Stablecoins: An Overview
2021 was a big year for Stablecoins, seeing a rise in global aggregate supply from $29 billion to over $140 billion; an increase of 388%. As we enter 2022, the stablecoin market aught to be watched closely as we see an increase in both market participation and utility.
What Is A Stablecoin?
Conceptually, A stablecoin introduces price-stability to the digital financial system. While currencies like Bitcoin and Ethereum have emerged to the forefront of this financial revolution, most people would willingly admit that both present significant shortcomings as a sound medium of exchange. If you had to estimate how much it might cost (in BTC) to buy a cup of coffee each day over the past 10 years, you would quickly find that, while the amount certainly has decreased over time, there can be quite a large variability in price day to day. How do we find stability amidst this level of volatility? Enter Stablecoins. Stablecoins work because they express the world in terms that we already understand.
At this point you may be wondering to yourself why we need such an invention, when we already have perfectly good (kidding) fiat currencies that accomplish this task of being a medium of exchange. For those who are less familiar with this space, the next major benefit of Stablecoins may not be entirely obvious. Blockchain technology has enabled near-instant finality of transactions globally, between trustless counter-parties, at an extremely low cost. This simply cannot be achieved with fiat currencies (think international settlement costs), and since Stablecoins inherit all these benefits of the Blockchain, they become an excellent facilitator of liquidity that can be accessed by market participants across the globe. They have also proven to be a safe-haven for capital during periods of prolonged volatility, which are more than common in this nascent crypto market.
But How Stable Are Fiat Currencies?
This is an important question and has led to terms like “Inflationcoin” from skeptics. The US dollar, and virtually all other currencies in circulation, have long suffered from their inflationary monetary policies. While there is certainly lots of argument surrounding the merit of such policies, it is hard to ignore their ramifications during times of monetary expansion. Assets inflate, purchasing power declines, and ultimately non asset-holders & savers suffer the most. It is a fair criticism of Stablecoins to suggest that inheriting these monetary characteristics from fiat currencies would be foolish.
So how do Stablecoins escape the inflationary monetary policy of fiat currencies in the long run? Conceptually, a Stablecoin pegged to the USD represents a Consumer Price Index (CPI) of 1 USD. In fact, remembering the USD’s role as a global reserve currency, we can see that many of the world’s currencies adhere to this approach of pegging to a CPI of 1 USD. But is this the most stable CPI that we could choose? What if instead of pegging our Stablecoin to 1USD, we pegged to another CPI? The goal here is to select a market basket of goods/services that are relatively stable in their intrinsic value, and stabilize our token around the buying power of that market basket.
As a starting point, we could simply take advantage of the US Bureau of Labor Statistics’ CPI. While this may be a viable first pass, a glaring conflict of interest emerges when the Government is responsible for both managing the narrative surrounding inflation, and selecting the basket of goods that comprise the CPI. The policy response to COVID-19 and the subsequent inflation reports have drawn rightful criticism surrounding their accuracy and honesty. As a gut check, I encourage anyone to come up with their own basket of goods and services, and see really how much inflation has impacted their spending power. The results may be surprising.
Recently Frax, an algorithmic Stablecoin issuer, announced a partnership with Chainlink seeking to tackle this ambitious problem. In the first iteration, Chainlink’s oracle network will provide the existing US Bureau of Labor Statistics’ CPI, along with some crypto-native components, to smart contracts on chain; the first step toward building a stablecoin that exhibits inflation-resistant properties. Decoupling Stablecoins from the monetary policy of the USD is an ambitious goal that will likely take a long time to realize, but the first steps are already being taken toward making this a reality. Democratizing access to unbiased consumer price data will also be pivotal in shaping the future conversation around inflation.
What Makes Stablecoins Stable?
Despite everything that has been outlined so far, a stablecoin is only as good as its ability to maintain its peg. How can Stablecoin issuers ensure that their coin remains stable in the face of highly volatile, or even adversarial market conditions? While there are at least a few distinct classes of Stablecoins, we can still identify some shared mechanisms that promote price stability, regardless of implementation details. At a high level, Stablecoins represent a balance sheet of assets and liabilities, where each stablecoin that is issued (liability), can be redeemed for an underlying asset. Like any properly functioning balance sheet, parity must be maintained between these assets and liabilities.
