What are Stablecoins?
Stablecoins are cryptocurrencies which attempt to be stable in value, maintaining low levels of volatility. In the traditional financial world, most attempts at stable currencies have generally involved pegging one government currency to another. Belize, for example, pegs the value of the Belize dollar to the US dollar, at a value of BZ$2 = US$1.
Stablecoins too, are typically pegged in value to a fiat currency (most often the US dollar). It is often stated that this is a stepping stone both to mass-adoption of blockchain systems and to the eventual creation of Nash-type ideal money.
Today, Stablecoins are primarily used as a non-volatile asset for speculative cryptocurrency trading and arbitrage. However, much of the interest in stablecoins is due to their potential to act as a catalyst for mass-adoption of cryptocurrencies. Designed to be low-volatility, they can act both as a medium of exchange and a low risk, store of value. The promise of stablecoins is that cryptocurrencies can evolve from purely speculative instruments into the cash of the digital era.
Overview of Existing Stablecoins
There are three general strategies used by stablecoin issuers to issue tokens designed to be stable in value. These are: off-chain-collateralized, on-chain-collateralized, and uncollateralized. Hybrid strategies which incorporate aspects of more than one of these general strategies are also sometimes used.
Off-chain-collateralized
Asset-collateralized stablecoins are backed by the promise of central deposit of real world assets. A promise (explicit or implicit) of redeemability of the stablecoin for the underlying assets provides the value peg. Underlying assets are most typically fiat-currency deposits in a bank, but some coins are backed by other assets (eg. a commodity such as gold).
Tether is the most popular example of a fiat-collateralized stablecoin. Founded in 2014, it has a current market cap of over US$16bn. TrueUSD, Circle USDC, and DigixDAO/DigixGold are other examples of off-chain-collateralized stablecoins.
On-chain-collateralized
On-chain-collateralized stablecoins are backed by deposits of other cryptocurrencies, held in on-chain escrow or baskets. MakerDAO’s DAI is the most popular example of a crypto-collateralized stablecoin. Launched in December 2017, it has a current market cap of over US$327M. Bitshares’ BitUSD, Augmint’s A-Euro, and Sweetcoin’s BridgeCoin are other examples of crypto-backed stablecoins.
Uncollateralized
Uncollateralized stablecoins are not backed by any deposits, but instead use algorithms to maintain a stable price, typically by expanding and contracting the supply of tokens in response to price movements. The most prominent examples currently are Terra and sUSD by Sythetix. Although the smallest category currently, Interest in non-collateralized stablecoins has been growing rapidly.
Problems and Risks of Existing Stablecoins
As the use of stablecoins has grown, problems and risks have emerged. Some of these are due to real-world constraints on broad strategies, and some specific to the issuer.
Strategy-based problems for fiat-collateralized stablecoins include lack of decentralization, counterparty risks, as well as regulatory constraints. As these tend to be regulated, they are typically only redeemable by customers of the issuer who have gone through KYC and AML verification. This makes it difficult for customers of one issuer, who are not themselves traders, to use the stablecoins as a medium of exchange to transact with customers of another issuer.
Cryptocurrency-collateralized stablecoins also come with strategy-based problems. Due to the volatility of cryptocurrency markets, these are typically over-collateralized, which necessitates large reserves, and often oracles as well. As was demonstrated during the market crash precipitated by the coronavirus pandemic in March, cryptocurrency-collateralized stablecoins are subject to sever deleveraging events in times of high volatility, as demonstrated below:
Additionally, these stablecoins cannot be converted directly from or into fiat currency which limits their adoption and issuance.
Non-collateralized stablecoins present their own set of problems. As they are typically implemented as smart contracts running on an individual blockchain, and as a blockchain can’t directly know anything that happens outside that blockchain, they typically require oracles (data feeds written into the blockchain by third parties), and these oracles themselves may be subject to manipulation. Further, it is an open question whether long term stability can be achieved without reserves.
As well as these underlying problems, individual stablecoins are also subject to risks specific to each coin. Levels of transparency, auditability, technical security, governance and compliance vary by issuer. This introduces risk in the form of questions about whether an issuer actually has the collateral that they claim, as well as the risk of regulatory intervention, as seen recently with Tether’s legal scrutiny by the New York Attorney General. Security is also a concern, particularly regarding the risk of security flaws in the software implementing the stablecoin as was demonstrated by a critical flaw in MakerDAO’s smart contract, which was uncovered in May of 2019. Security concerns arise not only with regard to potential bugs in the underlying code, but also in connection to the security controls implemented by issuers to safeguard their treasury. In November 2017, for example, Tether reported nearly US$31M worth of their tokens stolen, and in response suspended trading for nearly a month.
Finally, the stablecoin industry as a whole is subject to problems and risks due to the fragmented nature of the sector. Smaller issuers often suffer from shallow liquidity and poor convertibility. In an attempt to tackle the challenges of increasing fragmentation, Huobi, one of the largest cryptocurrency exchanges, implemented HUSD — a combined ticker on their platform that represented an aggregation of a number of different stablecoins. Huobi, in an attempt to appeal to additional stablecoin holders and overcome the fragmentation of liquidity on their exchange, allowed users to deposit and withdraw four different types of stablecoins, while combining them all into one aggregated currency that represents all USD-pegged stablecoins. This solution proved to be problematic however, since it provided a 1:1 exchange rate despite the fact that these four assets did not trade on par in the market. Consequently, Huobi was exposed to losses on these trades and experienced difficulty balancing the flow of stablecoins in and out of their exchange.
Due to the nascent nature of the space, even larger issuers can suffer from reputation loss caused by failures of unrelated projects. The myriad of approaches also presents difficulties for regulation, as it can be difficult to find a model that suits the majority of issuers.
Overall, the strategy based and issuer-specific problems in the stablecoin space promote the trend of increasing fragmentation of the market. Each stablecoin issuer will adopt a model and go-to-market approach that best aligns with their use case, regulatory approach and user base.
