RΞCAP: All In On Stablecoins?

At the end of my last article , I highlighted how stablecoins were getting more attention from both private and public markets. With the growing interest in the development of stablecoins, it makes sense to dive into the different mechanisms used by these assets in an effort to maintain a stable value and explore their evolving role in both cryptocurrency and wider markets.

In this article, I will cover not only the market leaders but also some of the exciting innovations taking place, as well as the challenges they face in gaining adoption. Whilst there is no certainty as to what the final state of play will look like in this sector - whether CBDCs succeed or private stablecoins become the norm - it can be said that for cryptocurrency to be adopted by the masses, stablecoin infrastructure is a necessity.

TLDR: Stablecoins Poised To Strike Back

What Are Stablecoins And What Is Their Purpose?

As highlighted in the previous article, there are a number of different approaches that are taken when designing stable crypto assets. In this article, we'll look into some of these and why algorithmic stablecoins are due for a resurgence.

To begin with, however, it can be helpful to better understand the purpose of these tokens. Put simply, stablecoins are a form of digital currency that is built on the blockchain and, in this sense, they are like any other cryptocurrency. Where they differ, however, is how they attempt to define their value. Whilst most crypto-assets are volatile in price - due to the impact of supply & demand, liquidity, speculation, and security all impacting their value - stablecoins aim to hold a fixed value. For this reason, they are a vital piece of infrastructure across the cryptocurrency ecosystem, given that the benefit of these are that they facilitate:

• A stable store of value with minimal volatility.
• Easier trade given their more constant value.
• A faster alternative to traditional money transfers.
• An alternative to local currencies that are inflationary/lack liquidity.

As highlighted by Multicoin Capital :

Stablecoins are one of the highest convexity opportunities in crypto. They aim to become global, fiat-free, digital cash, so the total addressable market (TAM) is simply that of all the money in the world: ~$90T . The opportunity for stablecoins is, intrinsically, the largest possible TAM. This vision is larger than that of Bitcoin itself. A fiat-free currency that’s price stable will challenge the legitimacy of weak governments around the world.

With this opportunity still to be capitalised on, it is unsurprising that there are a number of players in the stablecoin space, all vying for market share. They are also then faced with the same set of challenges - this is commonly presented as the "stablecoin trilemma" as set out below:

As we can see from the diagram above, there are 3 key features that a stablecoin should aspire for:

• Peg (Price) Stability: In order to be classed as a stablecoin, the asset needs to be "stable" - i.e. does it maintain its peg with the asset that backs it? This is important for it to retain purchasing power and ensure that it is consistent with the asset it is pegged to. The asset must maintain peg, particularly during times of market turbulence and volatility.
• Capital Efficiency (Scalability): This criteria looks at the cost of creating each unit of stablecoin/maintaining price stability, as well as any reserves needed to ensure price stability. For the stablecoin to be scalable, it needs high capital efficiency - i.e. a stablecoin that is required to be overcollateralised is less efficient than one that mints at a 1:1 ratio, or less.
• Decentralisation: As with any other cryptocurrency, decentralisation is an important factor to consider as this determines the control of the stablecoin. A centralised stablecoin would likely be under the control of a single entity, where as a decentralised stablecoin will have a governance system in place that decentralises control and mitigates against a single point of failure. Whereas a decentralised stablecoin will be fully transparent in terms of how it maintains peg (all readable on-chain), this is less possible in more centralised systems where the stablecoin issuer has more direct control and may not be as open with how they operate (e.g. not being fully transparent with an asset's backing).

Just as with the blockchain trilemma, however, it is difficult to satisfy all three bases as there are tradeoffs between each of these:

• For a stablecoin to be decentralised and to have capital efficiency, they often take the form of a non-collateralised algorithmic stablecoin. A consequence of this is that there is more risk of the price lacking stability. This is particularly due to the fact that these forms of algorithmic stablecoins use smart contracts to determine the money supply in the ecoststem in response to the demand within the system. As there is a lack of collateralisation, a volatile market could leave the stablecoin exposed to considerable market risk, with a common example of this being a "de-peg" event. An example that highlights such a weakness is the two-token system of Terra Luna, which saw its stablecoin ($UST) backed by $LUNA - read more about how this particular stablecoin collapsed here .

• For a stablecoin to be decentralised and to have price stability, this will likely take the form of being crypto-backed. What this means is that the stablecoin peg (1:1) is maintained by a pool of reserve assets that is equivalent in value or exceeds the value of the total number of stablecoins in circulation - i.e. it is collateralised, with most protocols choosing to be overcollateralised in order to weather any market volatility that could impact the total value of this collateral. Given that most approaches implement an overcollateralised approach, this lacks capital efficiency given the amount of capital required to safeguard the stablecoin. An example of this approach is highlighted through $DAI - a crypto-backed stablecoin that is created by the Maker Protocol - that uses collateralised debt.

