Stablecoin Quality Analysis

DISCLAIMER:?This is not financial advice; the article is for educational purposes only. These observations, takeaways, and predictions are based on my direct experiences with Blockchain and Cryptocurrencies for 10 years and have seen it evolve, crash, morph and grow. I am not a qualified financial advisor, please consult a professional for investment advice. I am also not advocating investing decisions based on any specific analysis mentioned in this article.

Introduction

Old economy minds consistently toot the volatility of cryptocurrencies making it the biggest point of criticism. Stablecoins challenge that argument by providing consistency in value, they are “collateralized” i.e., the total value of stablecoins is backed by assets held in reserve. More often they are pegged to the value of fiat currencies like USD, Euro, Yen, etc., but they can also be pegged to values of other commodity assets like oil, gold, etc.

Stablecoins have been valuable for crypto traders, investors, and speculators in times of market volatility to hedge against losses or by keeping profits in fiat during bear markets within the same asset class safeguarding value. Crypto industry champions view stablecoins as a terrific step to drive adoption. Price stability creates predictability creating overlapping use cases with fiat like recurring payments, rent, salaries, etc.

Figure 1: Types of Stablecoins (Image credit Medium)

The supply of stablecoins is also set to adjust according to market conditions, there are many stablecoins in the crypto ecosystem today with pros, cons, and unique aspects. To counter illicit financial activity such as money laundering, regulators in various countries have imposed guidelines requiring stablecoin trading platforms to implement KYC (Know-Your-Customer) policies.

Almost everyone in the blockchain and cryptocurrency space agrees on the need and value brought by a stablecoin. From the older Tether to the newer DAI (from Maker), there is a lot of debate on which is one is most stable, has the most longevity, privacy, and real stability, etc. Let us analytically examine a few for their unique signatures and creating value.

USDC or USD Coin

One of the largest and most adopted stablecoins, with exceptional growth since 2018 and generally observed to be in the top 25 coins on Coinmarketcap. It was launched by the centralized consortium between Circle Internet Financial (Goldman Sachs backed) and Coinbase. The coin is backed 1:1 with USD and audited regularly to ensure proper reserves are available in escrow accounts. Given it is issued by Coinbase makes it easier to redeem it into fiat and then back into the old economy financial systems. USDC is an ERC 20 token built on Ethereum, hence easily integrated with smart contracts creating use cases like lending, borrowing, investing and payments, etc. The foundation elements and processes behind USDC make it appear trustworthy and able to transact in seconds, but it controlled by centralized entities against the very socio fabric of blockchain. This creates hesitation with many people to take the leap of faith with USDC, even though Coinbase has FDIC insurance and has implemented some of the most robust security protocols known today. The hesitation of usage also indicates the transition underway between the old and the new economy with people not trusting centralization (too much power in the hands of too few) enough especially with their ability to freeze funds or blacklist addresses as they see fit.

Paxos

Today, a stablecoin which pivoted out of an exchange in 2012 and launched in 2018 as Paxcoin. Pax is like USDC with regular and stringent audits ensuring reserve liquidity backing coins in circulation. Pax has routinely been in the top 50 on Coinmarketcap, is listed on many exchanges, and can be immediately converted to fiat. It is also an ERC 20 token running on Ethereum creating utility and trust. However, Pax has not been growing in popularity or usage as compared to other stablecoins even with the liquidity it provides, it is generally used by early and loyal adopters who execute large block orders trading in and out of Pax.

True USD

True USD was also launched in the stablecoin season of 2018 and became one of the most trusted stablecoins in the circuit due to the level of transparency from its parent i.e., Trust Token. Just like USDC and Paxos, they maintain a 1:1 ratio with fiat and offer full disclosure on its reserves with multiple periodic audits by credible third parties enabling them to partner with many actors from the legacy financial system like banks, etc. They were the first to deliver one-click redemption to fiat and support multiple fiat currencies like USD, GBP, Euro, AUD, etc. Yet another ERC 20 token and has its challenge with its centralized issuance, management, control, and trust with True Token. Trust is an awful word in crypto, as they say, “Don’t trust, verify”. True USD also requires KYC and AML for purchase and redemption which is standard if there is a fiat gateway interface. The privacy hawks will not be easy adopters for True USD.

DAI

The newest and perhaps the most interesting of the stablecoins on the market, DAI positions itself as the only decentralized stablecoin around. It is not issued by any centralized authority and the people who built the project i.e., Maker DAO does not have control over its dynamics. Unlike others, DAI is not backed by fiat currencies instead uses collateralized debt to back its circulating value coded into smart contracts.

DAI is created when a collateralized debt position is created by locking Ethereum into a smart contract, this contract holds the staked coins and mints DAI which can be unlocked later. This creates the biggest advantages for DAI secure, verifiable, and decentralized and this also means there is no audit requirement, everything is confirmed on the blockchain itself and the collateralized assets are transparent.

