or mechanisms used to maintain stability should be transparent and verifiable. This is more readily available with fiat-backed and commodity-backed stablecoins, but can be more difficult to ascertain and trust with algorithmic stablecoins.
• Decentralization (Varies): Some stablecoins are more decentralized than others. For instance, algorithmic stablecoins are typically more decentralized than fiat-backed stablecoins, which rely on a centralized issuer.
• Programmability: They can be easily integrated into decentralized applications (dApps) and smart contracts, enabling various financial services.

How Stablecoins Work

Fiat-Collateralized Stablecoins: A Closer Look

Fiat-collateralized stablecoins are the most common type. Here’s how they typically work:

Issuance: The issuer (e.g., Tether Limited, Circle) holds fiat currency (e.g., USD) in a reserve account.

Minting: For every dollar held in reserve, one stablecoin (e.g., USDT, USDC) is minted and issued.

Circulation: The stablecoin is traded on cryptocurrency exchanges and used within the broader crypto ecosystem.

Redemption: Users can redeem their stablecoins for the underlying fiat currency held in reserve.

Audits: Ideally, regular audits are conducted by independent firms to verify the reserves and ensure transparency. This is a crucial element, but audit frequency and depth vary widely.

Example: If Circle holds $10 billion USD in reserve, it can issue 10 billion USDC stablecoins.

Crypto-Collateralized Stablecoins: Maintaining Stability with Crypto

Crypto-collateralized stablecoins use a more complex mechanism to maintain stability:

Over-Collateralization: Users deposit cryptocurrency (e.g., ETH, BTC) into a smart contract as collateral. Due to the volatility of cryptocurrencies, the value of the collateral must exceed the value of the stablecoins issued (e.g., 150% collateralization ratio).

Minting: The smart contract then mints and issues the stablecoin.

Price Stabilization Mechanisms: The smart contract employs mechanisms to maintain the peg, such as liquidation of collateral if its value falls below a certain threshold. DAI, for example, has a Stability Fee (interest rate) that is adjusted to control supply and demand.

Governance: DAO’s often govern crypto-collateralized stablecoins, proposing and voting on changes to the system parameters.

Example: To mint 100 DAI, a user might need to deposit $150 worth of ETH into a MakerDAO smart contract. If the value of ETH falls significantly, some of the user’s ETH may be automatically sold (liquidated) to maintain the stability of DAI.

Algorithmic Stablecoins: Reliance on Code

Algorithmic stablecoins are the most controversial due to their reliance on complex algorithms and lack of traditional collateral. The implosion of TerraUSD (UST) in 2022 is a stark reminder of the risks involved.

Algorithm-Based Supply Adjustment: The algorithm adjusts the supply of the stablecoin based on market demand. If the price of the stablecoin is above its peg, the algorithm mints more stablecoins and sells them on the market, increasing supply and driving the price down. If the price is below its peg, the algorithm buys back stablecoins, decreasing supply and driving the price up.

Incentive Mechanisms: Algorithmic stablecoins often use incentive mechanisms to encourage users to participate in the system. For example, users may be rewarded with additional tokens for providing liquidity or staking their stablecoins.

Reliance on Confidence: Algorithmic stablecoins are highly reliant on market confidence to maintain their peg. If confidence is lost, a “bank run” can occur, leading to a rapid de-pegging and collapse of the system.

Example: (Former) TerraUSD (UST) aimed to maintain its peg to the US dollar through a mechanism linked to its sister token, LUNA. Users could burn UST to mint LUNA, and vice versa, in an attempt to arbitrage the price back to $1. However, when confidence in the system wavered, a massive sell-off of UST triggered a hyperinflationary spiral of LUNA, leading to both tokens collapsing.

Benefits of Using Stablecoins

Reduced Volatility

Stablecoins offer a significant advantage over other cryptocurrencies by providing a stable store of value. This makes them ideal for:

• Preserving capital in volatile markets.
• Facilitating everyday transactions without the risk of price fluctuations.
• Acting as a safe haven asset within the crypto ecosystem.

Faster and Cheaper Transactions

Stablecoins enable faster and cheaper cross-border payments compared to traditional banking systems:

• Transactions can be settled within minutes or seconds, compared to days with traditional bank transfers.
• Transaction fees are typically lower than those charged by banks or payment processors.
• No need for intermediaries like correspondent banks.

Access to Decentralized Finance (DeFi)

Stablecoins are essential for participation in DeFi protocols:

• Used as collateral for lending and borrowing platforms.
• Facilitate trading on decentralized exchanges (DEXs).
• Enable yield farming and other DeFi strategies.
• Provide a stable base for pricing and valuation within DeFi ecosystems.

Increased Accessibility

Stablecoins can provide access to financial services for individuals who are unbanked or underbanked:

• Offer a way to store and transfer value without needing a traditional bank account.
• Enable access to DeFi services for those who may not have access to traditional financial products.
• Lower barriers to entry for participating in the global financial system.

Risks and Challenges of Stablecoins

Regulatory Uncertainty

The regulatory landscape for stablecoins is still evolving. Governments around the world are considering how to regulate stablecoins, and the lack of clear regulations creates uncertainty and risk.

• Potential for stricter regulations could impact the operation and availability of stablecoins.
• Different jurisdictions may adopt different regulatory approaches, creating complexity for stablecoin issuers.
• Regulatory scrutiny could lead to increased compliance costs and reduced innovation.

Counterparty Risk

Fiat-collateralized stablecoins rely on a central issuer to hold reserves and redeem stablecoins. This introduces counterparty risk:

• The issuer may become insolvent or unable to redeem stablecoins.
• The reserves may not be fully backed by the claimed assets.
• The issuer may be subject to government seizure or regulatory action. The USDC de-pegging during the SVB bank crisis serves as an example.

De-Pegging Risk

Even stablecoins can lose their peg to the reference asset. De-pegging can occur due to:

• Market volatility and liquidity issues.
• Loss of confidence in the stability mechanism.
• Malicious attacks or manipulation.
• Black swan events like geopolitical crises.

The Terra/LUNA collapse is a prime example of de-pegging risk.

Smart Contract Risk

Crypto-collateralized and algorithmic stablecoins rely on smart contracts, which are vulnerable to bugs and exploits:

• Smart contract vulnerabilities could lead to the loss of collateral or the creation of unauthorized stablecoins.
• Hacks and exploits could destabilize the system and cause a de-pegging event.
• Complex smart contracts can be difficult to audit and verify.

Conclusion

Stablecoins play a vital role in the cryptocurrency ecosystem by providing stability, facilitating transactions, and enabling access to DeFi. While they offer numerous benefits, it’s crucial to understand the different types of stablecoins, their underlying mechanisms, and their associated risks. The future of stablecoins depends on addressing regulatory uncertainty, enhancing transparency, and mitigating the risks associated with each type of stablecoin. Careful consideration and due diligence are essential for anyone using or investing in stablecoins.

Read our previous article: Silicon Architects: Rethinking Processor Design For AI

For more details, see Investopedia on Cryptocurrency.