Stablecoins

The currency part of CryptoCURRENCY is really important. You need to be able to use them to pay for things. The price volatility of Bitcoin and other major cryptocurrencies make it difficult to use them as a means of payment.

This is where stablecoins come into the picture.

These coins are designed to maintain a stable value relative to a fiat currency, like USD, or another asset. This stability means that they can be used as a medium of exchange or to park cash as people transfer their wealth in and out of crypto. For example, if I'm invested in some obscure memecoin and am experiencing a lot of volatility, I might want to temporarily move some money out. If I convert my money back to USD (fiat currency), that might be quite a hassle, and it would be even more of a hassle if I wanted to convert it back to crypto. Instead, what I can do is put my money into a stablecoin like Tether (USDT), so it is still in the crypto ecosystem, but I don't have to worry about volatility.

Types of Stablecoins

Fiat-Backed

A fiat-backed stablecoin is the easiest to explain and will make the most sense to many readers. Fiat-backed stablecoins are collateralised 1:1 with a specific fiat currency. For those of you that don't speak banker, let me explain. If my stablecoin is fiat-backed, it means that for every $1 of coin that I issue, I will have 1 actual US Dollar sitting in my treasury. So if I issue 10,000 of my stablecoin, I will have $10,000 sitting in my treasury.  If the price of my stablecoin goes below $1, I will sell some of the USD in my treasury and use it to buy my stablecoin, so that the demand for it increases and the price goes back to $1. If the price of my stablecoin goes above $1, I do the opposite. I sell my coin and use it to buy more dollars for my reserve until the price goes back down to $1 again. 

The top 3 stablecoins by market capitalisation: Tether (USDT), Circle's USD coin (USDC) and Binance USD (BUSD) are all fiat-backed. 

Crypto-Backed

Crypto-backed stablecoins are collateralised by another cryptocurrency. DAI is the most famous example of a crypto-backed stablecoin, it is backed by Ethereum (among other things). For this example, we will assume that DAI is only backed by ETH. The process of buying DAI and other crypto-backed stablecoins involves smart contracts. So to purchase $1000 worth of DAI, you would have to lock your ETH into a smart contract. $1000 worth of ETH would be used to obtain exactly 1000 DAI. 

Algorithmic Stablecoins

Algorithmic stablecoins use algorithms and smart contracts to manage the supply of tokens in circulation. This is how they keep the price pegged to the underlying asset being tracked. 

UST, also known as Terra USD is an example of an algorithmic stablecoin. It is part of the Terra Luna ecosystem. To keep UST pegged to the price of US Dollars, Terra uses the Luna token, which is central to the Terra ecosystem. The Luna token is not a stablecoin - its price varies considerably. Since Luna tokens are used to maintain the peg, I can exchange 1 UST for exactly $1 worth of Luna at any time. Right now, the price of one Luna token is around $85. So that means I can exchange 1UST for 1/85th of a Luna token, the value of which is $1.

So how can the Terra network be sure that 1 UST can always be exchanged for exactly $1 worth of Luna? Imagine that the price of UST has risen, and you can now exchange it for $1.20 worth of Luna. Terra's algorithm will burn (meaning destroy) Luna tokens to create more UST. This will mean the supply of Luna tokens has increased, and economics 101 tells us that when supply goes down, price rises. And on the other side, the supply of UST has increased, which means the price will go down, eventually back to the level of the peg, so 1UST will be worth $1 of Luna again. If the price of UST falls too low, the opposite mechanism kicks into effect, and UST is burned to create Luna tokens.

Commodity Backed

We've mainly been talking about stablecoins that track the price of USD or other fiat currencies, so I thought it was important to mention this fourth type of stablecoin. Stablecoins that track the price of physical assets like gold, oil and real-estate often use these physical assets as collateral in their treasury. 