The initial concerns on the impact of Ethereum’s volatility did not prove accurate with DAI maintaining its price and value through collateralization. The level of decentralization makes it popular with OGs making it a coin with a high turnover on several exchanges. On the downside, it is not backed from reserves hence difficult to convert into fiat. One must first go through an exchange to sell your crypto, then withdraw it into fiat incurring a higher transaction fee. Also, there are few order books for DAI on exchanges (no DAI/ALT, easier to find USD/ALT) you will likely have to buy ETH or BTC transitioning back through the volatile world.

Tether (USDT)

Tether, the first stablecoin to hit the circuit has been the most controversial and most popular of all stablecoins today. It has consistently been in the top 5 coins regarding market capitalization and with extensive liquidity. Its daily volume exceeds most other cryptocurrencies and has pre-defined order books paired with several altcoins on most exchanges e.g., UDST/ALT because it is easier for exchanges to list Tether ahead of fiat.

Despite all the controversy and opacity, it has alarming levels of adoption. Tether has many issues with opacity, their own lawyers admitted this year they only hold 74% with outstanding USDT. There are also many questions on their connection with Bitfinex, many of the founding directors of Tether are also directors of Bitfinex and they have refused to have a public audit sometimes.

Even after all this and many of its ups and downs in 2017, 2018, and 2020 they have always bounced back without producing much in defense and cement their place as the trader’s favorite doing the highest volume amongst all stablecoins. Limited slippage for large orders, small transaction fees, multiple exchange adoption, and pre-order book pairs make it attractive for users. The privacy hawks are difficult adopters due to KYC and AML requirements on all fiat edges, but many consider this thin. The more transparent Tether gets, the better it is for the entire crypto community, it is a matter of time they are forced to provide a public audit. The bigger Tether grows, so does the urgency on being transparent and the target on its back gets larger. This issue must resolve itself before being another crypto mayhem day in the making.

Algorithmic Stablecoins

The new kid on the block, they do not rely on collateral but uses smart contracts and algorithms to balance supply, demand, price pegs, and liquidity. For example, if a token’s price increases to $1.05, the circulation will be increased to bring prices down to $1 – this implies ownership of tokens changes on the same supply. There are several algorithmic stablecoins on the market like LUNA, AMPL, ESD, etc. These algorithms could come under stress during black swan events i.e., sudden drop in demand and a large percentage of users pull their money from the stablecoin as the algorithm triggers to buy up the supply to keep prices at $1- however lack of future demand could create serious problems. In addition, the complexity of algorithms and their opacity pose questions on their reliability to garner public trust. The reliance on the stability of algorithms and comfort around it will be critical for widespread adoption.

Criticism for Stablecoins

Critics of stablecoins suspect that stablecoins, specifically crypto-collateralized stablecoins, have a bleak future due to over-collateralized stablecoins subjected to black swan event risk. Given the printing of the USD over the past 12 months, it can become expensive to hold real-world currency pegs e.g., Saudi Riyal, Swiss Franc, etc. Others doubt that pegging a cryptocurrency to a fiat currency such as the US Dollar is the right fundamental problem to solve as the USD loses stability and purchasing power through inflation bringing back volatility in a different way. Second, a fully USD-pegged asset is yet another USD derivative enforcing the national legal tender law. By this logic, an actual stablecoin should not be stable towards a fiat currency but remain stable in its purchasing power.

Calibrating Stablecoin Positions

Let us further plot the core behaviors of stablecoins across four well-known metrics and criteria which have evolved over the years.

The $1 Delta

Observe each stablecoin’s high and low price on each of the past 1 year and record the most it deviated from its $1.00 peg in an upward or downward direction. The last 60-90 days have driven a lot of price action (at the time of writing July 2021) and would reveal rich data.

Deviation = Max Price (Highest Price — $1.00, $1.00 — Lowest Price)

The May 19th mayhem was an interesting day to use as a baseline for the range, Tether traded at a high of $1.02 and a low of $0.98, so the deviation is $0.02 up and down. Most stablecoins held $0.02 to $0.03 ranges very similar to USDT, but over longer periods there are more deviations with DAI deviating $0.06-$0.08 on at least 13 out of the past 90 days. USDC, True USD, Pax, and USDT hold well on this metric while DAI stands to lose. Some of the other lesser adopted stablecoin had $0.08 to $0.09 off the $1 base. While delta from $1 is only one metric, perhaps not the best given most people holding stablecoins are okay with the upside risk, they may think differently towards downward deviation.

Downward Pressure from $1

The prior metric magnified towards measuring the magnitude of downward pressure on the stablecoin.

