Crypto 101: Stablecoins
Stablecoins are the lifeblood of crypto trading, but what are they? How do they work, do we really need them, and why?
There ain’t no such thing as a free lunch — Unknown
Crypto Stablecoins: A Primer
At their core, stablecoins are attempting to solve three, semi-related problems in the crypto space:
- Asset price volatility
- The exchange of unrelated assets
- Facilitating trades exclusively on the blockchain
The first two problems are not unique to crypto. They are endemic to modern finance. They are also (partially) the result of a fundamental flaw in the modern concept of money. If you want to wander down that rabbit hole, I wrote a three-part series: part one, part two, and part three.
If a monetary history lesson isn’t your cup of tea, I’d recommend you at least read my article on how crypto liquidity pools work. I believe safe crypto investing requires a decent understanding of liquidity and trading. Without that knowledge, it is much harder to determine the risk of a crypto investment.
If the liquidity article is a little TL;DR for you, the nut-shell version is: in order to trade anything, there must be something to trade it for. For example, if people want to trade apples and oranges, there has to be enough of both in order to trade.
The more of each you have, the more liquid (available for trading) the apple/orange ‘market’ is. If there are only two apples and two oranges to start with, a person trading two apples will deplete the oranges entirely. If you have 100,000 apples and oranges (high liquidity), a person with two apples will barely make a dent.
Price volatility and mismatched trading
I imagine most people reading this are aware the price of a crypto asset can fluctuate wildly from (quite literally) minute to minute. One big cause of this volatility is the relatively low liquidity in crypto. As of this writing, the total dollar denominated market capitalization (cap) of the crypto space is around $1.84 trillion.
The trouble is, about $785 million is in Bitcoin (BTC) and another $326 million is in Ethereum (ETH). That leaves less than half the crypto market cap (roughly $700 million) to divide across all of the other crypto projects. For perspective, that’s roughly the same market cap as Berkshire Hathaway.
So, not only is the liquidity relatively low, it is also spread out across thousands of crypto projects. Moreover, before stablecoins, if you wanted to trade crypto, you only had two choices. You could either:
- trade your crypto for fiat (government backed currency); or
- trade it for another crypto
Trading for fiat works fine, but it defeats the purpose of a decentralized digital currency. Trading for another crypto is fine as well, except the dollar value of the crypto asset changes constantly due to supply and demand.
Imagine what it would be like if you could only trade Amazon (AMZN) stocks for Nike (NKE) stocks directly. The stock prices of both companies are changing constantly. If Nike had a record profit and Amazon had a loss, who in their right mind would trade Nike for Amazon directly in such a circumstance?
Of course, everyone could track the price changes and try to trade at opportune times. But the process would be very time consuming and inefficient. The more likely result would be trading would eventually stop altogether.
What crypto needed was a digital dollar that was on the blockchain. Since the US Government didn’t make one, the next best thing was a crypto token ‘pegged’ to the US dollar. As in, stablecoin protocol operators issue a token with a promise that you will always be able to exchange a $1 crypto stablecoin for $1 in fiat currency.
This way, someone can trade crypto assets just like stocks, except instead of trading crypto for fiat, they could trade it for a fiat equivalent token on the blockchain that always follows the price of a dollar. The only reason it has to ‘follow’ the dollar is because, like crypto, dollars trade on the open market.
Pegged assets are not a new idea
Today, as far as I know, all modern fiat currencies ‘float’ on the open market. Meaning, fiat currency is not ‘pegged’ to anything. Most major international fiat currencies trade for other currencies, just like crypto does.
Fiat currency is actually a debt instrument. Every US dollar you carry is a debt the United States government ‘owes’ you for holding those dollars. The ‘promise’ (thus promissory note) is the US government guarantees you can always redeem US dollars at a 1:1 ratio with, well….US dollars. They also mandate (legal tender law) that people accept US dollars in the USA.
What gives US dollars value is the ‘full faith and credit’ of the United States. It wasn’t always this way though. The US dollar used to be pegged to gold. The history of gold peg schemes goes back a few hundred years. Many countries have tried (and failed) to maintain those gold pegs.