If this sounds like a familiar idea, look no further than The US Federal Reserve, where we can think about the circulating supply of money as a liability on the balance sheet of the central bank. In the case of the FED, the assets that balance this book are primarily debt instruments, such as corporate and government bonds. This topic is more than worthy of its own discussion, so I won’t elaborate any further here.
Much like existing central banks, stablecoin issuers must devise a system that facilitates both the expansion and contraction of the money supply, in response to changes in demand for the stablecoin. This mechanism is often referred to as either mint/redemption, or mint/burn. The process of minting or burning these stablecoins should be as frictionless and inexpensive as possible in order to promote maximum market efficiency. The reason for this will become clear shortly. Lastly, and most importantly, the issuer must axiomatically provide a fixed exchange window between the liability and asset.
Let’s look at an example. How does Tether - currently the largest stablecoin issuer with >78B circulating supply circulating at the time of writing this - achieve price stability on their stablecoin, USDT? As the issuer, Tether guarantees that the exchange window will always facilitate the exchange between 1 USDT (liability) and $1 USD (asset). To mint 1 USDT, simply provide $1 USD to the issuer. To burn/redeem that USDT, return it to the issuer in exchange for the original $1 USD. The existence of this 1USDT:$1USD exchange axiom creates an open market incentive to maintain USDT’s peg at $1 USD, by allowing arbitragers to profit on fluctuations in demand for USDT. Let’s break it down.
Imagine that you just raised a ton of capital and decide to start a crypto exchange. One of the first things you might do is start buying inventory of various cryptocurrencies to ensure that you are prepared for all of the trading on your new platform. In order to ensure that you have sufficient liquidity across different currency pairs, you realize that you need alot of Tether, so you go to your friend, who also happens to run an exchange, and you start placing bids for Tether that is trading on her exchange. As you flood the market with bids, this increased demand for Tether starts driving the price upwards. Before too long, Tether is trading at $1.01 on her exchange; a premium of $0.01. Other market participants become aware of this discrepancy, so they go to the issuer to issue more stablecoins at the 1USDT:$1USD exchange rate, and subsequently sell them on her exchange for $1.01, effectively capturing the spread of $0.01 as profit. The additional supply drives price back down on her exchange, until Tether is once again trading at $1.00. The same happens in reverse when demand for Tether falls. In this case Tether is bought on an exchange for, say $0.99, and is redeemed at the issuer for $1.00 USD, once again capturing the spread of $0.01 as profit.
This type of arbitrage underpins stablecoin markets and ensures the stability of price at $1 USD. It is important to note that this type of strategy is generally performed by algorithms and sophisticated traders. Arbitraging requires both high speed and liquidity to be profitable.
Classes Of Stablecoins
Custodial Stablecoins
In the first example, we explored the mechanics that enable Tether’s Stablecoin, USDT. This example introduces us to the first primary class of stablecoins, known as custodial stablecoins. These stablecoins earn their name from the nature of the mechanism which enables their peg. Since USDT are issued by depositing USD with the issuer, those dollars become assets on Tether’s balance sheet while the circulating stablecoins represent their respective liabilities. It is the responsibility of Tether to maintain parity between these assets and liabilities, and as a result they can be viewed as the custodian of the dollars that are collateralizing the circulating USDT. This strategy of stablecoin issuance has proven to be effective at scale, as Tether and other custodial stablecoin issuers still represent the lion’s share of the broader stablecoin market. Minting and redemption of custodial stablecoins offer a clear arbitrage incentive through a reliable issuer window, and due to the size of these players, there is a strong trust in the robustness of the peg. Tether earns profit on the yield of the assets sitting in reserves, and those profits increase with scale since the reserves are growing linearly with issuance of new stablecoins.
The downside of custodial stablecoins primarily resides within the regulatory realm. Since the dollars that collateralize the stablecoins must sit in a bank account, they are entirely subject to regulatory pressure in the jurisdictions in which the issuer occupies. Drastic changes in regulation could challenge the viability of these types of stablecoins in the long run. These regulatory risks inherently makes custodial stablecoins significantly less decentralized, which has led to competitive pressure from more innovative stablecoin issuers. Additionally, the cost of redeeming USDT for the underlying USD collateral is more expensive as a result of its centralized design, requiring a withdrawal of USD from a regulated bank account.