Downside pressure = If Low Price < $1.00, Low Price — $1.00

This metric brings forth different results. Tether reveals the most downward pressure in the last 90 days dropping to $0.96 in May. The stablecoins with $0.08 to $0.09 deviations now went to the upside with values like $1.08-$1.12, but DAI continued to show downward pressure with averages around $0.92. PAX, USDC, and True USD continued to hold well to maintain value during downward pressure.

The average downside on downward pressure less than $0.01 for all 5 stablecoins. They generally trade above $1, not below but the equation changes during market downturns when peg maintenance is at risk.

Daily Price Volatility

Baselining stablecoins volatility as the standard deviation of daily price changes over a year (expressed annualized) confirms they are less volatile (about 1/10) than average cryptocurrencies. This metric places all the stablecoins mentioned on nearly even footing with no winners or losers. However, lesser-known stablecoins like Binance USD and Gemini USD, etc. stand to lose out on these metrics.

Downturn Market Dynamics

The elephant in the room i.e., stablecoin performance during market turbulence. This can be analyzed by correlating stablecoin price correlation with other crypto assets and plotting their decline. I looked at the data from 3 of the worst crashes in crypto history (in the post stablecoin era). The data and output reveal a few concerning things e.g., during the 11/24 crash BTC went down 12% but USDT and True USD also slipped 4%, but during the May 19th crash BTC dropped 33% while USDT lost 6% while BUSD and others lost a tad bit more in that mayhem. If you plot these in the old economy, one will realize that in 2008 when all diversified assets suddenly exposed their correlation. Stablecoin being a flight to safety asset by this measure is highly questionable. The market correlation metric does not show DAI, TrueUSD, and Tether in a comfortable place while PAX, USDC pass the market dynamics test well.

Other Qualitative Measures

It is very evident that the newer generation of Fiat-backed stable coins has now made material improvements over the first-generation product in Tether. Their performance across multiple tests and their transparency appeared to be more appealing to end-users.

Given the price fluctuation off Ethereum including its 90% drop in December 2017 and its 60% correction in 2021, Dai as a stable coin deserves credit for successfully anchoring the entire DeFi ecosystem which did not capitulate. The collateralization and decentralization come at the price of some volatility as compared to its more centralized stablecoin cousins.

More qualitative factors to consider are smart contract bugs, code contamination by hackers, and other security issues with crypto-collateralized coins. Sudden market collapses can still risk breaking the peg even for an over-collateralized coin.

A deeper look at the MAKER protocol indicates the last resort of printing DAI and selling those on marketplaces diluting token holders, but even this could only work in moderate declines. The multiple forms of collateral backing DAI have alleviated this issue to a fair degree and we assume we are past the era of any existential threats to Ethereum by now.

Once the overall cryptocurrency adoption increases, the collateralization risk will more or less fade away- until then keep your eyes and ears to the ground.

Stablecoin Supply Distribution

The distribution of these stablecoins varies a lot, the ERC 20 variant of Tether is well distributed with no concentration. Meanwhile, < 6 accounts own 80+% of the supply for Gemini USD, Binance USD, Tether (Tron), etc.

Stablecoin Activity Distribution

Stablecoin comparison on # of accounts responsible for most of the on-chain activity is another vector. For example, a few accounts responsible for most transactions show limited usage outside of a handful of exchanges.

Another interesting discovery is that the most active Tether (Tron) accounts are linked to “dividend” payouts. On specific days, it caused 90+% of Tether on Tron usage.

Paxos appears to have a broad active user base. However, looking at the top transactors on Paxos leads to an interesting discovery: the two most active accounts on Paxos are linked to MMM BSC, a ponzi scheme that underwent an exponential growth in activity in the past year. (Source: Coinmetrics)

Stablecoin Analysis

Based on all the above analysis, it becomes clear that some ease of use, fiat stability, adoption, liquidity come at the price of foregoing a certain degree of decentralization. The analysis is visually plotted in figure 2 below which also outlines the need for a stablecoin that will address these factors in a decentralized and efficient manner.

Figure 2: The Stablecoin Grid

The stablecoins space is evolving rapidly with a lot more room for innovation, improvement, and adoption. These assets are the cornerstone of DeFi with organizations, governments, and individuals continuing to wrap their heads around transparency, efficiency, and ease of use. It is also clear that some of these stable coin assets require auditability, transparency, and levels of decentralization more than the current state.

Concluding Thoughts

Each stablecoin has its own unique signature. The adoption and usage come down to preferences around liquidity, decentralization, ease of trading, ease of conversion, privacy, etc. Individuals like DAI, but traders prefer Tether or USDC. The real issue is the lack of universally accepted stablecoin which optimizes for all problems such as decentralization, privacy, price stability, undercapitalization, etc. A stablecoin solving this could be a major catalyst for long-term crypto innovation will be adopted easily and will challenge the legitimacy of weak, centralized currencies issued by governments.

References:

Coin Bureau YouTube Channel

Cryptos R Us

Glassnode