• For a stablecoin to have price stability and capital efficiency, then inevitably this needs to be the lowest risk/lowest friction offering and this is usually seen with the design of fiat-backed stablecoins. In these cases, the stablecoin creator is issuing stablecoins whilst ensuring that it has a 1:1 backing of its fiat currency, denominated in the same currency, in its reserves - i.e. for 1 USDC created, there will be $1 in cash equivalents in reserve, meaning that it can be exchange for cash at any time. Relying on fiat currency de-risks the proposition somewhat and helps achieve a tight peg, given the guarantee of there being 1:1 backing, meaning a fiat can be redeemed at a near perfect peg - thereby reducing volatility and market risk. It also means that it is much more capital efficient - in comparison to the overcollateralisation seen in other approaches. It should be noted, however, that these systems are obviously more centralised as a result, with one provider assuring the assets are backed in fiat. As we've seen in recent years, with this control comes a considerable trust issue - as demonstrated by the $USDT debates around whether it is fully backed or not and that we should not just trust that it is, but verify (read more here ).

So what does the current stablecoin landscape look like?

The Macro

Before exploring why algorithmic stablecoins are poised for a come back over the next 12-18 months and offer a compelling alternative to fiat-backed and crypto-backed stablecoins, we should first start by exploring the current state of play.

Firstly, starting high-level view, we can take a look at the current market landscape and the market capitalisations of each stablecoin on the market, using this as a proxy for the industry's trust in each stablecoin - a high market cap indicating that the market trusts that stablecoin to be a "safe" place to store value outside of more volatile crypto-assets but still within the crypto-ecosystem (as this is the primary purpose for stablecoins). What is clear is that it is a developing market with there being a number of different stablecoin offerings being launched and this is even before considering the evolving CBDC landscape and the collection of other stablecoins that will be released over the next year.

To explore this landscape a little further, it can be useful to pick out some examples from this table to further understand the differences in approaches and what is being offered.

Tether - $USDT

As we can see from this table, fiat-backed stables dominate by market cap with the top 3 stables owning over 90% of stablecoin market share, with $USDT - Tether - alone owning nearly 50% of the entire market, with $USDT being available on: Algorand, Avalanche, Ethereum, EOS, Liquid Network, NEAR, Omni, Polygon, Solana, Bitcoin Cash's Standard Ledger Protocol, Statemine, Statemint, Tezos, and Tron . It's unsurprising that Tether is the leading stable given its first move advantage having been created in 2014, 4 years prior to the creation of $USDC by Circle, leveraging this head start to become the most established stable dominating crypto exchange pairings.

Although it appears that Tether has been relatively unchallenged over the years, its journey to the leading stablecoin has not been without its challenges, having been surrounded by controversy of whether Tether can actually back each $USDT with the equivalent in cash . This goes to highlight the arguably the largest drawback of fiat-backed stablecoins: users having to trust a centralised party being able to fulfil their obligation if users look to redeem their stablecoin holdings for cash. Inevitably, in the case of a bank run, users would want to be confident that they could get the equivalent of their $USDT holdings in cash. Given crypto is designed to be trustless, this is a clear tradeoff for the purposes of capital efficiency.

$DAI

If we look to the first non-fiat-backed stable we see $DAI, capturing only 4% of the market. In this case, we can know for certainty how $DAI's price peg of 1:1 with the US Dollar is supported with the basket of assets it is collateralised with.

To this extent, it removes the concern one concern centralisation, offering reassurance on price stability with it maintaining a strong peg with thanks to $DAI's minimum collateral ratio of 130% . Even during the height of the 2022 market crash and black swan events, $DAI was able to maintain its peg - even when demand dropped significantly (i.e. borrowing fell), due to its Peg Stability Modules and being able to benefit from the fact that it was collateralised by (low-risk) collateral types that could not be liquidated. Yet, when we look at what this collateral is comprised of, a significant amount is the centralised stablecoin $USDC, thereby weaking the case that it is truly "decentralised" and more resiliant. So whilst it is more decentralised than more fiat-backed coins, there are limitations to this and given it's collateral ratio, it is not as capital efficient.

$FRAX

A few weeks ago I mentioned in one of my articles that Frax Finance had been the dark horse of DeFi over the past year, quitely becoming a more significant protocol in the stablecoin ecosystem, and in this section we can begin to understand why. Despite being a relatively new stablecoin, $FRAX has managed to capture a sizeable amount of market share for the amount of time it has been on the market. What is even more impressive, is that it has been able to do this at a time when scepticism in algorithmic stablecoins is at an all time high, post-$UST/$LUNA.

