Let’s Talk Stablecoins

MindWorks Capital
13 min readAug 1, 2022

Introduction

With Aave detailing their plan for their own stablecoin in a governance post earlier this month, let’s revisit the topic of stablecoins after UST tarnished the good name of stablecoins and left everyone, especially newcomers and crypto skeptics, suspicious of them.

Twitter account mistaking GHO as an algorithmic stalecoin
Rebuttal from Aave’s Head of Developers Relations

Generally speaking, there are 5 types of stablecoins:

  1. Central Bank Digital Currencies (CBDCs)
  2. Fiat-Backed Stablecoin
  3. Collateralized Debt Position (CDP) Stablecoin
  4. Fractional-Algorithmic Stablecoin
  5. Algorithmic Stablecoin
Primer on different types of stablecoins
Risk Spectrum of Stablecoins

Central Bank Digital Currencies (CBDCs)

Description

Central Bank Digital Currencies (CBDCs) are stablecoins that are issued by central banks that are pegged to the value of the country’s fiat currency. This is an evolution of fiat currencies that does not rely on any intermediaries such as banks, thus eliminating the risk of intermediaries failing.

Banks are not intermediaries with CBDCs, but are service providers instead

History

With governments across the world pushing out stimuli to their citizens during the COVID-19 era, central banks began to explore the idea of central bank digital currencies. CBDCs can shorten the lead time for central bankers to inject stimulus as well as reduce the complexity with intermediaries such as banks that are involved in the process.

A Bank For International Settlements (BIS) study in 2020 has shown that 86% of central banks were exploring CBDCs, 60% were conducting experiments or proofs-of-concept, and 14% were in the development of pilot arrangements.

Central banks’ work on CBDCs. Source: BIS

The most prominent CBDC project being implemented is in China with the digital renminbi. The digital renminbi began testing in April 2020 in four cities in China and has since expanded to over 12 regions. It was also rolled out for foreign attendees at the 2022 winter Olympics in Beijing. At the end of 2021, China’s official digital yuan app, e-CNY, had over 261 million unique users and has seen transactions totaling 87.6 billion RMB (US$13.8 billion).

Advantages

CBDCs will be the safest stablecoin as it is issued by central banks. CBDCs are safe from any intermediaries and counterparty risks to which current fiat money is subjected.

CBDCs would be much faster and cheaper to transact than the current financial system. Transactions can be completed in seconds rather than days, even with cross-border payments. This leads to a much more efficient financial system.

Using CBDCs can also increase the country's financial inclusion, especially in a country with a higher level of rural populations. People can bank themselves with a mobile phone, rather than having to go to a physical bank.

Disadvantages

Centralization is a major concern when it comes to CBDCs. As the ledger for CBDCs is controlled by the governments, theoretically, governments can freeze or seize assets in users’ accounts at any time without warning. Governments can also dictate where citizens will and will not be allowed to spend their money.

Privacy is also another great concern when it comes to CBDCs. The public ledger could be tracked to follow user spending, leaking individuals’ spending and transactions.

Key Risks

The same risks are subject to the country’s currency, such as default risk and FX risk. Otherwise, the CBDC should stay in pegged as it represents the country's fiat money.

The same risks are subject to the country’s currency, such as default risk and FX risk. Otherwise, the CBDC should stay in pegged as it represents the country's fiat money.

Fiat-Backed Stablecoins

Description

Stablecoins that are 100% backed by cash or government bonds held by the issuer. Fiat-backed stablecoins can be redeemed 1:1 for fiat currencies.

Fiat-backed stablecoin mint/burn mechanisms

History

Since Bitcoin’s release, researchers have been looking to build new cryptocurrencies on top of blockchains. In 2014, Tether entered its private beta with 3 Tether tokens: USTether, EuroTether, and YenTether. Bitfinex enabled trading of Tether on its exchange, and the stablecoin quietly gained popularity among crypto traders.

