Not All Stablecoins Are Created Equal

Tomer Bariach
9 min readJul 28, 2022

JUNE 14, 2022

Hi fellow economics nerds, I hope you enjoy the wild ride that crypto life is gracefully supplying us.

I found myself talking a lot about stablecoins lately, and I would love to share my two stable cents on how I analyze stablecoins when coming across them: What are the benefits? What are the risk factors? And of course, If you find any mistakes in the article, please retweet proudly.

Disclaimer: This is not financial advice. I have invested in 2 of the tokens discussed herein. DYOR.

How do I analyze a stablecoin?

I tend to look at five key areas when evaluating a stablecoin:

  1. Governance: Centralized? Decentralized?
  2. Reserve (collateral): Its type (fully backed / over collateralized / under collateralized / not collateralalized) and its composition (i.e. what’s in the reserve).
  3. Primary market: When are the tokens minted (created/printed) and when are they burnt (deleted).
  4. Reserve management strategy: What’s in reserve and how is the reserve managed?
  5. Potential to fail: Why would this happen? How would a ‘run on the bank’ be handled?

The tokens discussed in this article are not necessarily the biggest but represent a wide variety of models which would be interesting to discuss. These are USDC, USDT, DAI, cUSD, UST, and Frax.

Now, let’s deep-dive into each token and explore the above and in addition — their primary market, reserve management strategy and potential to fail.

USDC

USDC is a regulated instrument backed by assets held at regulated and audited institutions.

  1. Centralized — see websitecircle.com(for example): run by a Corporation, Circle Internet Financial Limited, based in the US.
  2. Fully backed — USD or USD-denominated investments of equivalent value — users can find audits on their website:circle.com/en/usdc#attestation-section.
    It is essential to notice that we as users lack the transparency of the actual assets held in terms of credit risk, duration, etc. This is the major setback of centralized stablecoins vs. decentralized stablecoins
  3. Primary market — tokens are minted when USD is added to the reserve and burnt when withdrawn from the reserve.
  4. The reserve is cash (~24%) and short-duration U.S treasuries (~76%).
  5. As USDC is mainly backed by U.S treasury governance bonds — and stands the to the restriction of U.S regulators, but does hold the risks of a centralized entity.

As USDC has a simple backing strategy, it enjoys the title of the most secured asset.

USDT

  1. Centralized — run by a corporation, Tether Operations Limited, based in the US:tether.to/en/about-us, but is not in the same regulatory position as USDc.
  2. Fully backed — Unlike USDc, USDt reserve is structured of multiple assets, as can be seen heretether.to/en/transparency/#reports

Because of its lack of “last mile” transparency, it’s hard for me to give an actual opinion on the asset management strategy, but from the audits published on the USDt website, USDt is backed as described.

3. Primary market — tokens are minted when USD is added to the reserved and burnt when withdrawn from the reserve.

4. Reserve management strategy — as the USDT team exposes no transparent “strategy”, I prefer not to overanalyze.

5. I cannot form an opinion on the reserve structure, but — at times like these, when the general markets are in a downtrend that we haven’t seen in years and that may might last a while, the USDT reserve structure is undoubtedly going through a stress test.

DAI

First, credit is due — DAI is the first decentralized stablecoin, and it has inspired & influenced the design of most other decentralized stablecoins.

  1. Decentralized — coordinated by makerDAOs (makerdao.com/en), a decentralized organization (DAO) run by the community and its governance system. This means that no single individual (no CEO) can decide what to do/not to do — all governance decisions are proposed to the community and voted upon by the holders of the token.
  2. Collateral — described atdaistats.com/# — DAI is collateralized by a basket of digital assets (including Ethereum, bitcoin, and more) with a collateralization rate of 167% (which means that there is $1.67 in the “basket” for every $1 in DAI).
  3. DAIs mint and burn:

3(a) DAI is created when people ask for a loan and burned when people pay off their loan. Here is how it works:

  • Jon owns $1,500 worth of ETH and wants to leverage his position (i.e. get a loan against his ETH).
  • Jon stakes (deposits) his ETH to MakerDAO protocol.
  • Now Jon can borrow from the protocol about 50%-60% of the value deposited (over collateralized loan).
  • The DAI that Jon borrows — are newly minted DAI that Jon can use to buy more bitcoin; when Jon pays back his loan to the protocol, the DAI will be burnt.
  • If ETH goes down in price to under the 150% collateralization — the ETH loan gets automatically sold and the loan liquidated by a smart contract see example below

3(b) Once DAI is created — the DAI in circulation has been used as a USD digital equivalent for many other functionalities.

4. There is a limited number of assets that can be borrowed against in DAI collateral — that’s due to the added risk that each new purchase brings to the pegging. For an asset to be added to the collateral, it should be voted on by the MakerDAO governance system.

5. Run to the bank:

5(a) The main reason to see a run to the bank would be a drop in the significant assets that are the collateral (mainly WBTC, ETH).

5(b) How does DAI repeg? If the value of the Collateral drop below “liquidation price” (see an example taken from the MakerDAO website below), the assets in the collateral will be sold for a discounted price in an auction to repay some of the borrowed loans at times of significant market collapse people can get pretty good discounts on the assets being auctioned, DAI been able to maintain (so far) it’s stability to $1 even in pretty hard markets.

