Stablecoins connect fiat currencies and cryptocurrencies.
Many people are hesitant to enter the cryptocurrency space because of the volatility. At the same time, their bank isn’t delivering much return on investment, offering ultra low-interest rates, charging higher fees and imposing limitations on use.
Stablecoins exist in between the centralized banking world and the decentralized universe of cryptocurrency.
Stablecoins reduce their volatility by pegging their value to existing assets. Many of the most popular stablecoins track the value of USD, using algorithms to help ensure that 1 stablecoin (Eg. USDC) is always worth $1 USD.
Stablecoins can participate in the decentralized finance DeFi ecosystem. This is one of their most appealing aspects. Depending on where you store your stablecoins, you can earn up to 8% interest through different DeFi applications. Essentially, supplying your stablecoins as collateral into a DeFi app allows you to earn rewards for providing liquidity to the network.
Bitcoin and Ethereum are becoming more and more popular, but their volatility may slow widespread adoption. Stablecoins provide owners with a low-volatility asset that does not lose value when the rest of the crypto market dips, making them ideal for adoption. Additionally, they make transferring money and remittance much faster and easier through the blockchain. No middlemen.
Note: you should be aware that any conversion of stablecoins to fiat, is considered a taxable event. It’s a way of selling the crypto and is count as a gain or a loss depending on the cost basis. Also any interest earned on stablecoins is sure to be considered to be income.
- Stablecoins are low-volatility assets that are pegged to a real-world asset such as USD or gold.
- Stablecoins use collateralization and other mechanisms to maintain their price consistently over time.
- You can use your stablecoins across the DeFi landscape to earn a decent yield. (up to 8% APY)
- Not all stablecoins are built equally and not all of them are fully decentralized.
- It’s possible for the price of a stablecoin, especially if it’s algorithmically-based to collapse. (Terra (UST) for example)
Tether’s USD stablecoin, called USDT for short, has been the source of ongoing regulatory controversy. Despite its run-ins with the Securities and Exchange Commission, USDT maintains an impressive 75 billion market cap as of May 2022
Tether’s history and controversy
USDT began trading in February 2015, designed as a fiat-collateralized bridge between coins like Ethereum or Bitcoin, and the USD. The company behind Tether, maintains a supply of USD that it uses to back the value of the stablecoin.
However, this also means that the company must undergo third-party audits; however, it did not receive any audits in 2018 for the previous year. Hilariously, they hired Friedman LLP to do an audit and were literally fired as a client, suggesting that not everything going on at Tether was above-board.
Some investors raised concerns that USDT isn’t fully backed by fiat collateral. If unbacked USDT were to be issued, it could then be exchanged for other cryptocurrencies for literally nothing.
A lawsuit in April 2019 brought to the courts by New York Attorney General Letitia James alleged that Tether and its parent company conspired to hide a $850 million loss. If the company behind USDT was no longer allowed to operate, it would tank many DeFi investments sending a shockwave through the entire crypto ecosystem.
A few other notable issues:
- The original Tether paper listed this under possible risks: “We could abscond with the reserve assets.”
- There is actually no way for retail investors to redeem USDT unless they have $100,000
Who does Tether go to?
Protos published an investigation of Tether in late 2021, detailing which companies are purchasing the stablecoin.
As of November 2021, almost $37 billion in Tether was sent to Alameda Research — a firm started by Sam Bankman-Fried who is also the leader of the FTX crypto exchange.
Nearly $30 billion of this amount was then sent directly to FTX. Alameda Research also functions like a bank for crypto companies who aren’t able to be banked by financial institutions due to a lack of regulation.
Cumberland Global received $27 billion, providing almost $20 billion in funding to Binance.
Tether may encourage users to keep their crypto gains on the exchange, especially since it would be difficult to redeem all customer accounts in fiat.
USDT is a fiat-collateralized stablecoin, pegging the value of 1 USDT to $1. Since it relies on fiat currency, it isn’t a fully destabilized asset in the same way as Bitcoin or Ethereum. Many researchers and analysts raise valid concerns, implying that the stablecoin isn’t actually backed by anything.
