Stablecoins: What Makes Them Stable & Staple
Crypto adoption is through the roof, and with every passing day, we're seeing more and more projects that aim to revolutionize traditional banking and financial systems. Stablecoins is one such attempt to find a global currency that is a mode of payment and gets the approval of financial regulators where there is a mix of traditional and digital infrastructure.
The need for stablecoins
1. Crypto Volatility - Cryptocurrencies such as bitcoin and ether offer several benefits. One of the most fundamental is not requiring trust in an intermediary institution to send payments, which opens up their use to anyone around the globe. But one key drawback is that cryptocurrencies' prices are unpredictable and have a tendency to fluctuate, often wildly. This makes them hard for everyday people to use.
Generally, people expect to know how much their money will be worth a week from now, both for their security and their livelihood. Cryptocurrency's unpredictability contrasts with the generally stable prices of fiat money, such as U.S. dollars, or other assets, such as gold. Values of currencies like the dollar change gradually over time, but the day-to-day changes are often more drastic for cryptocurrencies, which regularly rise and fall in value.
2. SWIFT Banking System - Have you ever thought about why an international bank transfer takes so much time and back and forth communication? It is because of a banking system called Swift. The Brussels-based Society for Worldwide Interbank Financial Telecommunication, or Swift, at its core is a system for cross-border transactions which often involve several intermediaries. According to a 2018 report by Swift and management consultants McKinsey & Co., not only does the system add up the cost to $25-35 per transaction, but it is one that barely works for smaller and poorer countries.
Attempts to make a low-fee, fast and transparent system for international transfers are being made with examples like Visa Direct and Mastercard Send - both of which don't depend on the Swift system. Still, the issue is that these would shift too much power in private institutions and have an end goal of expanding their bottom line numbers. Even countries like Russia and the European Union have attempted to make Swift like systems, namely SPFS(System for Transfer of Financial Messages') and Instex (which was created to facilitate non-USD and non-SWIFT transactions with Iran to avoid breaking U.S. sanctions.) have not borne much fruit. Also, most of these systems didn't work out because America from Day 1 has supported Swift, making it evident that other ally nations adhere to the same. This mass support not only made its position dominant but also is being used by the U.S. as a political tool, where it threatens to boot out countries with the likes of Russia and other nations who're trying to look them in the eye or just being notorious.
Thus, the need for a truly decentralized and globally accepted system of payments that people can use for day to day transactions and can be used to enable banking platforms is sought, and stablecoins seems to be the apt answer by some.
Types of Stablecoin
While there are multiple stablecoins on various chains, the value and credibility of these coins are decided based on their underlying asset and who's backing these currencies with reserves.
1. Fiat-Backed: Stablecoins that are backed by fiat currency are very popular. Fiat collateral remains in reserve with a central issuer or financial institution and must remain proportional to the number of stablecoin tokens in circulation.
2. Commodity-Backed: commodity-backed stablecoins are collateralized using physical assets like precious metals, oil, and real estate. The most popular commodity to be collateralized is gold. Stablecoins backed by commodities makes it easier to invest in assets that might otherwise be out of reach on a local level. Obtaining a gold bar and locating a secure storage site, for example, is difficult and expensive in many areas. As a result, owning tangible assets such as gold and silver is not always a viable option. However, commodity-backed stablecoins are also handy for those who want to swap tokens for cash or gain custody of the underlying tokenized asset.
3. Crypto-Backed: Crypto-collateralized stablecoins are backed by another cryptocurrency as collateral. This process occurs on-chain and employs smart contracts instead of relying on a central issuer. When purchasing this kind of stablecoin, you lock your cryptocurrency into a smart contract to obtain tokens of equal representative value. You can then put your stablecoin back into the same smart contract to withdraw your original collateral amount. Crypto-collateralized stablecoins are also over-collateralized to buffer against price fluctuations in the required cryptocurrency collateral asset.
For example, if you want to buy $1,000 worth of DAI stablecoins, you need to deposit $2,000 worth of ETH, which equates to a 200% collateralized ratio. If the market price of ETH drops but remains above a set threshold, the excess collateral buffers DAI's price to maintain stability. However, if the ETH price drops below a set threshold, collateral is paid back into the smart contract to liquidate the CDP.