Non-custodial Stablecoins
While there are many companies attempting to create a more decentralized stablecoin, the two stablecoins that have emerged to the forefront of this battle are MakerDAO’s DAI, and Terra’s UST. Let’s look at each of these solutions and compare their various tradeoffs.
MakerDAO
First on the scene was MakerDAO, promising an entirely decentralized Stablecoin governed by smart contracts on Ethereum’s blockchain. At its core, MakerDAO resembles a money market, similar to its centralized counterpart BlockFi. Users can borrow DAI by locking Ethereum collateral into a smart contract known as a Collateralized Debt Position (CDP), at a specified loan to value ratio (LTV). While users have flexibility on their LTV, it is important to note that the position must be over-collateralized, requiring a minimum LTV of 50%. So if a user wanted to receive 50K in DAI, they would need to post at least 100K in ETH.
Here, arbitragers facilitate peg maintenance by opening and closing CDP’s when DAI is trading at a discount or premium on secondary markets. Unlike custodial stablecoins however, there are some additional costs that make scaling DAI significantly more challenging. Since CDP’s must be over-collateralized, they have been criticized for being capital-inefficient; requiring more ETH than the size of the debt position. Ethereum itself poses its own problems since it is an asset that is exogenous to the MakerDAO protocol, meaning that CDP’s are subject to risk associated with the collateral itself. For example, if the price of Ethereum were to fall sharply, borrowers of DAI would need to be extremely mindful of their LTV to avoid liquidations of their collateral.
Over-collateralization also presents a challenge to arbitragers that are responsible for maintaining DAI’s peg. Since issuing new DAI requires posting 150%+ of the value of the DAI in Ethereum collateral, these market participants need to take on the additional risk of holding the underlying collateral for the duration of the arbitrage cycle. Imagine that an arbitrager wanted to capitalize on DAI trading at a premium in a secondary venue. In order to mint new DAI, an over-colleralized CDP would need to be opened. Unlike the Tether example where USDT and USD can be freely exchanged 1:1 at the issuer window, a CDP will only yield ~0.66 DAI per $1 worth of ETH. Even after capitalizing on the dislodgement of DAI’s price on the secondary venue, the arbitrager must figure out how to exit their CDP, which would require them to buy back DAI for less than they sold it for on the secondary market. Not to mention, the long exposure to Ethereum adds additional unpredictability to their strategy. Shorting ETH simultaneously could sterilize this risk, but would present additional borrowing costs.
Stablecoins like Tether offer what is known as closed cycle arbitrage, allowing these participants to capitalize on dislodgements in a stablecoin’s price without taking on market risk. The faster that this cycle can be closed, the more profitable and safe it is, leading to resiliency in the peg. This is the fundamental shortcoming of DAI as a highly scalable stablecoin.
In an effort to provide stability to the underlying collateral, MakerDAO began accepting USDC (Circle’s custodial stablecoin) and other select ERC-20 tokens in addition to Ethereum. While this decision introduced some additional stability to CDP’s, it did so at the expense of decentralization. Remember, custodial stablecoins like USDC and USDT rely on regulated bank reserves to maintain their own pegs.
Lastly, it should be noted that many people argue that DAI was never intended to scale infinitely as a stablecoin. It is more likely that the original goal was to provide a decentralized money market, allowing users to borrow against their crypto assets without having to sell them and face tax implications. For example, someone who is long ETH and has no intention to sell, but wants access to a stable asset to deploy for further speculation, or even to buy a Lambo.
Terra
In 2021, Terra’s UST emerged as the favorite among algorithmic stablecoins, with the goal of becoming the premier source of liquidity in DeFi and beyond. While Terra’s UST relies on a mint/redeem mechanism to maintain its peg, the implementation details vary significantly from the previous examples we have explored. Largely inspired by a 2014 paper titled “Seigniorage Shares”, Terra takes a two token approach to maintaining the Stablecoin’s peg on the Dollar; UST the stablecoin, and LUNA the ‘share’. The mint/redeem mechanism is governed algorithmically by guaranteeing that 1 UST can always be minted by burning $1 worth of LUNA, and vice versa. In this sense, LUNA can be thought of as the collateral that backs UST. It neither resides in a regulated bank account (Tether), nor is exogenous to the protocol (MakerDAO). This mint/burn mechanism enables the closed loop arbitrage that we discussed earlier, ensuring that UST’s peg remains intact.
