The appetite for stablecoins, from both the demand and supply side, is clearly as strong as ever. Since January 2021, they have grown 450% to $154bn, with Tether, Circle and Binance accounting for over 90% of all issued stablecoins. But what are stablecoins and what purpose do they serve?
Purpose and types of stablecoins, and risks
Stablecoins are a type of cryptocurrency that are pegged to a non-volatile asset (such as the US dollar). These stablecoins address the issues of inherent volatility risks within the crypto space and help to facilitate more predictable transactions. As evidenced below, stablecoins have become quite popular. The total value of all stablecoins grew ~450% from $28bn in January 2021 to $154bn in August 2022
The sharp drop seen in May 2022 arose from the collapse of UST, a stablecoin native to the Terra blockchain which also collapsed as a result. The dissolution of the UST highlights that not all stablecoins are made equal and each type poses its own trade-offs and risks. There are three types of stablecoins;
- Fiat-backed stablecoins
- Collateralised debt positioned stablecoins
- algorithmic stablecoins.
Fiat-backed stablecoins’ dominance is due to the ease at which stablecoins can be issued on-chain. The issuer receives deposits in a bank account and mints the equivalent amount on the chosen blockchain (in most cases Ethereum). The three most popular issuers are Circle, Tether and Binance, who account for ~98% of all fiat-backed stablecoins.
Collateralised debt positioned stablecoins
Collateralised debt positioned (CDP) stablecoins differ from fiat-backed in the following ways: i) they are native to the blockchain (no physical bank account), ii) they are over collateralised and iii) they are backed by crypto-assets (including fiat-backed stablecoins).
As mentioned before, fiat-backed stablecoins work by depositing dollars into a bank account and the equivalent value is minted on-chain. CDPs are smart contracts that accept deposits on-chain and mint stablecoins that are less than the value of the deposited assets. The minted stablecoin is effectively a loan for the user and the deposits are the collateral used to take out this loan. These deposits are crypto assets that have increased price volatility risk and hence loans are overcollateralised to compensate for this risk. As of August 2022, the market value of all CDP stablecoins stood at ~$12bn.
Algorithmic stablecoins are a relatively new concept and distinct from the other two stablecoin types. Instead of relying on a reserve of assets, algo-stablecoins maintain their peg through algorithmic incentives or systems. For instance, rebasing was an early technique used to control the peg such that the supply of the stablecoin would change based on the price. A lower price would cause the supply to reduce and vice versa. However, this mechanism was unable to maintain stability over longer periods.
More modern algo-stablecoins utilise a two-token model to function with one token used to absorb the volatility of the stablecoin. The volatile token is burned to create the equivalent units of the stable token and vice versa. However, with the current implementations of algorithmic stablecoins, reliance on a volatile token to maintain the peg can be detrimental. This is because as the stablecoin loses its peg, the governance token also loses trust and value, so both coins rely on each other holding value otherwise both fall into a “death spiral” as has happened numerous times before. The algo-stablecoin market is valued at $3.7bn.
The Stablecoin Trilemma
The blockchain industry is known to love its trilemmas and stablecoins are no different. The end goal for the “ideal” stablecoin is to be i) stable, ii) scalable and iii) decentralised. So far, no stablecoin has been able to fulfil all three criteria.
Fiat-backed stablecoins are scalable since it’s as easy as depositing dollars in a bank account. They’re also very stable as they’re essentially backed one-to-one by those same dollars in the bank. However, they are clearly not decentralised as there are only a few large, regulated entities which can mint these stablecoins, to begin with. Stablecoin issuers also have the ability to freeze these funds, preventing specific addresses from spending them.
On the other hand, CDPs can be decentralised so long as the crypto assets backing the borrowed stablecoins are decentralised as well. CDPs are also stable thanks to resilient risk management practices. Not every asset can be used as collateral, only those deemed pristine enough by the DAO. Furthermore, the mandated overcollateralization of these debt positions is the main factor driving this stability. However, requiring users to overcollateralise and borrow a fraction of their deposits is not inherently scalable.
Lastly, algorithmic stablecoins can possess both decentralisation and scalable properties. The algorithm dictates the mechanism so no one entity is in control - ideal for decentralisation. Likewise, the algorithms used tend to make it easy to create or burn the token allowing for increased scalability. Despite these dynamic capabilities, algo-stablecoins seem to continuously fail at maintaining a peg. A persistent peg for stablecoins may rely on faith more than a specific algorithm yet the search for the perfect algorithm continues.
State of the market
While stablecoins have become increasingly popular, the collapse of UST not only shrank the market size but also spurred redemptions in other stablecoins as well. Despite this implosion, the importance of stablecoins remains prominent across the entire ecosystem
Zooming out a bit, with a first-mover’s advantage, USDT has long been the market leader although USDC has been gaining traction and is widely seen as more legitimate. We show a breakdown of this stablecoin growth below.
Year to date we see that market shares have not been that volatile though there has been some movement. Other stablecoins have lost ground while BUSD and USDC have materially gained. However, despite what most think, USDC's market share gain since the start of the year has mostly been due to Terra USD's demise as opposed to capturing it from USDT.
As shown above, the vast majority of stablecoins (c.90%) are issued by Circle (USDC), Tether (USDT) and Binance (BUSD). These coins are mostly backed by US Cash & Cash equivalents & Other Short-Term Deposits & Commercial Paper held in bank accounts to help maintain trust in the peg. Among the three, Tether has the riskiest reserve holdings and reports its breakdown on a quarterly basis.
The integration of stablecoins within the traditional financial system provides easier access for users and adds to their legitimacy. In fact, on August 15th 2022, the US Federal Reserve’s governing board unveiled guidelines that will standardize applications for “master accounts” from institutions “with novel charters,” including “cryptocurrency custody banks and their trade associations.”
Another type of stablecoin being explored are Central bank digital currencies (CBDCs). Although there are not any CBDCs in use right now, proponents see them as an alternative solution to a digital currency tied to a fiat currency. The proposed differences between CBDCs and fiat-backed stablecoins are i) The issuer is a central bank, ii) they’re partially backed by reserves and the faith of the government and iii) would likely be built on a private blockchain for greater control.
Stablecoins have found product-market fit within the crypto industry. In fact, more projects continue to enter the stablecoin space with the fiat-backed entrant poundtoken getting the greenlight from the Isle of Man’s Financial Services Authority and Circle’s Euro Coin (EUROC). Algo stablecoins like USDN and USDD have also started to grow (though both have already depegged). Lastly, DeFi protocols Curve and Aave have both announced their intention to release CDP stablecoins in the near future. The appetite for stablecoins, from both the demand and supply side, is clearly as strong as ever.