Deconstructing Stablecoins: A Bridge to a Decentralized Future
The emergence of Bitcoin in 2009 allowed us to look at the financial market from a completely different perspective. We had known as the only monetary system that has gained a severe digital competitor. It’s incredible how, just a couple of years ago, no one would have believed that gold bugs and Bitcoin supporters would be debating which is the better store of value today.
With BTC holding the fort, thousands of new cryptos have emerged, and we are witnessing how our future as a society is unfolding with this new technology. But again, everything continues to be super unique. Despite gaining exponential global prominence in the last few years, crypto as an asset class can’t be accepted as traditional assets such as equity or gold. Growing acceptance and maturity of the market go hand in hand.
When you own crypto, there’s no central bank involved trying to pull strings to make the purchasing power of the currency stable over time. Most protocols, especially the new ones, continue to be highly volatile.
Some consider that this is one of the leading causes that prevent crypto from being adopted en masse.
Let’s think about it:
When you throw a small rock into a pond, you see the effect it has on it, right? But imagine throwing the same rock into the ocean. It will hardly have any impact.
That’s how we can think about small-cap coins. The smaller the market capitalization, the higher the volatility. These protocols are more affected by everyday buy and sell orders than higher cap coins or even fiat currency like the U.S. Dollar.
So, is there a safe escape ramp to prevent this volatility? Today, we will talk about stablecoins built to provide peace of mind in space.
What are Stablecoins?
While cryptocurrencies are often known for their volatility, stablecoins bring newfound stability to cryptocurrency markets by allowing fiat currencies like the U.S. dollar or other stable assets to be represented on the blockchain as digital tokens. The intention here is to allow anyone around the world to hold a synthetic form of currency that’s purposely designed to maintain its value concerning the underlying asset, for example, the fiat currency it emulates In most cases.
The most famous example is USDT, where 1 USDT tries to maintain a value of 1 U.S. dollar.
Fun fact: stablecoins began to rise in popularity after the 2017 mania. After Bitcoin rose to almost $20,000 then fell by more than 50%, investors looked for a less volatile crypto-based store of value.
In a nutshell, stablecoins aim to provide stability. Given the significant volatility of the market, cryptocurrencies do not allow to maintain the size of an investment portfolio constant in the long term. Stablecoins provide traders with a safe harbor, allowing them to reduce their risk to crypto-assets without leaving the crypto ecosystem. Having said this, another goal for this asset is to be widely used as currency for daily transactions, giving holders one less reason to need a bank account. For a whole movement about a declaration of independence from banks and other centralised financial providers, stablecoins are doing their part.
Stablecoins are one of the newest hot spots on the crypto market. They can enhance the efficiency of the provision of financial services, including payments, and promote financial inclusion. Interestingly, these projects are constantly iterating on finding new mechanisms to transact and retain value, redefining modern finance without fiat being the center of attention.
We all have seen their incredible growth in 2020 and 2021 under the DeFi market influence. The total dollar value of stablecoins has shot up from the low US$20 billion a year ago to US$139 billion today. In one sense, this is a sign that the cryptocurrency market is maturing, but it also has regulators worried about the risks that stablecoins could pose to the financial system.
How do stablecoins work?
There are several types of stablecoins; the most common types are listed below:
- Fiat-backed stablecoins: This is the most famous version, directly pegged to fiat currency at a 1:1 ratio. The coin’s issuer carries out the production and liquidation of the cash. In principle, the central authority issuer stores a certain amount in reserve currency and issues a proportional amount of tokens.
Famous examples: USDT, USDC, TrustToken, TrueUSD
- Crypto-backed stablecoins: this version uses other cryptocurrencies (e.g., ETH) as collateral for the stable coins. However, because the crypto values themselves are not stable, these stablecoins need to use a set of smart contracts to ensure that the price of the stablecoin issued remains at $1.
Crypto-backed stablecoins minimize the necessary trust; for this reason, it should be noted that the voters determine their monetary policy.
The term used to refer to such kinds of stablecoins is “over-collateralization.” It means that a relatively large amount of reserve cryptocurrencies may be needed to issue even a small number of tokens. To receive a crypto-collateralized stablecoin, you must lock your collateral tokens in a smart contract. The collateral is retrievable later by paying stablecoins back into the smart contract, thus liquidating the position.
Famous examples: MakerDAO (DAI), Havven.
While the previous methods have proven to be largely effective, some critics argue that collateralized stablecoins of this kind might be susceptible to custodial risks and may require on-chain over-collateralization.
- Algorithmic stablecoins: They represent a wholly different tokenomic methodology. Algorithmic stablecoins are not pegged to fiat, commodities, or cryptocurrencies. Instead, price stability is achieved solely by algorithms and smart contracts that manage the delivery of the token issue. Their resilience is derived from a working mechanism, such as a central bank.
By the principles of supply and demand, when demand increases, the total supply of the asset increases, and when demand decreases, its entire supply decreases, making it much more affordable to ensure that prices remain stable.
Famous examples: Ampleforth, DefiDollar (DUSD), Frax (utilizes characteristics from both collateralized and algorithmic models)
If you would like to go deeper into the mechanics of Stablecoins, we recommend you to read this article by Chainlink.
Future of stablecoins
When we talk about a ‘stablecoin,’ we usually mean a coin that is stable relative to something we care about. In the case of most stablecoins, they care about being stable to the dollar. More specifically, they aim to be worth exactly $1.
We believe there are several issues with this approach:
- It can be challenging to maintain the same peg, especially in phases of lower demand.
- Increasing regulatory pressures are primarily aimed at stablecoins backed by USD.
- In times of expansionary monetary policies (such as now), people’s purchasing power is constantly eroded.
- Given the global nature of crypto, it does not make sense to have its stable primary currency tied to one particular state’s fiat currency.
Currently, there is almost unlimited money in circulation; interest rates are still at record lows, and with the U.S. government having just voted to accept another economic stimulus package worth US$1.2 trillion, the supply of money is not likely to be reduced significantly any time soon. Why would we want to have our crypto tied to this monetary inflation?
It seems that new technologies like algorithmic stablecoins represent the actual quest for a genuinely decentralized stablecoin. However, algorithmic stablecoins have not yet achieved widespread adoption, given that their use typically requires more advanced familiarity with blockchain tech.
DeFi 2.0 is around the corner, and liquidity ownership can change the rules forever. With OlympusDAO or Tokemak, we are witnessing a new free-floating currency backed only by what’s held in the treasury of the protocols.
Earn Passive income with AVAX & Stablecoins
Despite market volatility, farming based on liquidity pools consisting only of stablecoins is one of the most conservative and low-risk ways of investing in cryptocurrency. For this reason, the rewards will be less attractive than in other pools.
Apart from not having to suffer from impermanent loss, you will be earning the swapping fees from the stable pools, and you can also win rewards from the issuance of tokens.
Some of the most famous protocols for farm stables are Curve, Axial, Popsicle Finance, and Orca. We strongly recommend you check them out since they are offering fantastic opportunities at the moment.
Incredible yields at Popsicle Finance for the USDC/UST pair
Talking about risks, there’s always the outside chance of a security hole in the smart contract. We recently saw what happened with Curve, which had locked billions over the years. The other risk is to the underlying stablecoin itself. There’s no risk of impermanent loss if the stablecoin stays stable. However, a sudden sharp drop in the price of Ethereum could make DAI break a dollar (as it’s issued over collateralized loans), and if you’re doing leveraged yield farming, this can get you liquidated. Of course, there are always external risks, such as USDC getting frozen by the SEC due to the American jurisdiction.