Circle, the issuer of USDC, saw the potential of the stablecoin market and launched USDC in 2018. Due to Tether’s controversial reputation and Circle building its brand around transparency and compliance, USDC quickly rose to prominence and became the 2nd largest stablecoin after USDT.

Advantages

Fiat-backed stablecoins are the current safest option when it comes to stablecoins on blockchain networks as it is backed by assets held by the issuers.

Fiat-backed stablecoins, such as USDC and USDT, are much cheaper and faster for businesses to transact when compared to the current financial infrastructure. Even for individuals, sending stablecoins remittance is cheaper, faster, and more secure than using traditional remittance companies.

Fiat-Backed Stablecoins vs Swift vs International Remittance

Disadvantages

Fiat-backed stablecoins are censorable. Stablecoin issuers such as Circle have the ability to blacklist addresses as well as prevent addresses from transacting the stablecoins.

Key Risks

As fiat-backed stablecoins are issued by a centralized entity and therefore carry risks subjected to the centralized entity. For example, USDC is issued by Circle. Circle could have its assets frozen by a court. In that case, USDC is no longer redeemable for $1 USD and would likely trade far below its peg.

Stablecoin holders should also exercise caution over the reserves of stablecoin issuers. The main revenue generator for Stablecoin issuers is the yield from fixed income products such as commercial paper & government bonds bought using the reserves.

Circle and Tether both disclose the reserve assets held in their respective treasury. However, there has long been speculation over the reserve assets for Tether, and critics and regulators have been calling for stronger oversight and transparency over reserves backing the stablecoins.

Circle Reserves Breakdown
Tether Reserves Breakdown

Collateralized Debt Position (CDP) Stablecoins

Description

Collateralized debt position (CDP) stablecoins are stablecoins that are backed by overcollateralized assets that are locked up in smart contracts. Although each protocol has a different approach to the protocol mechanism, it generally involves the following mechanisms.

CDP Stablecoin Minting and Redemption Mechanisms

For example, Using Maker, you could deposit any collateral accepted, such as ETH, stETH, wBTC, and mint DAI. The collateral ratio and the fees charged would depend on the asset chosen.

Maker Collateral Options

History

DAI was the first CDP stablecoin launched. Smart contracts used by the MakerDAO were launched on the Ethereum mainnet in December 2017. At first, it only had Ether as the only collateral available. DAI was able to maintain a close peg to 1 USD during the first years of its existence, despite Ether dropping more than 80% during the time.

As DeFi gained popularity, more CDP protocols emerged, with the biggest being Abracadabra. Money, Liquity, Yeti Finance, and more.

Use Cases

The primary use case for CDP stablecoin is for users to borrow against their digital assets, giving them access to spending power without having to sell. For example, if Bob has $100,000 in ETH and would like to purchase a car worth $20,000 without having to liquidate his asset. He can deposit $100,000 worth of ETH into Maker, borrowing $20,000 in DAI and converting it into USDC for his purchase.

Borrow Against Digital Assets

CDP also allows you to lever up on-chain without having to deal with centralized entities. For example, let’s say Bob has $100,000 worth of WBTC, and he is extremely bullish short-term and would like to lever up on WBTC. Bob can borrow DAI against his WBTC and immediately deposit WBTC back into Maker to maintain his collateralization ratio.

Levering Up on Digital Assets

DeFi protocols now offer one-click solutions for users to lever up their assets, such as the following by Maker. With certain collaterals, users can lever up their assets up to 4.33x.

Some DeFi protocols such as Abracadabra.Money and Yeti Finance allows you to deposit yield-generating assets, effectively allowing you to lever up and multiply your yield. The following was Abracadabra. Money’s degenbox strategy for the now defunct UST Anchor yield strategy. At this strategy's height, users could generate over 110% APY.

Credit: Abracadabra.Money

Advantages

CDP stablecoins are censorship-resistant and are free for all to use. DAI, MIM, or other CDP holders would not have to worry about their stablecoins being frozen and their assets on the protocol being seized.

