A stablecoin is cryptocurrency pegged to the value of an underlying asset, typically a fiat currency such as the US dollar. Stablecoins emerged to provide a stable means of entering and exiting volatile cryptocurrency positions without leaving the blockchain ecosystem. As such, while limited in their speculative potential, stablecoins share many of the same benefits as other cryptocurrencies, such as transparency and peer-to-peer transactions enabling fast settlement.
The use of stablecoins became popular on centralized exchanges following the bull market in 2017, with centralized issuers such as Tether (USDT) and Circle (USDC) leading the market. However, proponents of decentralization have long sought to develop a suitable mechanism for stabilizing the value of an asset that does not depend on centralized intermediaries – with varying degrees of success. Consequently, centralized stablecoins continue to dominate the market, although their future is far from certain, given the evolving regulatory situation.
This article will serve as the introduction to a series of four focusing on stablecoins. The first piece will outline the stablecoin “trilemma” – trade-offs that have emerged over the evolution of stablecoins to date, while future articles will examine fiat-backed, commodity-backed, crypto-backed, and algorithmic stablecoins respectively.
Evolution of stablecoins
The first stablecoins emerged in 2014, one of which was called Realcoin, which would later rebrand itself as Tether. The firm pioneered the most straightforward version of a stablecoin, whereby a centralized issuer mints a digital coin backed 1:1 by fiat currency, which is held in reserve. However, Tether has long been a controversial firm precisely because of the fact that for many years, it declined to offer proof of its reserves. Other leading stablecoins that have followed the fiat-reserves model include Circle’s USDC and Binance’s BUSD.
The risks of relying on centralized entities inspired the development of decentralized stablecoins backed by cryptocurrency, such as Maker’s DAI or Liquidty’s LUSD. The key challenge with this model is that crypto is notoriously volatile, creating a risk that stablecoins could become undercollateralized in the event of a market crash. Indeed, this event played out in March 2020 when the crypto markets crashed in response to the onset of the pandemic and the Maker protocol began liquidating its stablecoin loans.
To mitigate this risk, protocol rules typically state that stablecoins must be heavily overcollateralized to offset the risk of volatility. However, this makes crypto-backed stablecoins an inefficient use of capital.
The deficiencies in fiat- commodity- and crypto-backed stablecoins prompted the creation of a third type – algorithmic stablecoins. The best-known example to date has unfortunately become a cautionary tale. Terra’s UST token was backed by the LUNA currency and relied on a mint-and-burn algorithm to balance supply and demand, which was ostensibly to ensure that the price of UST would remain stable. Anyone could mint 1 UST by burning $1 worth of LUNA tokens, and vice versa.
If UST went above the $1 peg, then users would step in by depositing more LUNA to create more UST, increasing the supply and stabilizing the price. Conversely, if UST fell below the $1 peg, users would trade the premium by withdrawing their LUNA and reducing the supply of UST, increasing the price.
However, this previously untested model proved to be vulnerable in the face of unfavorable market conditions. In May 2022, UST lost its peg and the protocol faced the digital equivalent of a bank run. The two tokens entered a so-called “death spiral,” as traders scrambled to recover any value left in their UST holdings, and flooded the market with LUNA.
Each iteration of stablecoin – fiat-backed, commodity-backed, crypto-backed, and algorithmic – has demonstrated strengths and vulnerabilities that are often at odds with one another. Thus, stablecoins present a kind of trilemma, where issuers are forced to choose which factors are the most important: peg stability, capital efficiency, or decentralization.
The main purpose of a stablecoin is to track the value of the asset to which it is pegged at all times. Price stability can be achieved by backing the stablecoins with collateral - either fiat currency in a bank or cryptocurrency – or via an algorithm. The confidence of investors and users plays an important role in maintaining peg stability.
Centralized, fiat-backed stablecoins have proven the most effective at maintaining peg stability, while algorithmic stablecoins have fared the worst.
Capital efficiency describes the value needed to create one unit of the issued stablecoin. A high capital efficiency is necessary to drive the demand for, and therefore the supply of, the stablecoin. If the value needed to create the stablecoin is equivalent to or less than its nominal value, the system can be considered capital efficient. Fiat-backed, commodity-backed and algorithmic stablecoins are generally capital efficient. However, crypto-backed stablecoins that require over-collateralization are an inefficient use of capital.
The third part of the trilemma is decentralization. The decentralization of a stablecoin is characterized by the ability for anyone to create or destroy it, without having to go through a trusted intermediary such as a bank. Decentralized stablecoins generally aim to be censorship-resistant, transparent and permissionless.
Algorithmic and crypto-backed stablecoins can meet some or all of the criteria of decentralization, while there are currently no fiat-backed stablecoins that qualify as decentralized. The market evidently prizes peg stability as the most valuable of these features, as the top three centralized, fiat-backed stablecoins currently account for around one-third of the total market capitalization of crypto. However, due to recent events concerning BUSD, the market capitalization of stablecoins could prove volatile over the coming months.
The next article in this series will explore those events in more detail with an in-depth analysis of the current state of fiat-backed stablecoins. Further articles will examine commodity-backed, crypto-backed and algorithmic iterations. The requirement to manage multiple stablecoins across different accounts and exchanges is yet another operational challenge and risk vector facing digital asset portfolio managers.
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