Stablecoins: The Future of Money?

Hello!

Following on from last week’s post on the UST/LUNA debacle, I’ve been reading a lot about stablecoins and their potential use cases.

We’ll cover what they are, the different types of stablecoins and the risks involved.

Let’s get to it!

What is a Stablecoin?

They are a token that’s pegged (tied) to a specific real currency, often the US dollar (but not always the case, which we’ll get into).

They are the bridge between the fiat world (where banks hold our $ on their balance sheets) and the crypto world (or, the ‘bankless’ world).

The benefits of a stablecoin

Stablecoins are used to keep assets in digital financial systems (aka, DeFi) without converting into fiat currency.

This allows anyone to benefit from ‘decentralization’ & the speed of transacting in crypto, without all the volatility that usually come with classic crypto price swings.

As stablecoins maintain a fixed value over time, you’re able to earn yield with stablecoins to offset inflation (you can do this with a regular ol’ dollar too, but stablecoins unlock access to earning yield with crypto protocols…basically, the fun stuff).

There’s no perfect stablecoin and there’s a bunch a trade-offs with each.

The different types of stablecoins

1. Fiat-Backed Stablecoins

These are backed by actual US dollars or cash equivalents.

For every token in circulation, fiat-backed stablecoins often have one dollar in reserve.

Stablecoin reserves are maintained by central entities that audit their funds and work with regulators to remain compliant.

Examples:

1. Tether (USDT)

The largest stablecoin by market cap, and the most widely available.

It is closely linked to the crypto-exchange Bitfinex, which has helped Tether’s issuance of tokens grow to over $70bn.

However….they were recently fined $41m by Commodity Futures Trading Commission owing to not having enough $ to claim they were ‘fully backed’ by US dollars. It’s got a pretty controversial history in general, and there’s no transparency into their exact holdings. Seems legit.

2. USD Coin ($USDC)

The #2 largest stablecoin is regulated in the US and fully backed by US dollars, cash equivalents and US short-duration Treasuries with $32bn in circulation.

USDC has been playing a lot nicer with the authorities, so has been taking market share from Tether, to now hold 24.1% of the stablecoin market.

But what’s wrong with fiat-backed stablecoins?!

Having a fiat-backed stablecoin doesn’t mitigate any of the risks of just keeping all your money in a bank account. Your assets can still be frozen!

Also, the backings are ‘off-chain’ - so we’re essentially trusting the company and auditors that the money’s actually there. Don’t know about you, but that doesn’t sound too appealing to me in the crypto wild west.

The Crypto Collateralized Stablecoin

Alright, moving up the chain.

A crypto-collateralized stablecoin offers up crypto assets to mint new stablecoins.

So, the stablecoins require OVER-collateralization to account for the crypto assets possibly losing their value. So you gotta give 150% in order to get 50%.

An example is DAI - MakerDAO’s stablecoin. It’s primarily backed by Ethereum and USDC (which has its own issues, as USDC is primarily fiat-backed…it’s complicated 🤷‍♂️).

The Algorithmic-Stablecoin

Too soon?

As we all know now, LUNA/UST was the poster child. Till last month, that is. They’re typically either (severely) under-collateralized or not backed by anything.

As a quick reminder of how Luna/UST works:

If 1 UST goes below $1, you can swap it for $1 worth of Luna and immediately make a profit.

(UST drops to $0.95. People buy and swap for $1 of Luna, and immediately make a $.05 profit).

The problem is people lost faith in Luna, and the value plummeted.

It failed the ultimate stress test.

The future of algorithmic stablecoins?

In my research, I came across one that seemed to blend a lot of the learnings into

Semi Algorithmic Stablecoin

These coins are an attempt at the best of both worlds - they're backed by collateral AND there's an algorithm portion.

The one most talked about right now: Frax Finance.

How does Frax work?

In a similar approach to the LUNA/UST relationship, if Frax is <$1, you can mint new Frax and make a profit.

However, instead of being backed by nothing..Frax is backed by collateral (a mixture of crypto-currency assets, fiat and the Frax token, FXS).

The collateralization is looking pretty healthy at 89%:

Conclusion:

Stablecoins will have a strong say in how cryptocurrency enters the mainstream. From paying for goods & services using digital currency or from earning yield in innovative ways, even after the recent LUNA collapse, we just can’t help ourselves to experimenting with new Stablecoin models.

Additional Reading:

• CoinTelegraph: Stablecoins 101

• The Future of Money: Blockchain Stablecoins

Until next time

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Fahim