Disadvantages

As CDP stablecoins are overcollateralized, it is very capital intensive to scale. For example, Maker has a TVL of $7.97 billion, but DAI in circulation is only 6.9 billion. In comparison, Abracadabra.Money has a TVL of $490 million, but the total MIM borrowed is $202 million.

Moreover, because CDP stablecoins are often swapped for fiat-backed stablecoins in order for users to lever up, they often trade very slightly below peg under normal market conditions as selling pressure > buying pressure. However, the inverse happens in a bear market when users have to acquire CDP stablecoins to repay their loans, leading to periods when CDP stablecoins trade above peg.

Key Risks

The most important aspects of a CDP protocol are the protocol’s liquidation engine as well as the collateral enabled by the protocol.

Liquidation Engine

The liquidation engine refers to the mechanisms in which the protocol liquidates outstanding positions in which the collateralization ratio has fallen below the protocol’s threshold. Take Maker, for example, its ETH positions require a minimal collateralization ratio of 170%. Once the collateralization ratio for an open position falls below that 170%, it should be liquidated as soon as possible to protect the over-collateralization of the protocol.

This is done differently with each protocol.

For Maker, it utilizes a Dutch auction that functions as follows:

  1. Collateral trove has fallen below its minimal collateralization ratio, and a Keeper triggers liquidation.
  2. Once liquidation is triggered, all collateral in the trove will be put for auction to cover outstanding DAI and liquidation penalty.
  3. Bidders now bid in DAI to cover outstanding DAI and the liquidation penalty.
  4. A reverse auction occurs, and bidders compete to liquidate by accepting less collateral for the DAI they bid.
  5. Once the reverse auction completes, bidders receive the collateral from the auction, and the trove owner receives the remaining collateral.
Dutch Auction Overview

For Liquity and Yeti Finance, they employ a stability pool to act as the first line of defense in maintaining protocol solvency. The stability pool functions as follows:

  1. Users can stake CDP stablecoin of the protocol into a stability pool to participate in liquidations.
  2. When troves fall below their minimum collateral ratio, stablecoins in the stability pool are used to pay back loans, and the stability pool receives the collateral as a result.
  3. Users are incentivized to stake in the stability pool as the pool benefits from the liquidation penalty, typically around 10%. In other words, when $100 LUSD in Liquity stability pool liquidates a trove, it typically receives $110 in ETH in return.
  4. Over time, stability pool stakers lose a pro-rata share of their deposits while gaining a pro-rata share of the liquidated collateral.
Stability Pool Overview

Collateral Enabled

It is crucial to remember that every collateral in a CDP protocol is equally important for the integrity of the protocol. A protocol is only as strong as its weakest collateral as even one asset free falling could put enormous stress on the liquidation engine of the protocol.

Fractional-Algorithmic Stablecoin

Description

Fractional-Algorithmic stablecoins are partially backed by fiat-backed stablecoins and partially backed by crypto tokens. It is soft-pegged to one USD by seigniorage, trading incentives for traders to maintain the peg.

Frax uses its DAO to set the collateral ratio for its FRAX stablecoin. Hypothetically, let’s say the collateral ratio is at 80%. 80% of FRAX should be made up of collateral such as USDC, and 20% made up of FXS.

When FRAX trades below $1, it creates an arbitrage for traders to purchase FRAX and redeem it for $0.8 in USDC and $0.2 in FXS. Conversely, when FRAX trades above $1, an arbitrage opportunity is available for traders to mint FRAX using $0.8 in USDC and $0.2 in FXS and selling it above $1.

FRAX’s Minting & Redeeming Mechanisms Source: Frax Finance

History

When Maker and DAI were launched, many DeFi researchers bemoaned DAI’s lack of scalability as the protocol is required to be overcollateralized. As a result, Frax, then known as Decentral Bank, was first announced in May 2019 as the first fractional-algorithmic stablecoin protocol.

Frax draws inspiration from both CDP protocols and algorithmic stablecoins to create a new scalable, trustless, stable on-chain money called FRAX. FRAX was initially fully collateralized by USDC, but over time FXS, Frax Shares, can be used to mint and redeem FRAX stablecoin.

