Stablecoins: Digital Dollars Demystified
This post was originally written in June 2021. One year later, a complete rewrite was released, sponsored by Notional Finance. It has now been thoroughly revised in May of 2023 with no official sponsor. If you like what you read, please feel free to collect this post as an NFT on Optimism.
Hey friends 👋
At the time of writing, there are over ten thousand tokens listed on CoinGecko, a popular site for keeping track of cryptocurrency value. These tokens are listed by market capitalization (coin price multiplied by circulating supply), and the first two are, as one might expect, Bitcoin and Ethereum. But many of the top 100 have something else in common. They are stablecoins.
What are Stablecoins?
Stablecoins are basically digital dollars. In simplest terms, these are cryptocurrency tokens that are valued 1:1 to a fiat currency; most commonly the US dollar. The idea that these coins stay close to their intended value, or peg, offers a few distinct features not found in cryptocurrencies like Bitcoin. Allow me to explain.
When it comes to building wealth, most people will tell you that you’re better off holding assets like stocks, bonds, commodities, or real estate than dollars. This is because it’s hard to earn a good return on dollars, especially at most traditional banks.
For years, Bitcoin (which is programmatically disinflationary) and Ethereum (which uses a burn mechanism called EIP-1559 to disinflate/deflate supply as network demand increases) have been touted as currencies, and while more and more commerce is taking place with these units of exchange, they are not ideally suited to this function.
But why?
Stability, my dear Watson
Just like deflation may disincentivize the use of a currency due to the opportunity cost of spending versus saving, volatility, introduces further uncertainty into every transaction. Either the payment I gave you will be worth more than what I received, or the payment you received will be worth less when by the time you go to spend it on something else.
One of the most iconic examples of this is the so-called bitcoin pizza. In 2010, Laszlo Hanyecz wanting to demonstrate the promise of Bitcoin to be, as its creator Satoshi Nakamoto described it, a peer-to-peer electronic cash, purchased two pizzas for 10,000 Bitcoins; now worth over $250,000,000
Laszlo claims not to regret the decision, but one could imagine a person with real financial need feeling differently. Over the years, for most people, Bitcoin has shifted the role from a currency to a long-term investment; digital gold.
By contrast, stablecoins allow two parties to transact without worry of sudden shifts in value. They are, thus, a requirement for most formal contracts, the most practical form of currency for everyday transactions, the preferred option for cross-border remittances, and a sensible half of any exchange traded pair of tokens.
And, importantly, since stablecoins do not fluctuate wildly in price, those living in countries with capital gains taxes on the disposition of cryptocurrencies, can avoid triggering taxable events when making purchases.
Now that we’ve covered the reason for their existence, let’s dive deep on what is undoubtedly the most important question we can ask…
Where do they get their value?
As I mentioned at the beginning of this article, there are many popular stablecoins in circulation, each claiming to be pegged to a given reference currency, but what is a peg, and how do these so-called stablecoins maintain that peg? Anyone can say “this coin is worth 1 USD” but unless there’s consensus between every buyer, seller, sender, and receiver that the coin is worth 1 USD, the whole thing falls apart. And this has happened occasionally, so we definitely want to do our research before converting our greenbacks to digital dollars.
Let’s take a look at exactly what underlies the most popular stablecoins.
Fiat-collateralized Stablecoins
Examples: USDC, GLO, GUSD, TUSD, USDT
The most common way to create a trusted stablecoin is to collateralize each token at a ratio of 1:1 with actual fiat, held by a trust, ideally in some sort of audited reserve at one or more banks. But that’s not always the way so-called fiat-backed stablecoins work.
You may have heard of Tether, aka USDT. Tether is basically the OG stablecoin, originally launched on the Bitcoin blockchain via the Omni protocol. Now ported to basically every major blockchain, Tether enjoys the highest level of acceptance in the DeFi space, holding for many years the number three spot by market cap. However, not everyone trusts Tether.