4. Algorithmic: This category of stablecoins is not backed by any "real-world" commodities. Instead, it uses algorithms to modulate the supply based on its market demand. In short, these algorithms automatically burn (permanently remove coins from circulation) or mint new coins based on the fluctuating demand for the stablecoin at any given time.
"Burning" crypto means permanently removing a number of tokens from circulation. This is typically done by transferring the tokens in question to a burn address, i.e. a wallet from which they cannot ever be retrieved.
Algorithmic stablecoins automatically mint new tokens and burn them frequently to maintain their dollar-pegged value. For example, if demand for the stablecoin rises and the price diverges above its dollar peg, the protocol's smart contract will automatically issue a number of new tokens to bring the price back down and vice versa.
1. USDT - Also known by the namesake of its backer Tether, USDT is pegged to the U.S. Dollar in a 1:1 ratio, i.e., 1 Tether or 1 USDT is equivalent to 1 U.S. Dollar. The Tether parent company claims to hold assets equal to its currency's total outstanding market value. That means it has a dollar in cash or highly liquid investment assets for every one USDT in circulation. Tether is a unique coin in that it works on multiple blockchains. That currently includes Bitcoin (via Omni), Ethereum, Tron, EOS, Liquid, Algorand, SLP, and Solana.
USDT has had its fair share of controversy with Tether is closely intertwined with cryptocurrency exchange Bitfinex, with both sharing CEO JL van der Velde and other executives. Like many other crypto companies, iFinex, the parent company of Tether and cryptocurrency exchange Bitfinex, struggled to find real banks to process their financial transactions and store their money. So it resorted to Crypto Capital, an alleged Panamanian "shadow bank."
Crypto Capital was run by (alleged) unscrupulous fellows, who have been charged with, among other things, stealing around $850 million of Tether/Bitfinex's money—including the money that backed Tether's stablecoin. Law enforcement has since frozen some of the funds that remain. To ensure that Bitfinex could satisfy requests for redemptions, Bitfinex (essentially, itself) took $650 million in real money from Tether's account and credited Tether's Crypto Capital account—which didn't actually contain any money, since it was all stolen or lost—with $650 million from its own inaccessible Crypto Capital account.
Among them the New York Attorney General, Tether critics argue that iFinex essentially used Tether reserves as a slush fund to mask the hole in Bitfinex's finances, thereby defrauding its clients. That would also mean that Tether's stablecoins aren't fully backed by the U.S. dollar.
As far as the regulators are concerned, the size of Tether's supposed dollar holdings is so big that it would be dangerous even assuming the dollars are real. If enough traders asked for their dollars back at once, the company could have to liquidate its assets at a loss, setting off a run on the not-bank. The losses could cascade into the regulated financial system by crashing credit markets.
2. USDC - USD Coin (USDC) is a fiat-collateralized stablecoin established by the CENTRE consortium, a collaboration between FinTech firm - Circle and crypto exchange - Coinbase to develop price-stable crypto assets and network protocols. It was launched in October 2018.
Each USDC is redeemable for one dollar and is backed by one dollar or a dollar-denominated asset with the equivalent value held in accounts at regulated U.S. financial institutions. Those accounts are audited by U.S. accounting firm Grant Thornton LLP, which issues monthly attestations on the reserves backing USDC.
On the Ethereum blockchain, USD Coin (USDC) is a 1:1 representation of one U.S. dollar. It's an ERC-20 coin that works with any app that supports the protocol. Except for a US$50 penalty for erroneous and rejected bank transactions, Circle USDC does not charge customers any fees for tokenizing and redeeming services. All normal costs apply to Coinbase USDC transactions. The minimum amount of USDC that may be redeemed is 100 USDC. Only business days are used to process tokens, and the procedure might take up to 24 hours. The course can take up to two business days, and there is no minimum tokenization value.
3. DAI - DAI is a unique stablecoin in several ways. The architecture underlying this stablecoin - Maker Protocol was launched in 2017. MakerDAO is an Ethereum-based protocol that issues the Dai stablecoin and facilitates collateral-backed loans without an intermediary.
Firstly, DAI enjoys a degree of decentralization which is rarely seen by most stablecoin projects. No one entity controls the issuance of DAI, not even MakerDAO. Instead, users looking to hold DAI submit Ethereum-based assets into a smart contract that uses them as collateral in maintaining DAI's peg to the U.S. dollar.