Advantages

As fractional-algorithmic stablecoins are decentralized, it is censorship resistant, similar to CDP stablecoins.

As fractional-algorithmic stablecoins are not fully collateralized, so they are much more scalable than CDP stablecoins. FRAX has been able to grow to 1.5 billion marketcap in less than 2 years.

As FRAX is partially collateralized, it is much more resilient than algorithmic stablecoins. In fact, FRAX has never seen a serious depegging to $1.

Disadvantages

Fractional-algorithmic stablecoins rely on arbitrage to maintain the peg. During periods of high volatility, traders may be less inclined to participate, causing the stablecoins to depeg during high-stress periods.

Fractional-algorithmic stablecoins with a low collateralization ratio may also be prone to bank runs when asset prices greatly decline.

Use cases of fractional-algorithmic stablecoins protocols also pale in comparison to CDP protocols. Most of the on-chain use cases other than as a store of value are yield farming on decentralized exchanges.

Key Risks

Collateral stored in the protocol, such as USDC in Frax, has a chance to be frozen as it is issued by a centralized entity. Although unlikely, FRAX investors could enter a scenario where the partial backing of the stablecoin suddenly is unable to be redeemed.

Algorithmic Stablecoin

Description

Algorithmic stablecoins are entirely backed by crypto tokens, and they rely on seigniorage, trading incentives, and arbitrages to maintain the peg.

UST Mint & Burn Mechanism

Similar to fractional-algorithmic stablecoins, algorithmic stablecoins rely on arbitrate traders to maintain the peg. For example, traders can redeem 1 UST for $1 of LUNA when UST trades below peg. Conversely, when UST trades above peg, traders can mint 1 UST using $1 of LUNA.

History

First attempts in algorithmic stablecoins started in 2018 with notable projects such as Basis and Havvy. Both did not succeed as algorithmic, and Basis even returned capital back to investors after SEC deemed it as offering unregistered securities to users.

Basis Cash, a Basis imitator, was launched by an anonymous team that later was discovered to be led by Do Kwon, founder of Terraform Labs.

Basis Cash failed to maintain its peg and shortly found its stablecoin trading below peg and spiraling to zero. The project was subsequently abandoned.

Algorithmic stablecoin, along with Do Kwon, caught a break with LUNA and UST bursting onto the scene. LUNA, the token native to the Terra ecosystem, was designed to mint and burn UST stablecoins. With Terraform labs building Anchor and offering 20% APY for UST deposits, UST quickly gained popularity amongst retail and even institutional investors.

At its peak, UST had a market capitalization of 18.8 billion and became the third largest stablecoin behind USDT and USDC.

Market Cap for UST

However, it all quickly evaporated when UST and LUNA entered a death spiral following UST’s depeg. For a summary of the events leading to UST’s death spiral, please visit our Twitter thread on the subject.

Advantages

Algorithmic stablecoin is the easiest to scale and has the best capital efficiency as no collateral is needed at all. This is why UST could go from 0 to almost 19 billion in market cap in less than two years.

Disadvantages

As there is collateral for the stablecoins, algorithmic stablecoins are extremely prone to a bank run. Once the bank run starts, strong liquidity relative to its market cap is needed to repeg its peg. Therefore, the bigger the stablecoin, the harder it is to restore the peg.

Key Risks

Depth of liquidity for the digital assets is crucial to the successful maintenance of the peg. However, constant deep liquidity is impossible to maintain, especially in times of great volatility. Therefore, algorithmic stablecoins are most prone to depeg during market crashes, an extremely important time for a store of value to maintain its value.

Closing Remarks

After UST, investors have been indiscriminately worried about stablecoins’ ability to stay in peg regardless of their categories. While some skepticism is healthy, it is important for investors to understand the stablecoins they are holding and the key risks associated with them.

Stablecoins on blockchains are a wonderful way for people across the world, especially in developing countries, to gain access to a safe store of value and its importance and development should not be hindered by blind mistrust after the UST fiasco.

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