In 2019, the New York Attorney General filed a lawsuit against Tether accusing the company of misappropriating funds. The lawsuit was settled out of court for $18.5M, but questions have repeatedly come up about Tether’s use of debt to collateralize their issuance, as well as their inconsistent self-reporting of their offshore reserves.
For this reason, many people prefer to bypass Tether in favour of some of these other options:
USD Coin, aka USDC, is the second most popular stablecoin by market capitalization. Like Tether, it is fiat-collateralized, but unlike Tether, it is backed only by USD cash and cash-equivalents, is held in custody in the United States in a fully audited and monitored account, and is redeemable 1:1 for US dollars via Circle’s website, Coinbase, and other exchanges.
Something you may not know about USDC is that it is a business; and it’s profitable. This is because Circle holds a portion of USDCs backing in short-term treasury bills, so it earns interest. By their estimates, they intend to earn over a billion in 2023. And this is essentially harmless, posing little to risk to USDC as these are considered liquid assets. Still, many people have no idea that this is part of the business model.
Enter GLO, a stablecoin that functions identically to USDC in every way, except one. GLO is a product of the non-profit Glo Foundation, and the income generated from these interest-bearing assets is donated to GiveDirectly to provide basic income for those living in extreme poverty. It’s a subtle tweak to an already successful formula that I find extremely compelling.
TUSD, not to be confused with USDT, is another interesting fiat-backed stablecoin. The innovation behind TrueUSD and its siblings TrueGBP, TrueCAD, TrueAUD, and TrueHKD is that real-time, on-chain data is viewable at any time via a technology called LedgerLens pioneered by TrueCoin and their partners at Chainlink and Orum. If you prefer to steadfastly follow the maxim “don’t trust, verify.” you should check out their real-time reserve balance dashboard, here.
Fiat-backed stable coins are popular, especially among users in the United States (and lawmakers), and something like USDC will be preferable especially for institutions settling large dollar sums, but this type of coin does suffer from one particular flaw…
Centralized Risk
The reason many people prefer to keep their money in a bank is because those deposits are insured. Not insured from theft, fraud, or misuse by you or any joint account-holder, but insured from the bank itself.
FDIC insurance exists because banks can go out of business. But when they go out of business, what happens to the funds? The answer before the 1930s was that all your money was gone. And gone it was for many during the great depression. The solution came from Franklin D. Roosevelt with his inauguration of the Federal Deposit Insurance Corporation. The FDIC, like the CDIC in Canada, has banks pay a form of insurance on deposits they hold, such that a reasonable amount is protected for every depositor. Here’s an interesting anecdote from the FDIC’s 1998 report: A Brief History of Deposit Insurance in the United States.
Federal deposit insurance became effective on January 1, 1934, providing depositors with $2,500 in coverage, and by any measure it was an immediate success in restoring public confidence and stability to the banking system. Only nine banks failed in 1934, compared to more than 9,000 in the preceding four years.
9000! So, the mere existence of deposit insurance helped to provide a tremendous amount of stability to the financial system, to the benefit of many Americans. And yet, ironically, trust in financial institutions is at an all-time low. This is due in part to the disenfranchisement of many communities, high fees, and scandal after scandal from greedy bankers. Clearly, insurance is not a solution to all the problems with the current financial system.
Recently, there have been a slew of bank runs, leading to some of the largest bank failures since the 2008 financial crisis, and even causing ripple effects into the crypto markets. On March 11, 2023, Silicon Valley Bank collapsed with $3.3 billion of Circle’s assets trapped inside. Furthermore, the collapse took place on a weekend, outside of regular banking hours, meaning Circle had no recourse—outside their public statements—to cool off the markets. The result was a massive depegging event that took more than 10% off the value of USDC.
Market fear, coupled with the poor design decision of allowing stablecoins like DAI to be backed by a portion of USDC, led to depegging across many stable assets. Those which fared the best, typically had something in common. They were not backed by fiat.
