We are already at the third part of our DeFi Educational Series. As we introduced DeFi and its history in Part 1 and the DeFi Stack in Part 2, we will now focus on concrete applications of DeFi; that is, ways in which retail investors and institutions may engage with it. We have decided to dedicate this entire article to stablecoins, as there is so much to say about them.
At the very core of all DeFi sit stablecoins. Economists agree around the fact that sound money serves 3 different roles, as it should be used as:
- A store of value (we may be years without using it, as its value won’t degrade)
- A unit of account (we may express other items’ prices using it)
- A medium of exchange (we may transact with others using it)
While some people claim that Bitcoin does possess these 3 traits, its price volatility is too significant to make it usable as a unit of account (imagine a supermarket changing item prices — in $BTC or satoshis — every time Bitcoin’s price changed). The same goes for altcoins, as their lower market capitalizations make them even more volatile than Bitcoin.
This is where stablecoins come into play: Their goal is to remain pegged 1:1 to other currencies (most often, the reference asset being the $USD). The idea launched with Tether USD ($USDT) in 2014 and has since enjoyed continued growth, as there are now more than 85 stablecoins listed on CoinGecko at the time of writing. Finally, just like any other cryptocurrency, a stablecoin can exist on many different chains.
Stablecoins are used for a wide range of purposes:
- Pricing other cryptocurrencies (through order books on centralized exchanges or liquidity pools on decentralized exchanges)
- Making payments for products/services (without fearing the sent amount to be higher or lower by the time the transaction is received)
There are many ways to classify stablecoins, one of which being “Custodial” VS “Decentralized”:
- Custodial stablecoins are operated by centralized entities (Ex: Tether) which maintain a basket of off-chain assets like money, bonds, and commodities. In such case, the stablecoins (Ex: $USDT) represents an off-chain version of the off-chain assets held by the entity. However, the assets’ being off-chain makes it harder to audit and verify the entity’s claims, which goes against crypto fans’ vision of decentralization.
- Decentralized stablecoins are, as the name suggests, the most decentralized and auditable class of stablecoins. All assets ensuring the peg are maintained on-chain, which makes investigating them more accessible. However, they are generally regarded as being more volatile.
The Stablecoin trilemma
According to many cryptocurrency researchers, the ideal stablecoin would possess 3 characteristics:
- Capital efficient (we don’t need an overwhelming amount of capital to maintain the price stable)
- Stable (price doesn’t fluctuate against the reference asset)
- Decentralized (no single entity is responsible for maintaining the peg, making censorship possible)
Stablecoins aren’t strangers to crypto’s innovation-first mindset, which has led to various peg-keeping mechanisms. However, in nature, only 2 characteristics can be achieved at once, giving rise to 3 categories of stablecoins
- Typically, custodial stablecoins are reserve-based.
- Collateral-based stablecoins like $DAI are backed by on-chain reserves (ex: $ETH deposited into Maker), but aren’t capital efficient as overcollateralization is necessary to overcome big price fluctuations.
- Algorithmic stablecoins are the most decentralized of all 3, but are less stable as they are backed by assets that are themselves volatile.
The European Central Bank introduced a “crypto cube” to classify stablecoins. We won’t go into it but thought it was worth mentioning.
However, even if stablecoins aim to remain stable, they might fail to do so in turbulent times. MIT professor Christian Catalini’s research classifies stablecoins according to how they are backed and how volatile assets are against the reference asset. This gives each stablecoin group a “likelihood of a death spiral”.
Without much surprise, Central Bank Digital Currencies (CBDCs) are considered to be the safest alternative, as they are issued by government bodies and remain tied to off-chain assets (likely, cash reserves). However, they go against the “decentralized economy” ideals of many crypto fanatics.
A good example to illustrate Catalini’s claims is Terra and the $LUNA/$UST disaster of May 2022. $UST was a [decentralized] algorithmic stablecoin mimicking the $USD. For every $1 in $UST minted, $1 worth of $LUNA (the volatile asset) was burned (thus making $LUNA deflationary as long as $UST demand kept growing).
We won’t go into too much detail over what happened but $UST was attacked causing a minor deped to 0.95$. However, widespread FUD on social media caused panic in the Terra community, causing $LUNA to be minted to infinity and $UST dropping to as low as 0.05$, wiping out over $40B in less than a week.
Since this incident, regulators have raised their voices and many other algorithmic stablecoins have struggled to keep their peg.
What to Expect Next
We are already nearing the end of our DeFi educational series, but still have more content to address! Don’t miss our last article (Part 4), which will cover the following:
- Next up: DEXs, Borrowing & Lending, Insurance
- Advanced Concepts: Flash Loans, Interest Rate Swaps, Yield Hacking & More
Have a concept or trend you’d like us to explain? Let us know on Twitter!
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DISCLAIMER: Content in this article does not constitute financial advice. Cryptocurrencies are volatile assets. Always do your own research and invest at your own risk.