USDT isn’t regulated and it has been fined for financial misconduct while evading audits. That, along with ongoing court cases makes USDT riskier than the other stablecoins. Despite all this, high volumes of USDT continue to be traded while it maintains a higher market cap than any other stablecoin.
Breaking Down the Next Possible Tether Controversy
Be careful — USDT is the Stablecoin that could destabilize the entire crypto ecosystem.
USDC is another fiat-collateralized stablecoin, created in September 2018 through a collaboration between Circle and Coinbase.
USDC was introduced as an alternative to USDT, and right now is the second-most traded stablecoin due to its $52 billion market cap.
To provide more choice in stablecoins for investors, Circle and Coinbase formed the Centre consortium. Circle is a startup backed by Goldman Sachs that acts as an official Money Transmitter in the US. Before USDC can be issued, an equal amount of USD must be exchanged with an accredited partner. In contrast to USDT, all USDC tokens are transparently regulated and verifiable. Reports generated by Grant Thornton LLP maintain USDC’s transparency by releasing regular auditing reports.
USDC is the second-largest stablecoin by market cap and like USDT, it is a fiat-collateralized stablecoin. However, unlike USDT, it provides transparency, demonstrating that USDC is pegged to USD. USDC is another centralized stablecoin, as it is government-regulated and undergoes frequent audits.
DAI, one of the most popular USD-backed stablecoins, differentiates itself from the competition because it is decentralized.
It emerged from the MakerDAO decentralized lending system as a borrowable currency. It currently has a market cap of $6 billion.
History of DAI
Rune Christensen, the founder of MakerDAO is also the creator of DAI. MakerDAO is a decentralized lending and governance platform for the Maker token, which lets users who hold its vote on new protocols and changes.
DAO stands for “Decentralized Autonomous Organization” and returns the means of governance and control of a token to its users. That means that Christensen himself can’t just arbitrarily change the rules, they must be voted on by the community as a whole.
DAI emerged as an algorithmic stablecoin alternative, issued as loans. When the loan is returned, the tokens get burnt (or alternatively, the DAI dies). There’s a higher level of trust in DAI since the algorithm is autonomous. It is also a good investment if you believe the market is going to go down, as the price of DAI will remain stable. Since this is built as a smart contract, it isn’t governed or regulated by any person or corporation, making DAI a decentralized stablecoin.
That’s not to say that things can’t go wrong. If there’s a substantial shift in the market for the price of collateralized assets, they may not be able to restabilize DAI. There’s no guarantee that a combination of rough market conditions and irrational trades from retail investors won’t crash it.
DAI is one of the five most popular stablecoins by market cap, but unlike USDC and USDT, it is decentralized. By participating in the MakerDAO community, DAI investors can also have a say in the future of DAI.
The smart contract underlying DAI mints or burns Maker tokens to algorithmically keep the price stable at $1. As it isn’t run by any individual entity, as is the case for fiat-collateralized stablecoins, but this does not mean it will always maintain its value.
Terra (LUNA) is an emerging stablecoin that may give Tether, USDC, and DAI a run for its money.
Like DAI, Terra is not backed by an equal amount of USD collateral. Instead it uses an algorithm to maintain a stable value.
Some companies in South Korea and Southeast Asia are already accepting LUNA stablecoins like TerraUSD (UST). The market cap of UST flew past $10 billion, before collapsing.
Terra emerged out of a need for stable cross-country currency and transactions; it is no surprise that it’s built with e-commerce applications in mind. It boasts lower transaction fees than other payment systems. But to boost their volume and market cap, they resorted to Ponzi-nomics using the Anchor protocol, which offered 20% yield.
If we told you to give us $500 and we promised a 20% fiat return, you would rightfully call it a scam. But when obfuscated by smart contracts and cryptocurrency, it led to a boon in investment. As crypto began to slump, the value of underlying assets like LUNA and Bitcoin dropped and people began to sell.