Overcollateralized (Crypto-backed) Stablecoins
Examples: DAI, LUSD, agEUR
What if anyone, anywhere in the world, could mint their own stablecoin? This was the question that MakerDAO was seeking to answer with the creation of the Dai Stablecoin.
Maker allows users to deposit Ether into a vault to create an overcollateralized loan, against which DAI is minted and borrowed. This overcollateralization allows Maker to ensure that DAI can hold its peg even through wild swings.
In March 2020, as the global pandemic was declared, extraordinary market volatility caused a deleveraging spiral that allowed DAI to briefly reach $1.11 and caused liquidation for many users. MakerDAO responded quickly with changes to how the protocol handles liquidations and with the new Multi-Collateral Dai (MCD) system which allows for collateral supply of other cryptocurrencies, including, as I alluded to before, other stablecoins.
In fact, even as DAI’s collateral has diversified in the past year to include (wrapped) staked Ether and even real-world assets, it remains majority-backed by USDC. This stake led to DAI temporarily losing around 8% of its value during the depegging event and called into question whether it is sufficiently decentralized.
When DAI diverged from its roots and became multi-collateral, it left a hole in the market that needed to be filled. Decentralization maximalists wanted a token which was backed exclusively by Ether. One response to this was Reflexer Finance’s RAI, which we will discuss in the section on flatcoins. The other, was Liquity.
Liquity USD, or LUSD, is an ETH backed stablecoin. Similar to DAI, LUSD can be minted and borrowed against crypto collateral; in this case ETH exclusively, at a minimum collateral ratio of 110%. Depositors can take an interest-free loan with no repayment schedule, making it a promising option for those going long Ether.
Like any loan, there is the risk of liquidation, and during periods of volatility, it is probably a good idea to use a higher collateral ratio to reduce this risk, but that is not exclusive to this protocol.
What is unique to Liquity is its governance free protocol design, not to mention its capital efficiency. During the depegging event that affected USDC and DAI, LUSD was less affected by the market panic, and because of its design, users were able to buy LUSD at a discount and repay their loans.
For as much as I’ve mentioned the depegging event, it was not the catastrophe some feared it would be. Fiat-backed stablecoins were able to be collateralized thanks to FDIC insurance and Circle’s own profit reserves. Similarly, DAI and Liquity’s own mechanisms helped to bring them back on peg fairly quickly.
That’s the benefit of collateral. Its sole function is to backstop the value when market faith or game-theory are simply not enough. The last time a big stablecoin depegging event happened, collateral wasn’t available, by design…
Undercollateralized Stablecoins
Examples: UST, BAC, USDD
Imagine a stable, currency-pegged token, that was bankless like Dai, but didn’t require overcollateralization. Sounds too good to be true, right? Well, so far, it has been. Every so-called algorithmic stablecoin thus far has had its controversy and chaos. In my piece Crypto Misadventures: (Im)permanent Loser, I talked about how I got rekt taking a gamble on Iron Finance’s vision of an algorithmic stablecoin. In retrospect, Iron’s approach had pretty obvious flaws that neither I nor Mark Cuban took the time to study.
Since then, we’ve seen an even bigger meltdown by way of the Terra Luna collapse. Terra was an EVM compatible blockchain that used a symbiotic relationship between the platform’s native token, LUNA, and a family of stablecoins, the most prominent of which was a US dollar-pegged token called UST.
Using a system very similar to the one employed by failed projects Iron Finance and Basis Cash, Terra tried to create a stablecoin where rather than backing the coin, a process of seignorage is employed. How this works is that when UST goes above the $1 peg, the protocol incentivizes users to burn LUNA and mint UST. When UST goes below the $1 peg, the protocol incentivizes users to burn UST and mint LUNA.