The US Dollar Gold Peg
The 20th century gold peg in the US started as: The US government will trade you a $20 bill you have to accept for all payments (legal tender law), but that $20 bill is guaranteed to be redeemable (able to trade back) for one ounce of gold.
The US government couldn’t keep that promise though, because they didn’t have enough gold to cover the dollars in circulation. To fix the problem, they outlawed private gold ownership, collected (stole) all the privately held gold and changed the redemption fee to $35 instead.
And you thought crypto was risky.
There’s also an important lesson from all this: in ANY pegging system, whether gold to dollars, apples to oranges, or xUSDx crypto tokens to US dollars, if there are insufficient assets to cover demands for redemption, sooner or later the protocol WILL collapse.
This is especially true in a crisis. During a crisis, most people want the valuable thing, not the promise to receive it. If enough people demand a return of the pegged asset (the one with actual value) and there’s not enough of that asset to go around, the promise becomes worthless.
This is commonly known as a ‘bank-run’ and it’s what caused the Iron Bank ‘stablecoin’ to collapse. It’s also what caused thousands of banks to collapse in the 1920s. In all cases, these collapses are the result of under-capitalization. Meaning, there were not enough reserve assets to cover demand for redemption.
Knowing this should help you tremendously in figuring out which crypto stablecoins are ‘better’ than others.
Types of crypto stablecoins by reserve mechanism
Crypto stablecoins can be broken down into four asset reserve categories:
- Full reserve: where the token is collateralized 1:1 with US dollars
- Partial reserve: where the token is collateralized with a mix of US dollars and other financial assets like commercial paper (corporate debt).
- Crypto reserve: where the token is collateralized (usually overcollaterlized at 1.5:1 or 2:1 because of price volatility) by other crypto assets
- Magical Unicorn reserve: where the token is backed by a mix of math (algorithms), game theory based incentives, flawed reasoning, and/or ‘hopium’
Full reserve tokens are the safest by far
Binance USD (BUSD), Paxos Standard (USDP) and TrueUSD (TUSD) are the three largest full reserve crypto stablecoins. These three tokens are almost certainly backed 1:1 by US dollars.
I say almost because I haven’t audited the reserves myself. But trustworthy third parties have, and they’re all regulated (more or less) by recognized financial authorities in the US. Basically, they’re about as safe as you’re going to get in crypto, at least in terms of redeemability for US dollars.
Partial reserve tokens are riskier, but some are safer than others
Tether (USDT) and Circle/Coinbase (USDC) are partial reserves. Between the two, USDC is by far the safer option. There was a (very) long period in Tether’s early days where they had a few billion dollars of USDT outstanding, but the company didn’t have a single bank account anywhere in the world.
Tether ranks high among the shadiest companies on the planet. They also have the highest stablecoin market cap by a good margin. I use USDT regularly because it is the most widely accepted stablecoin out there.
I also think it is as toxic as strawberries from Chernobyl. For the time being it is very liquid, but it wouldn’t take too many dominoes to fall for Tether to completely implode. I use it when I have to, but otherwise I avoid it as much as possible.
The vast majority of Tether’s ‘reserves’ are in commercial paper. At one point, they held the most commercial paper on the planet. The trouble was, companies like Goldman-Sachs and Chase Bank, who deal regularly in commercial paper, had never heard of Tether. That might be a red flag — just sayin’.
USDC’s reserves are a mix of treasuries, securities, commercial paper, cash and commodities. These assets are regularly audited by reputable companies. They are also more volatile than US dollars and enough pressure from large enough external shocks (major war, natural disasters, aliens invading, etc.) can leave USDC undercollateralized. It’s not likely, but it’s definitely possible.
Crypto reserve tokens are experimental
MakerDAO (DAI) is a crypto reserve token that uses some Magical Unicorn algorithms to maintain its dollar peg. In terms of risk, the protocol is very much an experiment, but it’s done quite well holding peg through some pretty turbulent market conditions.