Secondly, there isn't one single fiat or cryptocurrency to which DAI is collateralized. This means that tokens like Ether, Brave Browser's reward token BAT(Basic Attention Token), USDC, wrapped-BTC(wBTC), which is bitcoin based stablecoin running on Ethereum's blockchain - can be used as collateral to get DAI. The increased number of collateralizable currencies diminishes user risk and increases DAI's price stability. New collateral options continue to be added through voting by the MakerDAO community.
Also, DAI token holders earn interest on their DAI. Those who hold MKR, MakerDao's native governance token, set the DAI Savings Rate and act as guarantors for DAI — meaning, their MKR tokens can be liquidated if the system were to crash. This structure incentivizes guarantors to ensure the proper functioning of the DAI system and its collateralized tokens.
In order to assess the collateral deposited on the platform, MakerDAO must have information on the prices of collateral assets. This is provided by a decentralized network of trusted oracles selected by MKR voters.
4. Diem - In 2018, Facebook(now Meta) founded the Libra Association, a non-profit consortium headquartered in Geneva, Switzerland, to support its ambition of creating a global stablecoin 'Libra'. The association would oversee the development of the token, the reserve of real-world assets that give it value and the governance rules of the blockchain.
Initially, there were 28 original members, including industry big-hitters such as Mastercard, PayPal, Stripe and eBay. Each partner is said to have contributed $10 million to the project and could optionally become a validator node operator, gain one vote in the Libra Association council and be entitled to a share (proportionate to their investment) of the dividends from interest earned on the Libra reserve into which users pay fiat currency to receive Libra.
Facebook also was a member with no more authority or voting power than any other member (at least on paper). Facebook had joined through its subsidiary - Calibra, whose first product with its namesake was a Libra-based wallet with integrations in WhatsApp and Messenger. The subsidiary was subsequently renamed to 'Novi', in a move to make it super clear that the Libra project isn't a Facebook project per se.
The focal point was to be the Libra token, a global stablecoin pegged to a pool of assets, including existing currencies from around the world. The currency was intended to be first launched on a permissioned blockchain; then later, a permissionless version would be launched. The Calibra/Novi wallet would help people send each other Libra.
In several course correction moves, after receiving much flak from the global community, legislators and departure of early partners like Visa, MasterCard, Stripe and eBay; not only was the association renamed to Diem Association but also dropped its plan of creating a global stablecoin and instead launch multiple stablecoins, each tied to a different fiat currency (such as the U.S. dollar and the euro).
Due to continued resistance from the federal regulators, Diem Association announced the sale of its intellectual property and other assets related to the running of the Diem Payment Network was sold to Silvergate Capital. As per reports, the assets were liquidated in order to return capital to investors.
5. Paxos - Paxos Gold (PAXG) is a crypto asset backed by real gold reserves held by Paxos, a for-profit company based in New York. Each PAXG token is redeemable for 1 troy fine ounce of gold custodied in vaults by Paxos and its partners, and its market value is meant to mirror the physical gold it represents.
In 2015, the Paxos Trust Company became the first company in the world to be approved by the New York State Department of Financial Services (NYDFS) for offering fully regulated crypto assets.
The company charges a small fee for the creation and destruction of PAXG tokens (around 0.02%). There are also on-chain fees users pay for moving the tokens on Ethereum. Paxos charges no storage or custody fees, and its minimal creation/destruction fees are tiered based on volume. The process of tokenization allows anyone in the world to own fractional amounts of gold via PAXG with a minimum purchase of 0.001 troy ounces (t oz), or about $20 USD at the time of this writing.
6. Terra - Terra (LUNA) is a blockchain protocol for issuing algorithmic stablecoins and creating decentralized financial infrastructure. To accomplish its basic premise as a stablecoin platform, Terra uses a seigniorage model that minimizes volatility to keep a close fiat currency peg.
Terra has two significant components. Terra is the blockchain protocol for issuing algorithmic stablecoins pegged to any regional denomination. Luna is the protocol token used to stake and govern Terra while also locking value into the Terra ecosystem.