The problem, of course, is that when both assets fall in tandem, the only solution in the protocol is to rapidly inflate LUNA to be able to burn enough to bring UST back towards its peg. If there is no demand for UST because people are jumping ships as the price collapses, both tokens can easily go to zero.
And that’s precisely what happened. Both LUNA and UST lost so much value that the only remaining option was to fork the blockchain, and create a new ecosystem in which the algorithmic stablecoins were no longer a feature.
Now, we’re seeing this exact model being proposed once again with USDD on the Tron blockchain and given how little difference there is between this project and Terra, it’s probably best to sit this one out too.
One undercollateralized stablecoin that remains relatively successful is FRAX.
Frax gets its name from the fractional-algorithmic stability mechanism it employs. This novel approach shifts the ratio of collateralization algorithmically according to the market’s pricing of the FRAX token. If FRAX is trading at above $1, the protocol decreases the collateral ratio. If FRAX is trading at under $1, the protocol increases the collateral ratio.
The idea here is actually based on the design of collateralized stablecoins. If we assume that the market only has confidence in a token because they believe it is redeemable for $1 of value, then logically, why not back it accordingly? Adding collateral increases confidence during times of doubt, and reducing collateral decreases confidence at times when the market has started to overvalue or speculate against the token.
Currently, the only accepted collateral for FRAX is USDC, which on one hand reduces risk of volatility, but on the other hand, introduces sufficient counterparty risk. As a result, it more or less tracks the price of its collateral, which, given its approach to collateralization, is pretty interesting to say the least.
With that said, I wonder if FRAX is better to be understood as a derivative (of USDC) than a currency in its own right. There’s nothing wrong with that. It adds value to the ecosystem, and can even function as a medium of exchange, but I’m just not sure if I’d necessarily call it a stablecoin.
Speaking of things that are not quite stablecoins, let’s look at an emerging category, of cryptocurrencies that aim to be stable, but not pegged to fiat.
Flatcoins
AMPL — Elastic Supply Rebasing Token Ampleforth is a rebasing token that aims to maintain a peg over long periods (while being volatile over short periods) through a novel mechanism of supply elasticity.
Essentially, the protocol inflates or deflates supply every single day algorithmically to ensure long-term stable value. Interestingly, and perhaps most importantly, it is non-dilutive, which means you are not buying a number of coins, but rather a percentage of the total. This means, as the supply shifts, your balance shifts to help the currency return to its peg.
While stablecoins aim to maintain a peg to the current value of the US dollar (or whatever fiat currency they’re pegged to), Ampleforth is now, and will (theoretically) be forever, pegged to the value of the 2019 US dollar. Making this, ideally, a truly stable currency, even free from the effects of currency debasement.
However, due to the volatility that AMPL sees in the short term, it’s not ideal for spending, so a solution was needed. Enter, SPOT.
According to the Ampleforth Docs,
SPOT is a perpetual note backed by fully collateralized AMPL derivatives. SPOT can fulfill many properties of modern day stablecoins but is not pegged to any particular value. Its price will likely float within a range similar to AMPL and you can think of SPOT as a derivative that strips away most of AMPL's supply volatility.
A deeper dive into SPOT could fill out an entire article; one which I’ll probably write at some point. For a pretty decent understanding, I recommend watching the above video.
There’s one other flatcoin, I want to talk about, which is one of the most well known.
Reflexer’s RAI token is a decentralized and non-pegged stable asset that ignores the USD paradigm entirely. Like AMPL it is intended to free float closely to an original value of $3.14 USD (February 2021 price) but that’s where the similarities end.
CoinTelegraph explained the design well:
RAI’s ability to maintain a stable price despite fluctuations in the value of its ETH backing revolves around its PID Controller — a control loop mechanism similar to a car’s cruise control. The asset has two prices, a redemption price and a market price. When the market price deviates from the redemption price, an interest rate for those who have staked Ethereum is set to oppose the price move, incentivizing users to return RAI to the target price.
