BanklessDAO
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BanklessDAO

What’s Behind the Backing of Stablecoins?

Close up pile of lime green legos.
Stablecoins are a bit like money legos. (Photo by Greg Rosenke on Unsplash)

Introduction

With a lot of volatility in cryptocurrencies, there is a need for a calm place to store your investment when you redeploy your capital or just trade in and out of investments. For non-HODLers this could mean trying to time the market and selling some assets at the top or buying when a dip occurs. To do this you have two options: buy fiat currency such as USD or EUR, or convert your crypto into a stablecoin pegged to a fiat currency. But what is a stablecoin?

A stablecoin is a type of cryptocurrency whose value is tied to an outside asset, such as the U.S. dollar or gold, to stabilize the price.

Think of it as a virtual dollar. And since this dollar is also a cryptocurrency, you can trade them on the same decentralized exchanges you trade your other cryptocurrencies on. It is a much faster way to move in and out of assets as you do not need to send your money back to your bank account and wait for settlement. Many centralized exchanges allow you to trade directly into fiat, decentralized exchanges do not provide that option and thus stablecoins are a great alternative.

Three Types of Stablecoins

Fiat backed: Ideally every stablecoin is matched to a reserve of one unit of fiat currency. A physical bank stores the collateral so the owner of a stablecoin can redeem it for a real dollar. However, with fractional reserve banking, the banks can achieve a higher return by investing the collateral elsewhere instead of storing it in a vault waiting for stablecoin holders to redeem it. Tether, the largest stablecoin by market cap, is under constant scrutiny to reveal their real backing rate.

Crypto backed: This stablecoin is backed by a collateral of cryptocurrencies. In the case of DAI, the collateral can be posted in ETH and is then locked up in a collateralized debt position, or CDP. The contract is overcollateralized at a rate of 150%, so when you want 1 DAI (pegged to 1 USD), you need to post 1.5 USD worth of ETH. The contract tracks the value of your ETH and will automatically sell off ETH to maintain 150% collateral (this page provides a good summary).

Algorithmic: Instead of holding collateral in a bank, an algorithm burns or mints stablecoin tokens depending on the movement of the stablecoin’s price. This keeps the price pegged at $1. UST, the stablecoin of the Terra ecosystem, is balanced by Luna, the utility token of the ecosystem. It enables arbitrage opportunities that help keep UST pegged to USD. This is how it works: When the demand for UST increases and its value rises above the peg of $1, Luna can be swapped 1:1 for UST. This lets Luna holders profit from a rise until they have swapped enough, or introduced enough supply, to bring the peg back down.

What are Stablecoins Used For?

In countries with high inflation or uncertain economic conditions, stablecoins can be a way to store money in a less inflationary and safer way. In many such countries, it’s difficult to get real USD without a US bank account. A stablecoin might be a good alternative here.

Urban street depicting one story shop with blue awning reading Money Transfer and a man standing in the doorway.
Old-fashioned money transfer storefront. (Photo by Tech Daily on Unsplash)

Transferring money globally with very low transaction fees is something remittance was waiting for. You can send money to your family in another country and they can swap it for local fiat currency on their local exchange without paying Western Union or another remittance service a large part in fees.

Stablecoins’ main use case is being a stable asset inside the crypto environment. It’s a substitute for the dollar, which is used as the trading currency in the traditional financial markets. It’s also the lubricant of financial and crypto markets. Coingecko’s stats show that 24 hour trading volume of stablecoins makes up more than 50% of all crypto trading volume. The chart below lists the top three coins per market cap. BTC and ETH dwarf USDT’s market cap, yet you can see that USDT’s 24 hour volume is more than BTC and ETH combined.

This indicates what an important role stablecoins play. Crypto needs them for trading and yet the mechanisms they are supplied with are disputed heavily in the crypto space. Let’s look into the issues.

Can We Trust Stablecoins to Hold the Peg?

If you use stablecoins as a substitute for fiat dollars, you want them to stay stable even if the crypto market is very volatile. Most of the fiat-backed stablecoins don’t seem to be 100% backed by USD cash reserves so in case of a bank run it will be questionable if you can redeem your money. Tether’s terms of service highlight that you might not get USD cash and a payment could be delayed.

