Understanding Stablecoins (Part 1/2)

In my last edition, I wrote about why you should care about Bitcoin. However, the one intrinsic problem with bitcoin and traditional cryptocurrencies as a means of payment is that they can be highly volatile, which is slightly ironic since Bitcoin was primarily created as a decentralized solution for payments.

Imagine I want to pay a freelancer in bitcoin for a service rendered. A few major issues crop up.

• The price of bitcoin could have fluctuated massively between the time the terms of payment were agreed upon, to when the payment was actually made
• I may want to hold on to bitcoin instead of spending it (after all, it has appreciated an average of 115% annually since 2014), which essentially induces a form of buyer's remorse
• Bitcoin transactions are slow, compared to other cryptocurrencies. While the average transaction takes 10 minutes, transactions can take 1-2 hours to process, during which time, the price of bitcoin can fluctuate wildly

Enter, stable digital currencies which are pegged to fiat currencies, solving all these problems: stablecoins.

What are stablecoins

Stablecoins are a form of cryptocurrency which are stable in value, as they are pegged to another asset. Usually, stablecoins are pegged to fiat currencies, but they can also be pegged to commodities, or even other cryptocurrencies.

The most popular fiat-based stablecoins are USDT and USDC, which are both pegged to the US dollar. Essentially, one USDT or USDC is equivalent to one US dollar.

As of today's date - Nov 5th, 2024 - the total market cap of all stablecoins issued is $173 billion, out of which, $165 billion is via USD based stablecoins, and $335 million is via EUR based stablecoins.

Out of the $173 billion market capitalization in stablecoins, two giants dominate the arena: USDT ($120 billion, also known as Tether, managed by Tether Limited Inc.), and USDC ($35 billion, managed by Circle).

Fiat-based stablecoins, like USDT and USDC, maintain reserves equivalent to the total issuance amount. Furthermore, these reserves are regularly audited and maintained by independent contractors. For example, Tether's website specifies that "all Tether tokens are pegged at 1-to-1 with a matching fiat currency and are backed 100% by Tether’s Reserves."

The four types of stablecoins

There are four forms of stablecoins, three of which are collateralized and backed by reserves.

Fiat-collateralized

Fiat-collateralized stablecoins, as the name suggests, are backed and collateralized by fiat. As specified above, this includes your popular USD based stablecoins like USDT and USDC- but also includes stablecoins based in other currencies, including but not limited to EUR, AUD, JPY, INR, CAD, and many other fiat currencies.

Crypto-collateralized

DAI, the third most popular USD based stablecoin (and pegged to USD), is not backed by fiat; rather, it is backed (collateralized) by crypto, and is a form of a crypto-collateralized stablecoin. To account for volatility in crypto prices, crypto-collaterized stablecoins often have crypto reserves worth more than the value of the stablecoins.

For example, in order for $100 of DAI to be created, about $150 worth of Ether would need to be collateralized. The crypto-collateralized stablecoin is issued after collateral tokens are pledged via a smart contract. In order to liquidate the collateral, stablecoins must be paid back into the smart contract.

Commodity-collateralized

The third type of stablecoin backed by an asset is a commodity-collateralized stablecoin. In this scenario, typically a 1:1 ratio of a specific commodity is pledged as a reserve against the amount of stablecoin issued. As of today, the only commodity that acts as a reserve asset against stablecoin is gold, and there are two prominent gold backed stablecoins in the market: Paxos Gold (PAXG) and Tether Gold (XAUT), each with a current market cap of over $500M.

Non-collateralized (algorithmic)

Finally, there is a fourth category of stablecoins: algorithmic stablecoins. These stablecoins are not collateralized by reserves. Instead, they regulate supply and demand by using algorithmic models. At face value, I don't see a lot of value in algorithmic stablecoins, apart from the argument that an algorithmic stablecoin classically adheres to the tenet of decentralization by breaking any ties to the fiat world.

The collapse of the Terra stablecoin, TerraUSD (USTC), which was backed by LUNA via an algorithmic process, is an example of why algorithmic stablecoins should probably be avoided. In the Terra/Luna example, one USTC was pegged to one LUNA. Via an arbitrage and redemption process, the theoretical idea was that the peg was unbreakable. However, through a series of unforeseen events which led to panic selling, Terra lost half its value within 24 hours and the two tokens got depegged, leading to a complete collapse of both coins.

The rise of stablecoins, explained in numbers, by a16z crypto

In the latest State of Crypto Report - 2024, issued by a16z crypto (highly recommended read), the authors conclusively state that stablecoins have finally found a product market fit, marking 2024 as a pivotal year.

Some highlights / quotes of the report which supplement the Product Market Fit argument.

• "Major scaling upgrades have drastically reduced the cost to execute crypto transactions, including those involving stablecoins, in some cases by over 99%. On Ethereum, transactions involving USDC, a popular U.S. dollar-pegged stablecoin, cost on average $1 in gas fees this month, down from $12 on average in 2021"
• "Sending USDC on Base, Coinbase’s popular L2 network, costs less than a cent on average...compare these fees to the $44 on average that it costs to send an international wire transfer. "
• "Stablecoins make it easy to transfer value. They amounted to $8.5 trillion in transaction volume across 1.1 billion transactions in the second quarter of 2024 ended June 30. Stablecoin transaction volumes more than doubled Visa’s $3.9 trillion in transactions over the same period."

• In Q2 2024, transaction volumes via stablecoins were more than 2x of Visa, a remarkable achievement. Stablecoins also enjoy a high volume/transaction ratio of ~$8000, as compared to a ratio of ~$75 for Paypal, ~67 for Visa, and ~$2600 for ACH.

• Finally, the most conclusive data point has to be the following, which pins stablecoin monthly sending address vs spot crypto trading volume. While trading volume is highly cyclic, due to the fact that volumes pick up when leading crypto assets appreciate in price, stablecoin monthly sending addresses have consistently been rising over the past decade, with new highs being hit virtually each month. As the authors beautifully state, "stablecoin activity has grown depite crypto market cyclicality, highlighting their adoption beyond trading"

In Part 2, I will cover the following:

• The current state of stablecoins regulation
• How stablecoins maintain their market value
• Getting started with stablecoins
• The future of stablecoins

Stay tuned!