Liquidation example: the current minimum collateralization ratio for an ETH-A Vault is 150%. Suppose a user has deposited $ 1,500 worth of Ethereum as collateral on Oasis and generated 750 Dai. So, the initial collateralization ratio is 200% ($ 1,500/750). If the price of ETH falls or the debt increases due to accrued stability fee and the collateralization ratio falls below the minimum 150% threshold, then the Vault can be liquidated.

cUSD (cSTABLE)

A unique feature of cSTABLE, the Mento stable assets on Celo, is the ability of the protocol to support multiple stable coins with single collateral, which i believe would be crucial for real-life adoption

  1. Decentralized — governed by Mento, a decentralized, open-source smart-contract-based stability protocol on Celo run by the community and coordinated by a governance system.
  2. Collateral — celoreserve.org — collateralization rate today is 279% (the value backing the asset divided by the assets backing it). Currently backed 50% by CELO, the other 50% are non-CELO assets like BTC, ETH, and DAI.
  3. Primary market:

3(a) Mint — a user can buy one cUSD for $1 Celo

3(b) Burn — a user can redeem $1 celo for 1 cUSD

3(c) Because the crypto market is inefficient, if there’s a demand to cUSD on Binance, e.g the price of cUSD could go above $1 to $1.1 a user can then buy cUSD from the reserve at the price of $1 — this is when new cUSD are being minted and sell it on Binance for $1 — that action is called arbitrage.

3(d) The opposite can happen if cUSD is traded at $0.9; users can buy cUSD and sell back to the reserve in profit to balance the price of the market.

4. Reserve management — cUSD has a pretty exciting concept when it comes to its reserve management which is called “dynamic hedging”:

Dynamic hedging is a unique risk management tool that allows for a more conservative strategy in the moments of low demand (for example, if collateralization ratio is low, like 200% — the governance would adjust to 50% stablecoin and 50% variable) and for a more creative and risk-tolerant strategy in the moments of growth (for example, if collateralization ratio is high, like 400% — there can be 25% stablecoin and 75% other assets — including carbon credits).

Celo believes that if we align the creation of money with the creation of regenerative assets (like carbon credits) we will increase their demand and incentivize their creation. By linking the reserve to these regenerative assets — we are building a better, more sustainable kind of money.

5. Run to the Bank -

5(a) Half of the collateral is Celo tokens. A significant drop in its price could cause a run to the bank

5(b) The other half is backed by non-Celo assets. With an over collateralization of >2, all Mento stable assets are backed by non-Celo assets of more than 100%.

5(c) However, as explained above, dynamic hedging is designed to always have enough stable value in reserve to answer the demand in case of a run to the bank.

UST

  1. Decentralized — governed by Terra, a decentralized organization run by the community and coordinated by a governance system.
  2. Collateral:

2(a) On-chain — no collateral.

2(b) Off-chain — When UST was at $19B, the Luna foundation mentioned that they hold $3B to maintain the pegging on UST — which is about 15.7% — and the Luna Foundation Guard managed it in a way that was not transparent to the community or independently audited.

3. Primary market:

3(a) Mint — you can mint 1 UST with $1 of Luna

3(b) Burn — now this is the smoking gun, unlike the other stablecoins above that are burnt when converted to the assets in reserve, when 1 UST is being sold, Luna tokens in value of $1 are being minted.

4. Reserve management — there’s no reserve so no management, the Luna Foundation said that they used $3B of bitcoin to try and save the pegging.

5. Run to the Bank:

5(a) When Luna’s price was $100 Jon bought $1M of UST with only 10,000 Luna.

5(b) One day Luna’s price dropped to 10$ and caused a run to the bank: Jon sold his $1M UST and got back 100,000 Lunas — opening the door for an unlimited amount of Luna to be minted, at the moment that demand is most needed, increasing the selling pressure which enhances the run to the bank.

Frax

Frax takes another shot at making an under collateralized stable coin — they claim, that over collateralized asset has a scaling problem, and that’s why it’s worth trying under collateralized stablecoins

  1. Decentralized, governed by the Frax Finance, a decentralized organization run by the community and coordinated by a governance system
  2. Under collateralized -app.frax.finance — at the time of writing the reserve is structured as follows:

2(a) 89% collateralized — mainly by stable assets

2(b) 11% — backed by the future demand of FXS token. (similar to the relationship between UST al Luna above)

3. Primary market:

3(a) Minting — Frax is minted when a user adds $1 value, but only if the value on the secondary market is above $1.00333.

3(b) Burn — users can Redeem $1 for 1 Frax, only when the price of Frax is lower than 0.99333.

4. The unique part about Frax is how the decision to lower the reserve ratio (at the moment stands at 89%) simply speaking, when the price of Frax is low, the reserve ratio goes up, when the price is high, the reserve ratio goes down. This allows them to be more conservative in times of high risk (low demand — higher collateralization ratio) and support fast growth in moments of high demand (low demand — lower collateralization ratio).

5. Run to the Bank — As its reserve is backed mainly by various crypto assets, and barely has exposure to it’s native asset it could happen in a case of a market crash, but, and that’s a big but — the more the demand goes up, the higher the exposure to FRX token will be, in a good bull-bear market cycle, Frax token can become overexposed to FRX, and in a quick turn of FRX price create a run to the bank.

In conclusion, not all stablecoins are created equal. The different characteristics give us different scaling abilities and risk factors. As you choose a stablecoin, look at compatibility (which is important) and consider how comfortable you are with the organizations and economic design backing them. They ALL have inherent risks, and ALL can be pushed to the limit. Their security mechanism is tested when unexpected events happen (like an overnight 90% drop in value of their underlying assets).

At the same time, stablecoins are a great invention that make crypto more usable for real world use cases, and are a critical part of the infrastructure and ecosystem that will bring web3 to the world & life-changing applications.

Thanks to all my friends for reading drafts of this article, and every other human being that survived reading all of it.

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Tomer Bariach

Blockchain, Bitcoin, Nerd, love macroeconomics, atlas shrugged, community currencies, D&D player as a young kid, Token economics is a real thing.