The Controversy

These different types of stablecoins each have their drawbacks. But the controversy over stablecoins as a whole came to head when people found out some worrying news about the most widely used one, Tether (also known as USDT). 

Recent Problems with Fiat-Backed - The Tether Controversy

Tether had initially claimed that they would have a dollar in their reserves for every USDT issued, meaning that USDT would be 100% backed. But many felt there was a lack of transparency, and some discrepancies in Tether's collateralised reserves were found. In layman's terms, they were being real shady. 

Tether was charged $41 million by the US Commodity Futures Trading Commission (CFTC) because it made untrue and misleading statements. It claimed that between June 2016 and February 2019 they had the dollar reserves to back every dollar token when in fact, they didn't for most of that period. 

The Problem with Crypto-Backed - Market Crashes

Crypto-backed stablecoins are over-collateralised to protect against price fluctuations. In the past, if you wanted to buy $1000 worth of DAI, you needed to deposit $2000 worth of ETH. This was just in case the price of ETH fell, you would still have enough ETH deposited to be able to cover your $1000 DAI. The problem was if the price of ETH tanked (went below a certain threshold). Then, collateral had to be paid back into the smart contract and the position had to be liquidated. If that happened, it meant there was not enough money backing DAI to maintain a stable peg to the US Dollar. 

This situation occurred in March 2020, when the price of ETH fell 30% and as a result, the value of DAI fell to 90 cents, 10% below the $1 value it should always be pegged at. This event led to a complete change in the system. DAI is now backed by another Stablecoin, USDC, whose reserves are maintained by Coinbase and Circle. 

The Problem with Algorithmic - The Death Spiral 

One major risk for algorithmic stablecoins is known as the Death Spiral. Sounds serious, I know. And to explain it, we can go back to the example we were using before, of UST and the Terra Luna ecosystem. 

In May 2021, the crypto market crashed. Luna crashed with it - the price of Luna fell around 75%. Remember that Luna tokens are what Terra uses to keep the price of UST fixed to $1. As the price of Luna crashed, demand for UST also reduced, causing it to fall below the peg of $1. At this point, the algorithm burned UST to print Luna tokens, prompting the price of Luna to fall even further. Some were talking about a full-on collapse. This has happened before, to projects like Titan. But compared to Titan, Terra had extra stabilising features, a good team and a very engaged community. All of which helped it survive this scary episode.

The biggest protection from this risk is demand for the stablecoin. And in the case of UST there is a lot of it, thanks to the success of Chai, Anchor Protocol, Mirror Protocol and some of the other successful projects that have been built on the Terra Luna ecosystem. More on that next week

The Treasury

The US Treasury recently released a detailed report on stablecoins and the risks they pose to the financial system in November. They concluded that Congress should act quickly and enact legislation. They called for more supervision and regulation around stablecoin issuers, to guard against stablecoin runs. This is a situation where users lose confidence in a stablecoin and all try to sell it and exchange it for USD at the same time. The Treasury also mentions that they would like to see more interoperability between different stablecoins and limited affiliation between stablecoin issuers and other commercial entities. This is to prevent economic power from being too concentrated among a few entities because that would lead to huge system risks. You can read the full report here, but don't try and read it just before bed. Or do, you might get a very good night's sleep. 

Conclusion

Saying stablecoins are important is an understatement. In some ways, they are the backbone of the crypto ecosystem. When you rank cryptocurrencies by market capitalisation, you see that three of the top five are stablecoins.  A research site CryptoCompare estimated that in February 2021, 57% of all Bitcoin transactions were done in Tether (USDT). 

We have all heard of scams and rug pulls in the crypto space. There is a lot of opportunity in crypto right now, but on the flip side, there aren't many guard rails in place to stop people from losing their shirts while chasing some of these opportunities. Ensuring the stability of stablecoins will be a key piece of this puzzle. While we may not be there yet, I think there is reason to be hopeful that these guard rails (around stablecoins and other aspects of web3) will be in place eventually.