Of all the stablecoins I want to find success, DAI is probably at the top of the list. So far, it appears to be the closest to a truly decentralized stablecoin that might actually work. To get DAI, basically a user locks Ethereum (or some other crypto asset) to borrow DAI.
They can then use that borrowed DAI to buy other crypto assets. Clever little bees will often use that to buy more ETH, which they redeposit to borrow more DAI. The selling point is you can have your ETH and use it too.
The downside is, if you are over-levered (more DAI debt than ETH), you can get liquidated (lose your collateral deposit). If ETH were stable, this wouldn’t be too much of a risk. But ETH is not stable and in times of high volatility, it’s really easy to get burnt.
The DAI protocol has an in-built ‘emergency brake’ that theoretically will prevent a bank run. If the total locked asset value drops to a certain point, all DAI transactions are ‘frozen’, so everyone who put an asset in can get it back. I’d hate to be a test case for that scenario.
Unfortunately, my gut tells me that scenario is going to happen sooner or later. But in the meantime, I don’t mind using a little hopium to cheer on the DAI experiment.
Magical Unicorn reserve tokens are by far the riskiest play
Terra (UST) is a ‘stablecoin’ token that backs itself with the protocol issued LUNA token to maintain the dollar peg. It does this through arbitrage (profit incentive from price imbalances) and seigniorage (making currency less valuable). The biggest problem with this scheme is — it can’t work.
The way the wheels fall off these protocols (and the wheels have fallen off many) goes like this:
- Stablecoin loses peg due to sell pressure from manipulation, external shock, irrational investor behavior, zombie apocalypse, etc.
- Confidence in governance/bond/share token (LUNA for UST) plummets because peg is broken
- Governance/bond/share token value drops
- More sell pressure on stablecoin as investors try to cut losses
- Death spiral into oblivion
All of the Magical Unicorn protocols have a treasury mechanism that is supposed to buy up the stablecoin and burn them to reclaim peg under downward sell pressure. But as the famous economist John Maynard Keynes once pointed out:
Markets can remain irrational far longer than you can remain solvent
In truth, the governance/bond/share token is an illusion. The only true backstop to the stablecoin is the treasury reserve. If you take nothing else from this lesson, remember people ALWAYS want to be able to redeem the pegged asset for the valuable asset.
The ONLY way a pegged asset can ALWAYS pay that debt is to have a 1:1 reserve. You can’t have a third (or fourth) un-backed asset ‘back’ the peg. The ONLY way these Magical Unicorn protocols can continue to maintain the peg is with new money (suckers) coming in.
If you know that going in, you can make money on the backs of the suckers. If you don’t know that going in and buy into the idea of ‘money printers going brrr’ type thinking, sooner or later, you’re going to be the sucker.
How can I make money with stablecoins?
In my opinion the safest (and my most favored strategy) is to provide full reserve or partial reserve stable pair liquidity. A protocol I’ve been using a lot lately is Planet Finance.
On Planet Finance right now, you can earn around 12% APR for providing USDC/BUSD liquidity, 10% for TUSD/BUSD, and 8% for DAI/BUSD. I know those aren’t 3000% degen yields. I also know they probably won’t collapse overnight.
To be fair, I’ve done quite well with Terra and Anchor earning 20%. I also know it’s a gamble and I’m in the process of pulling my LUNA stake as I write this. I did quite well with the recent price pump, provided it doesn’t drop before the 21-day un-bonding period expires. I’ve also had solid gains with other Magical Unicorn protocols, like Tomb Finance.
They have pretty amazing APRs if you can stomach the risk. Tomb seems to be holding up fine right now, but I know it’s just a matter of time before they poop the bed. I’m too risk-adverse to stay in those projects for more than a week or two. And I definitely don’t commit any significant money to them.
I hope you’ve found this helpful. Of course, these are just my opinions. I’m not a financial advisor, this isn’t financial advice, and always DYOR. Following any of these ideas might cause you to lose all of your money. I am 100% serious about that. I like tinkering with this stuff, but I’m on record acting like a total baboon. Invest accordingly.
Until next time, be safe, be smart and be sure to tie the camel.