It has achieved this through a two token system, but one that is arguably more sustainable. The stablecoin is minted at a 1:1 ratio with USD through using both $USDC as collateral and the $FXS Frax Share token (it's governance token). Whereas $UST was undercollateralised from the beginning, $FRAX is starting from a position of being crypto-collateralised and over time, becoming less collateralised with $USDC and more algorithmic in nature. $FRAX is collateralised with $USDC and the collateralisation ratio is determined by the market rate of $FRAX - if the price is above $1, the collateral ratio required for minting $FRAX drops, meaning less $USDC is required. Vise-versa, if $FRAX falls below the $1 peg, the collateral ratio increases. It should be noted that all $FRAX are fungible no matter the collateral ratio they mint at.

The example highlights what this can look like if the market rate of $FRAX is above $1:

The protocol achieves this control over the stablecoin's price peg through owning over 50% of the $FRAX total supply and this ratio is managed by Frax's Algorithmic Market Operations Controller , which sets Frax's monetary policy. In the first instance (v1) this solely managed collateral ratios. In the latest iteration that was released in March 2021, v2 set out to add further AMOs to add to the stablecoin's stability . The fact that $FRAX managed to hold a tight peg throught the $UST crash is testament to the fact its AMO system works and protects against a death-spiral.

In light of this, it is evident that the stablecoin is relatively capital efficient and price stable as things stand, and operates on a relatively decentralised basis (with the exception of $USDC being a centralised for of collateral), it is well placed to improve on capital efficiency and decentralisation as it becomes more algorithmic in nature. As for the peg, this will be the real test of price stability.

So what does this mean for the stablecoins market?

As seen above, market participants have an ever-growing number of choices for which stablecoins to use. Each ecosystem will have different offerings but all will be looking to satisfy as many of these criteria as possible:

• Deep liquidity to facilitate swaps in size
• Peg protection in order to safeguard against market volatility
• Minimised risk of single point of failure
• Capital efficiency & yield generation to attract capital

Given their marketcap's, the market is still signalling that $USDT and $USDC are the most trusted stables with $USDT having the most trading pairs on the market and $USDC being created by a reputable regulated fintech that is audited by Grant Thornton LLP that provides monthly attestations on $USDC's reserves that back it. But these stablecoins are not perfect with Tether having been accused of being ambiguous about $USDT's backing in the past and $USDC being known for blacklisting assets, it is clear to see how there are tradeoffs to be made when using either of these dominant coins.

Post-$LUNA, it's safe to say the market became more wary around stablecoins that did not have a 1:1 USD backing. In the US, activity amongst regulators has picked up, with the first draft of Congress' Stablecoin Bill looking to mitigate the risk within this field with the bill proposing a ban on endogenously collateralised stablecoins - i.e. stablecoins that are backed by other tokens that are created by the same entity that mints the stablecoins. In the case of $UST, this was collateralised entirely by $LUNA - Terra's native token. Given the US is looking at this approach to stablecoin regulation, it would be unsurprising if other regulators around the world were to follow in the name of consumer protection. Recent news from Hong Kong , suggests this may be the case.

Yet, as seen by the $FRAX stablecoin economy, there is an intermediary path that can be taken and, arguably, there is a compelling case for stablecoins that are not just 1:1 USD backed coins.

So What Comes Next?

What Frax Finance has proven is that algorithmic stablecoins can be resilient to adverse market conditions and that there are still new approaches to take when designing stablecoin ecosystems. DeFi protocols such as Curve Finance and AAVE are both looking to launch their new stablecoins imminently with both stablecoins varying in design: Curve opting for a mechanism that is similar to $DAI in that it will be overcollateralised but offer a collateralisation mechanism that leverages their novel Lending-Liquidating AMM (LLAMMA) that is designed to protect borrowers that have their collateral fall below the liquidation price and AAVE choosing to use a multifaceted approach that will use different "facilitators" to back it's stablecoin with excess collateral. Given these are two of the most established DeFi protocols, these are two serious contenders in the ongoing battle for liquidity amongst stablecoins. With trust having weakend in centralised institutions over the past several months, adoption of these new stables wouldn't be surprising. Both are battle-tested and highly composable, meaning that these stablecoins would likely become major features of other ecosystems.

The eagle-eyed will have noticed that we didn't cover any of the stETH stablecoins that have also started entering the market recently.... Do not worry - I'll be covering those, on their own, soon.

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