The collapse of Terra play-by-play
On May 7th, $500 million in various cryptos was withdrawn from the Anchor Protocol, which is supposed to supply the 20 percent, leaving only $300 million in liquidity which is a problem given that there were 14 billions UST deposited within the protocol. Then, people holding UST (mainly nervous fund managers) withdrew $3.8 billion to Anchor, depegging the price to $0.987 and dropping the price of LUNA.
The next domino to fall was Curve, a DeFi liquidity pool: One user took 85 million UST out and placed 108 million into Binance. Terra themselves took 150 million UST out of Curve, but later put 100 million back in. Terra ended up knocking the peg off themselves at this point.
On May 8th, the Luna Foundation Guard lent out $1.5 billion in Bitcoin to help protect the price of UST but the damage was done. Nobody wanted to use Anchor and the pool went down to 9 billion UST, leading to a further collapse in the price of LUNA. By May 9th, the entire Bitcoin reserve was deployed and UST hit $0.65.
As of May 2022, this so-called stablecoin sat at $0.13 and the Luna Foundation issued a halt on the blockchain, blaming its collapse on an attack rather than its own smart contract. This wasn’t unexpected as many different economists (and @VitalikButerin) had predicted this could happen.
Later, CoinDesk reported that Do Kwon, the founder of Terra, had previously started another algorithmic stablecoin (at the same time he was supposed to be working on Terra) which also collapsed spectacularly.
UST is a decentralized stablecoin that’s built on the Terra ecosystem and serves as a perfect example for why algorithmic stablecoins are risky. Any stablecoin that offers such high returns is probably going to collapse, the only question is going to be when. Do Kwon is hoping to restore Terra but it is unlikely there’s any trust left to rebuild it, as the price of LUNA has delved into the range of weird Elon-fanboy memecoins.
Governments are beginning to take notice of all this.
After a few decades, they are ready to wade into the only currency space. Several central banks in other countries have either proposed or issued digital currencies. These are not decentralized as they are issued and controlled by a government or bank.
Many Central Bank Digital Currencies will be collateralized against fiat to maintain a stable value. However, it is unclear whether this strategy will work in the long run.
Unlike stablecoins, you can’t use central bank digital currencies on DeFi platforms. And again, we would run into the same concerns as other fiat currencies. Despite being digital, these currencies will still be trapped in heaps of government bureaucracy.
We’d recommend USDC as the safest option for a stablecoin.
Consider DAI if you want to delve into the riskier world of algorithmic stablecoins and higher earning potential.
Be wary of anything that looks way too good to be true. (You know what they say.)
Stablecoins are a minimally-volatile type of cryptocurrency, that is pegged to the value of real-world assets.
Most commonly, these cryptos track the price of the US dollar.
Tether and Circle govern centralized types of stablecoins, where they back up the cryptocurrency with fiat currency.
Tether actually isn’t backed one-to-one or audited.
Tether has faced great controversy for its lack of transparency and auditing, with some critics even questioning whether USDT is backed by anything at all.
Circle’s USDC remains highly transparent, but it’s still a human-run organization that will only function as well as its executives.
Another approach is using a smart contract or algorithm to peg the price of a stablecoin to the USD, in essence decentralizing the stablecoin. In practice however, a few large crypto banks and exchanges will still own the majority of the market cap. These stablecoins are paired with another cryptocurrency, allowing for continued issuance or burning to automatically stabilize the price.
MakerDAO’s DAI is issued as a loan and burned when it is repaid.
Meanwhile, Terra’s UST uses the supply of LUNA cryptocurrency to help track the USD accurately. Terra has also shown what happens when offering Ponzi-like incentives to stake UST, leading to its inevitable collapse.
So yes, algorithmic stablecoins are risky.
Countries are attempting to digitize their fiat currencies, but it’s unclear whether they will succeed.
Beware of high yields in DeFi to earn interest!
|Market Cap||$75 billion||$52 billion||$6.5 billion||$1.5 billion|
|Decentralized (in theory)?||No||No||Yes||Yes|
Updated May 2022