What makes Terra’s stablecoin design so compelling is the way that it separates concerns between transactional value and speculative value. UST is designed to be an entirely decentralized stablecoin, offering transactional utility to holders. On the other hand LUNA is responsible for absorbing volatility, as well as capturing seigniorage, the profits from money creation.
As the demand for UST increases, it will naturally begin to trade at a premium in secondary venues, incentivizing arbitragers to mint new UST in exchange for $1 of LUNA to close the arbitrage cycle. As LUNA is burnt from circulation, the overall supply decreases, driving up the price. For this reason, speculating on the LUNA token can be viewed primarily as a bet on the adoption of UST. The greater the demand for UST, the more LUNA will need to be burned, further driving up its price.
While this may sound great, LUNA is also responsible for absorbing volatility as demand for UST falls, leading to the creation of more LUNA in exchange for UST to close the arbitrage cycle in the other direction. During black swan events in the market, investor confidence could be shaken, causing participants to flee the Terra ecosystem. As demand for UST falls, LUNA can suffer significantly.
Additionally, leveraged borrowing strategies involving UST collateral in DeFi can create a precarious situation for UST if those strategies account for a significant amount of the UST in circulation. When markets go south and those UST collateral positions face liquidation, the subsequent selling pressure on UST can drive LUNA’s price down significantly as well.
Despite these risks, Terra has focused on creating sustainable, organic demand for UST. Anchor protocol - Terra’s flagship money market product - provides investors with a venue to borrow UST against crypto collateral, and also earn attractive yields on UST deposits, strengthening UST’s hold in DeFi during bull and bear markets alike.
Why Are Stablecoin Yields So High?
If stablecoins are designed to resemble fiat currencies so closely, what explains the astronomical yields that can be earned on stablecoin deposits when compared to your standard fiat savings or checking account? While it is quite certain that APYs on stablecoin lending will eventually fall, it is still mind-boggling to most people that yields as high as 10-20% can be achieved in the market today. There are a number of reasons for this, and I will try to lay out a few of them as succinctly as possible.
First, prior to stablecoins, trading pairs were almost exclusively quoted in either Ethereum or Bitcoin. This means that any time an investor wanted to buy a hot, new cryptocurrency, they would do so in exchange for one of the aforementioned. While this was a fine solution in the early days, there was still a quantifiable risk in denominating liquidity in BTC or ETH, since both assets were, and still are, quite volatile. This problem became even more significant during the rise of institutional players in the space, as they began to account for the majority of volume in the market on a given day. The sheer size of these players’ trades could cause significant slippage in the price of the quote currency on the venue which it was exchanged. Before long, stablecoins took the place of ETH and BTC as the quote currency of choice on virtually all venues. But despite the demand for stablecoins as a risk-off source of liquidity, this feature alone was likely not enough to warrant such extreme yields.
In its nascency, the crypto ecosystem at large can be much more aptly classified as a system of loosely coupled fragments (sometimes) cooperating with one another, rather than a cohesive, singular market structure. The fragmented nature of crypto markets lead to glaring inefficiencies, often manifesting themselves as lucrative arbitrage opportunities. These asymmetries have garnered a large appetite for market-neutral, risk-less strategies, that involve participation on multiple venues simultaneously. What follows, is a massive demand for price-stable liquidity to facilitate these strategies. The borrowing demand from these market makers, block traders, and liquidity providers naturally drives up the yield on stablecoins. Additionally, the cost of lending is significantly lower on the blockchain than within the traditional financial rails, especially when thinking internationally. That means that much more of the lending APR can be passed along to depositors.
Lastly, the emergence of DeFi has brought novel ways to lend and borrow stablecoins, governed by code in smart contracts. Terra’s Anchor Protocol seeks to provide industry leading APY to UST depositors by passing along the staking yields of the underlying collateral provided by UST borrowers.
While none of these factors can be individually attributed to stablecoin lending/borrowing rates today, they certainly play a role. Above all else, we should expect to see rates make their way downward as markets mature and become more efficient.