Terra has created a mechanism that issues regional stablecoins that can also be swapped easily, but the catch here is that Terra stablecoins are not backed by dollars, Korean won, or any other fiat currency, for that matter. Instead, Terra issues crypto-collateralized algorithmic stablecoins. These stablecoins hold a pegged value using a circular dual-token system that creates arbitrage opportunities via seigniorage.
While this sounds confusing, Terra has two key mechanisms to keep stablecoins stable.
a) Luna- Luna is the governance token that helps in stabilizing and collateralizing the price of Terra Stablecoins, TUSD, TerraKwon and others.
Even when the market price of UST isn't $1 per token, the conversion rate for minting treats 1 UST as equal to $1. Thus to mint Luna, one needs to burn Terra and vice versa.
In case of an arbitrage opportunity, the mechanism automatically corrects the supply to close such mishandling. For example, if a trader sees that Terra is trading for $0.98, they may decide to buy $100 worth of Terra, and since 1 UST = $1 when exchanging Terra for Luna, the person would get $100 worth of Luna, marking a profit of $2 worth of Luna.
The increased demand for UST by arbitrageurs increases UST's price. Terra burns the UST during the exchange to LUNA, reducing its supply and increasing UST's price. Once 1 UST reaches $1, the arbitrage opportunity closes.
Something similar would happen when the price of Terra goes beyond $1. But in this case, Luna tokens would be burnt so that the supply of Terra increases, correcting the price to $1.
b) TerraSDR - It is the basket of currencies that are collateralized by the Luna tokens. TerraSDR is pegged via Band oracles to the price of the IMF SDR — a special asset made up of a weighted basket of currencies (USD, EUR, YEN, GBP, RMB). Because the SDR is composed of globally important currencies, it creates a non-volatile reference point for TerraSDR.
When the price of 1 TerraSDR = .95 SDR, one can send 1 TerraSDR to Terra's smart contract to receive 1 SDR worth of LUNA. This reduces the supply of TerraSDR to boost its value back to parity with SDR.
7. OHM - OlympusDAO is a decentralized reserve currency protocol based on the OHM token. Each OHM token is backed by a basket of assets in the Olympus treasury. The goal of the project is to build a policy-controlled currency system in which the behaviour of the OHM token is controlled at a high level by the OlympusDAO. The pseudonymous founder(s) believe this system can be used to optimize for stability and consistency so that OHM can function as a global unit-of-account and medium-of-exchange currency.
There are three main attributes of the OHM token that make it path-breaking, confusing and also one of the hottest projects in DeFi:
OHM is a free-floating currency. This means that rather than having its price pegged to that of another asset, such as USD, the value of OHM is determined by the free market. Because of this, its price in dollar terms can and has been volatile, as, like any other non-pegged asset, it is subject to the whims of supply and demand.
It is Algorithmic in nature - which means Olympus allows the market to largely determine the price of OHM (more on that below). It does utilize the assets in the treasury to help keep the price as close to $1 as possible. When OHM trades at a premium, the protocol mints new tokens and increases supply to drive down the price as close to $1 as possible, and it burns tokens should the price drops below $1 to check the supply.
OHM is fully backed. The DAO has decided that each OHM issued has to be backed by $1 in collateral. Initially, this consisted of just DAI, with every OHM issued having 1 DAI in the treasury as its backing. However, the protocol has since expanded the treasury to include other assets, such as FRAX, another algorithmic stablecoin, as well as OHM-DAI LP tokens from SushiSwap, and OHM-FRAX LP tokens from Uniswap.
No Man's Land
1. KYC Triumphing Pseudonymity - A large chunk of stablecoin usage is pseudonymous. This means one can hold them in an unhosted wallet(i.e., not on an exchange) and not provide their identity to the issuer of these stablecoins. End to end transactions can be completed without any party needing to unveil their identity.
The need for KYC comes in only when one is to redeem their stablecoins for traditional banknotes or vice versa, i.e., to deposit notes and get minted stablecoins in their wallets.
While this is the moat of crypto transactions, providing users privacy, the ideal situation of crypto being recognized by banks and the same regulators building platforms on top of blockchain would come at the cost of this freedom.
This is a very slippery slope. As countries start recognizing digital assets and as the trading and transactions volume starts increasing - international regulators like FATF(Financial Action Task Force) and domestic regulators like USA's FinCEN would push for KYC'd profiles or else these issuers like Tether, Circle, MakerDao would have to cut them off from the system.
