DeFi Basics #6 | Stablecoins:

I am writing a series of posts on DeFi basics from the past several months(sorry for my inconsistency). In this post, I wrote about Stablecoins which are one of the most important aspect of crypto. Check the previous articles here

Introduction

The emergence of cryptocurrencies like bitcoin, ethereum etc., has introduced a revolutionary way to think about financial transactions, free from the constraints of intermediaries like traditional banking systems. With their ability to facilitate secure, transparent, and rapid transactions on a global scale, crypto has created a level playing field for developers, creators and users alike. However, their price volatility hampers their adoption for everyday transactions . As of this writing the total stablecoin marketcap and in circulation is above 160bn with USDT leading the pack.

Stable-coins are a category of cryptocurrencies that seek to offer the benefits of digital currency — like security, transparency, and speed — but with a stable value. They achieve this stability by pegging their value to more stable assets, such as fiat currencies (e.g., the US dollar), commodities (e.g., gold), or sometimes to other cryptocurrencies.

This hybrid nature makes Stable-coins a solution to the problem of volatility of digital currencies. Stable-coins are also more practical and useful for daily transactions, savings, and act as a medium of exchange in decentralized finance (DeFi). The trifecta effect in the ecosystem that is enabling Stable-coins as a medium of global commerce are

1. Digital wallet infrastructure — UI/UX has to be improved a lot.
2. Reduced transaction costs(gas fees reduction due to blobs or whatever)
3. Speed of settlement through movement of value.

In this post, I would like to delve deep into the different models out there in the current market as a first step for understanding followed by details and examples(of protocols) in each of them.

To begin with, I found this simple framework posted by @_portersmith (slightly changed to reflect the current state of market) super helpful for initial understanding.

Use-cases for Stable-coins(in and outside of crypto) :

Stable-coins have wide variety of use-cases as depicted above. Within the DeFi ecosystem, they are used in LPs and provide collateral across different dApps. Also an emerging use case which interests me the most is to settle instant payments and cross-border transfers from B2B and peer to peer money transfers. This use case is big and I hope to see several apps coming out in this space.

Collateral Types: Exogenous vs. Endogenous

The classification into exogenous and endogenous collateral is crucial for understanding how different stablecoins aim to achieve stability.

Exogenous Collateral

• This involves assets external to the stablecoin’s ecosystem, such as fiat money or other cryptocurrencies that have independent uses and value. For instance, DAI uses Ethereum as collateral, which remains valuable and functional outside of its role in backing DAI. This separation ensures that the collapse of the stablecoin wouldn’t necessarily affect the value of the collateral asset. In centralised stablecoins USDC and USDT have exogeneous collateral in the form of US dollars in a US bank account.

Centrally Managed (e.g., USDT)

• Mechanism and Stability: USDT, or Tether, is pegged to the US dollar, with reserves held by a central issuer. This central management ensures cost-effectiveness by avoiding the need for over-collateralization, but it introduces counterparty risk and potential vulnerabilities to regulatory actions.
• Market Data: As of early 2024, USDT’s market capitalization reached approximately $112 billion, capturing around 70.6% of the stablecoin market share. Its 24-hour trading volume was about $120 billion, highlighting its extensive use in crypto transactions (CryptoGlobe) (Binance).

Decentrally Managed (e.g., DAI)

• Mechanism and Stability: DAI is an Ethereum-based stablecoin managed by MakerDAO, backed by cryptocurrencies like ETH through smart contracts requiring over-collateralization. This model ensures stability but increases costs due to the need for higher collateral ratios.
• Market Data: DAI’s market capitalization is around $5.3 billion. It is extensively used in DeFi applications for lending, borrowing, and trading (CoinDesk) (Binance).
• Advantages: Provides greater independence and transparency as users can redeem stablecoins independently without relying on a central authority.

Endogenous Collateral

• This refers to assets that are inherently part of the Stable-coin’s system, often created within the same protocol. The stability and value of the Stable-coin are intrinsically linked to these internal assets, meaning a failure in the Stable-coin could directly impact the collateral’s worth. UST’s reliance on LUNA as collateral is an example where both the Stable-coin and its collateral were deeply interwoven, leading to mutual vulnerability and eventual collapse.

Centrally Managed (e.g., TerraUSD)

• Mechanism and Stability: TerraUSD (UST) was an algorithmic stablecoin backed by LUNA. Its stability mechanism involved minting and burning LUNA to maintain the peg. However, this interdependence made it vulnerable to market confidence crises.
• Controversies: The collapse of UST in 2022, due to a loss of market confidence, led to a significant financial disaster, questioning the viability of algorithmic stablecoins without robust collateral.
• Market Impact: The failure of UST has led to increased regulatory scrutiny and skepticism about algorithmic stablecoins’ ability to maintain stability (CryptoGlobe).

Decentrally Managed (e.g., sUSD)

• Stability and Costs: Stable-coins like sUSD are backed by assets within the same blockchain ecosystem (e.g., SNX tokens for sUSD) and are managed decentrally. This arrangement offers better stability compared to centrally managed endogenous Stable-coins and provides a high degree of independence. However, they also require significant over-collateralization (often more than 400%), which increases their costs but helps maintain stability during market volatility.

Over the last few years, the stablecoin market has experienced significant changes due to regulatory actions and technological advancements. The Lummis-Gillibrand Payment Stable-coin Act was introduced on April 17, 2024. This legislation requires stablecoin issuers to maintain 1:1 reserves, effectively bans algorithmic Stable-coins, and establishes an FDIC-supervised process for managing insolvent issuers. These measures aim to enhance consumer protection and ensure market stability by treating stablecoins similarly to traditional financial instruments

Stablecoins are becoming a critical component of the global financial system, bridging the gap between traditional finance and the crypto world. Regulatory frameworks like the Lummis-Gillibrand Payment Stablecoin Act are providing the necessary oversight to ensure stability and consumer protection. Technological advancements are making stablecoins more efficient and practical for various uses.