Reflexer has managed to remain relatively stable, albeit having fallen well below the initial price target to a stability zone of around $2.80. It does all this while being what Reflexer refers to as governance minimized.
Recently, the Reflexer community announced a fork of RAI, called HAI which is going to be launched on Optimism. It’s similar to RAI, but also quite different. Here’s a snippet from the announcement on the Reflexer community forum.
Additionally, HAI will have a governance token, KITE (yes, the whole thing is a 420 themed joke about being high as a kite), and the token holders will guide the direction of the protocol, including which assets to consider as collateral. While, I’m excited for a RAI fork on Optimism with a less arbitrary price target, the idea of it being multi-collateral worries me. We’ll just have to see whether this poses any issues, like it has for DAI.
As if all of these tokens weren’t enough, there’s one more I want to talk about because it has the potential to become one of the biggest. From the brilliant team at Aave comes a stablecoin that’s just slightly outside all of these other designs, GHO.
GHO, pronounced like go, is an overcollateralized stablecoin minted against deposits into Aave, which, interestingly, continue to earn interest in the protocol.
The key innovation is the introduction of a new set of trustless minters, known as facilitators. These facilitators can allow for minting GHO against various criteria from collateralized loans of varying asset types, to treasury-backed collateral, to uncollateralized and even algorithmically defined minting. Each facilitator will have a specified capacity of GHO it can mint via its strategy to retain decentralization and diversification.
It’s a little hard to grasp, but what this means is that GHO combines many different stablecoin approaches into one. Who knows if it will work, but it’s nonetheless intriguing.
A Note on CBDCs
Since cryptocurrencies on public blockchains are censorship resistant and immutable, governments and banks can’t control the flow of dollars. This is a laudable goal for those that favour the rights of the individual, and correspondingly, it is the reason for why many governments are trying to push Central Bank Digital Currencies (CBDCs).
CBDCs like China’s Digital Yuan are inherently problematic, and, if hosted on government controlled blockchains, or worse, non-public databases, would constitute the most problematic overreach imaginable: revokable money, social credit scores, and the ability to exclude people from participation in society entirely. It’s right out of a black mirror episode.
Even on open-source, smart contract blockchains like Ethereum, tokens could be created which can be revoked, diluted, or blacklisted. It’s worrying to think of this happening in countries like the US or many in Western Europe, but in more repressive regimes like Iran, Russia, or China, it’s a nearly guaranteed outcome of CBDC systems.
Collectively we need to push for open-source, permissionless money systems, and insist that any CBDC be able to be exchanged for decentralized alternatives without wallets becoming blacklisted. More importantly, any currency should be transacted with privately via zero-knowledge smart contracts like Railgun and rollups like Aztec to protect all parties involved. As I explained in the Progressive Case for Crypto Privacy, “privacy preserving technologies like these can create greater personal and political freedom and, perhaps most importantly, greatly improve safety for their users.”
Conclusion
Stablecoins serve many of the same functions as fiat currencies, but within the framework of self-sovereign finance, free from banks, borders, and middlemen. By merely existing on open-source, permissionless blockchains, they offer access to stable currencies to the unbanked, and give the already banked a way to move away from traditional finance to more open, transparent, and equitable systems.
By simply moving from US dollars to USDC, you can go from earning 0.01% on your savings account at the bank, to earning a fixed rate hundreds of times that on Notional Finance. And with asymmetric returns on PoolTogether you could potentially see a return in the double or even triple digits. There are just so many options for what you can do with your money when you have complete sovereignty over it.
I hope I’ve opened your eyes to the benefits of stablecoins and, most importantly, I hope I’ve helped demystify what they are and how the various digital currencies differ from each other. Whether you choose to own stablecoins as well as which stablecoins you prefer is going to depend on your risk tolerance, your financial approach, and even your theses around things like decentralization and US monetary policy.
As always, go off and do your own research 🤝
And until next time,
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