Tether reserves the right to delay the redemption or withdrawal of Tether Tokens if such delay is necessitated by the illiquidity or unavailability or loss of any Reserves held by Tether to back the Tether Tokens, and Tether reserves the right to redeem Tether Tokens by in-kind redemptions of securities and other assets held in the Reserves.

Tether is in fact only backed by 75% cash and cash equivalents, of which less than 3% are actual cash reserves. A while back they misplaced 850 million dollars in USDT, and shelled out 18.5 Million to the New York Attorney General to settle the matter. Tether Holdings has 15 employees.

Can we trust 15 people hanging around a water cooler with access to 850 Million in liquidity? Maybe, maybe not. After constant scrutiny, Tether finally revealed their backing rate.

Breakdown of what’s backs a Tether token depicted in a pie graph. 75.85% Cash and cash equivalents, 12.55% secured loans, 9.96% corporate bonds, 1.64% other investments.
Composition of one unit of Tether.

Iron Finance’s TITAN token is another example of an untrustworthy stablecoin. Designed as an algorithmic stablecoin, it was backed partly by an algorithm and partly by its own TITAN token and USDC. The algorithm design is crucial, but it did not maintain well on a major price drop. In an event similar to a bank run, the value of the supporting token TITAN dropped to zero because of its oversupply. This caused the IRON stablecoin to completely lose its peg, unable to recover. Here is a part of the post mortem from the Iron Finance team:

Later, at around 3pm UTC, a few big holders started selling again. This time, after they started, a lot of users panicked and started to redeem IRON and sell their TITAN. Because of how the 10mins TWAP oracle works, TITAN spot price drops even further in comparison to the TWAP redemption price. This caused a negative feedback loop, as more TITAN was created (as a result of IRON redemptions) and the price kept going down. A classic definition of an irrational and panicked event also known as a bank run. At the time of writing this, the TITAN supply is 27,805 billion.

Breakdown of “What’s in a DAI?” (Source: Streamlit.io)

DAI, the crypto-backed stablecoin introduced above, had its own issues holding its peg to the USD. When the market tanked and the crypto assets it used to back the stablecoin went down dramatically, DAI was not able to maintain stability to the US Dollar. As a result, MakerDAO now backs a large percentage of DAI with centralized assets (USDC). DAI is currently about 2/3rds USDC and ⅓ ETH. For a deeper dive look here. Although DAI was and is a step in the right direction, it’s now mostly centralized.

Decentralized Stablecoins

Crypto is all about decentralization, breaking down centralized institutions and distributing their power. Yet, the majority of stablecoins are still tied to the centralized institutions — banks — which the Bankless DAO would like to see changed. Our best shot at this probably are algorithmic stablecoins.

Terra’s algorithmic stablecoin has a different approach: it tries to base UST on real world use. This is done in the form of a payment network (CHAI), synthetic assets (Mirror) or UST lending protocol (Anchor) and a bunch more. Think of the US Dollar here. The US Dollar is not important because of the Fed, but because of its global utility. Terra taxes real transactions to reward staking, avoiding a feedback loop (improving on IRON/TITAN). It might take some more market crashes and bear markets though to see if it can survive some rough weather.

Green ropes tied together forming a tetrahedron-looking object.
RAI tokens are purely backed by Ethereum, and thus are always on-chain.

In February of 2021, a purely ETH-backed fork of DAI called RAI arrived on the scene. Rai is not pegged to a fiat currency. RAI only uses ETH as collateral. RAI remains relatively stable compared to ETH, but can fluctuate in its dollar value. Basically, it’s a smart contract that runs a “cruise control buy sell machine” which incentives interest rates on one or the other to maintain stability between the two over time. RAI is truly decentralized. RAI co-founder and CEO explains,

It works kind of like a spring: the further the market price of RAI moves from the target price, the more powerful the interest rate, and the greater the incentive to return RAI to equilibrium.

The pure ETH-backing means it is fully decentralized. It acts like a sovereign currency because it’s not pegged to USD. CEO Ammen Soleimani called it, “Money God”.

Conclusion

Stablecoins have great importance and without them, the ecosystem wouldn’t work the way it does. Like everything early, there are flaws and room for improvement. As we keep building and innovating, better protocols and opportunities will arise. For the time being, try to research and check the background of a stablecoin before holding large sums for long time periods. The key takeaways are: not every stablecoin is decentralized and many rely on central institutions, and not every stablecoin will stay stable.

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