As per JP Koning, this could lead to DeFi splitting into two. Purely decentralized protocols would avoid stablecoins altogether to avoid subjecting their users to KYC. Not-so-decentralized finance would start to verify users to maintain access to stablecoins.
2. No Global Standard - With so many types of stablecoins, that too all different not only by the virtue of their issue but also how they manage their underlying value - it has become increasingly difficult for people to understand and fix their minds on one currency that they can do transactions with.
Eventually, we might see all stablecoins being accepted, with every token being pegged to each other in a 1:1 fashion. But this will take quite some time and a flurry of regulations before a global gold standard comes into play.
3. Love-Hate Relationship with Banks - What these stablecoin issuers are forgetting they're trying to bypass banking but need the support of banks to vouch for them during times of crisis. Even though the structure of these reserves, which serve as the collateral for these stablecoins, is similar to that of MMFs, one needs to be timely reminded that these are nowhere close to them.
A money market fund(MMF) is a kind of mutual fund that invests in highly liquid, near-term instruments. These instruments include cash, cash equivalent securities, and high-credit-rating, debt-based securities with a short-term maturity (such as U.S. Treasuries). Money market funds are intended to offer investors high liquidity with a very low level of risk. A money market fund is an investment that is sponsored by an investment fund company. Therefore, it carries no guarantee of principle.
While the Federal Reserve rescued MMFs in 2008 and 2020, it used U.S. banks and their dealers as intermediaries. The same is least expected to happen in the case of these stablecoin players.
Also, these intermediary banks will also have to attest that the end borrower met the Fed's terms for lending – which typically include being solvent, being the U.S. domiciled, having pledge-able and eligible collateral and more. While this is not only very difficult, it is also uncertain how these small banks that have partnered with these players would be able to do so much and how quickly.
4. Shaking Credibility - The banks holding reserves in accounts on behalf of these stablecoin issuers aren't typically household names like Goldman Sachs or JPMorgan but rather are small banks that have taken on a crypto-friendly stance. Several stablecoins are banked with Signature Bank, while the Meta's (previously, Facebook) pet project Diem(previously Libra) has partnered with Silvergate Bank, to which its assets have now been sold.
Also, while stablecoins have proved enormously successful given their trading and transaction volumes, the issuers are still under scrutiny. This is because of the opaque nature of their reserves that, in turn, give value to these currencies and also because of their various claims. One such claim is that some of the banks where reserves are held and the issuers are FDIC insured, making stablecoins a safer option to transact on the blockchain.
The Federal Deposit Insurance Corporation (FDIC) is an independent agency—created by the U.S. government—designed to protect consumers in the U.S. financial system. FDIC-insured banks qualify for pass-through insurance, which protects bank depositors against losses of up to $250,000 in case of a bank failure. But even FDIC couldn't confirm whether the actual token holder, in this case, would be subject to the pass-through insurance and, therefore, protected against losses of up to $250,000. In fact, the FDIC is still considering whether stablecoin reserves would qualify for such insurance, thus marking the frivolity of the claims.
Are CBDCs and Stablecoins the same?
Central Bank Digital Currency is a centralized monetary system that is governed by a particular country's finance authorities. A nation's official currency is represented in a digital form. It represents the fiat currency of that particular country.
CBDCs have become fairly popular with a number of countries with the support of their central banks testing the viability of these projects. The list included South Korea, China, the European Union and now India as well.
While a lot of people confuse CBDCs with Stabelcoins, they are different in a number of ways. The main difference between Stablecoin and CBDC is the mode in which the monetary system works. Stablecoin is a cryptocurrency that is not regulated, while CBDC is completely regulated and monitored by the monetary authorities of a nation. That means to say Stablecoin is decentralized while CBDC aims at being centralized.
Thus, CBDC is an evolution that can protect the banking business, and they're here to safeguard the nation's interest and the traditional banking system. The aim is to keep a check on these crypto-assets by introducing their own. They're fairly centralized and are controlled by the Central Banks of the respective country the CBDC belongs to.
In conclusion, while there is a long way for stablecoins to become regulators darling, it has amassed much attention to become the staple currency to do international transfers and many other things on the blockchain.
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