The Future of Stablecoins
Stablecoins are the cornerstone of the entire DeFi and crypto ecosystem. As opposed to the relatively volatile general cryptocurrency market, stablecoins aims to help investors preserve their funds. This two-part article seeks to comprehend the risks involved with the different types of stablecoins in the market as well as our thoughts on the future of stablecoins.
As of June 29, 2022, the total supply of stablecoins in the entire market is approximately $143.38 B. After de-peg of UST, USDT, USDC and BUSD are currently in an overwhelming leading position in the entire stablecoin market, occupying more than 90% of the market share: the total supply of USDT is $66.17 B, and the market share is 46%; the total supply of USDC is $46.97B, and the market share is 32%; the total supply of BUSD is $17.55B, and the market share is 12%.
Classification of stablecoins
The main obligation of stablecoins is to maintain the peg with the US dollar. In the process of achieving this goal, similar to blockchain scaling and cross-chain bridge design, stablecoins have gradually emerged with their own trilemma: it is difficult for a stablecoin protocol to have decentralization (how dependent is the stablecoin on centralized systems), stability and capital efficiency. There will have to be some trade-offs.
Based on the different trade-offs made by different protocols, the mechanisms of stablecoin protocols are varied. We can classify stablecoins according to three categories which are fiat-based fully-collateralized stablecoin, crypto-based fully-collateralized stablecoins, and crypto-based under-collateralized stablecoins.
Fiat-based fully-collateralized stablecoin
Fiat-based fully-collateralized mechanism is the most intuitive and stable design mechanism. The protocol issues the same amount of stablecoins when U.S. dollars received, and users can get back the same amount of U.S. dollars when they redeem their stablecoins, guaranteeing the peg of the stablecoin to the U.S. dollar. Currently, this type of stablecoin occupies more than 90% share of the stablecoin market and mainstream stablecoins such as USDT, USDC, BUSD, TUSD all use this mechanism.
USDT is a U.S. dollar pegged stablecoin issued by Tether. It is anchored by sufficient cash, corporate bonds and other low-risk liquid assets. Tether will regularly publish audit reports to ensure the transparency of backing assets. The latest audit report shows that as of December 31, 2021, the $78,480,852,949 debt generated by issuance of USDT was guaranteed by at least $78,675,642,677, protecting the peg stability.
USDC is a USD stablecoin issued by Circle and it is also backed by a 1:1 U.S. dollar denominated asset to guarantee the peg. Circle issues an audit report every month to improve the transparency. Currently, the latest audit report shows that as of the end of March, 2022, there were 51,388,555,903 USDC in circulation. The value of USD assets is more than the circulating value of USDC, and the asset types are cash and short-dated US government obligations but specific details are not announced.
BUSD is a USD-pegged stablecoin approved by the New York State Department of Financial Services (NYDFS) and issued by Binance in partnership with Paxos. Paxos will publish Monthly Attestation Reports to announce collateral information. The latest report shows that as of April 29, 2022, the total issuance amount of BUSD is 17,651,702,084.31, the value of The Reserve Funds is greater than $17,651,702,084.31 and the asset type is U.S. dollars and U.S. dollar equivalents.
TUSD is a regulated stablecoin fully backed by the U.S. Dollar. According to the recent report on May 17, 2022, the total issuance amount of TUSD on Ethereum, Tron, Avalanche and Binance Chain is 1,223,680,869.80, and the value of U.S. dollar denominated assets in the account is $1,225,745,111.56, and the asset types are cash and cash equivalents.
Crypto-based fully-collateralized stablecoin
Crypto-based fully-collateralized mechanism is similar to the fiat-based fully-collateralized mechanism. Both mechanisms rely on the value of the collateral to maintain the peg stability of the stablecoin. Due to the volatility of crypto assets, over-collateralization is usually required to ensure the value of the collateral still exceeds the value of the issued stablecoin when the price of underlying assets fluctuates.
Currently, DAI is the most widely accepted fully-collateralized stablecoin based on crypto assets. Users can deposit cryptocurrencies in Maker Vault to generate DAI. When users return DAI and pay a certain stability fee, they can get back their collateralized cryptocurrencies. Currently, cryptocurrencies allowed to be used as collateral in Maker Vault include ETH, WBTC, USDC, etc., and the liquidation ratio required by different collaterals are also different based on different risks. The Maker protocol will compare the user’s collateral-to-debt ratio with the set liquidation ratio.
When the liquidation conditions are met, a collateral auction will be held. The DAI obtained from the auction will be used to repay the debt and liquidation penalty. When the amount of DAI is insufficient, the loss will be covered by the Maker Buffer. If the amount of DAI in the Maker Buffer is also insufficient, the Maker protocol will conduct a debt auction and the system will mint new MKR tokens to obtain DAI in order to repay the debt. As of June 29, 2022, the total circulation of DAI is $6.3 B, the amount of collateralized encrypted assets is $8.61 B, and the average collateral ratio is 127.08%.
Crypto-based under-collateralized stablecoin
Crypto-based under-collateralized stablecoin or algorithmic stablecoins hopes to issue stablecoins that rely on algorithms instead of collaterals, which can greatly improve capital efficiency and the scalability of issuance. The biggest challenge for algorithmic stablecoins is how to maintain peg stability, especially after the recent collapse of Terra.
The largest crypto-based under-collateralized stablecoin now is Frax. Frax adopts the mechanism of fully-collateralization in the initial stage. Users collateralize $1 assets (mainly stablecoins such as USDC) to mint 1 FRAX and redeem 1 FRAX to get back the collateral. However, in the subsequent fractional phase, the collateral rate can be less than 100%. For example, when the collateral rate is 98%, users need to collateralize $0.98 assets and burn $0.02 FXS to mint a FRAX or redeem a FRAX to get back $0.98 assets and $0.02 minted FXS. When the FRAX price deviates from $1, users can arbitrage by minting or redeeming FRAX, stabilizing the price of FRAX.This mechanism allows FXS to absorb the volatility of FRAX, but in order to maintain the peg stability of FRAX, it should be ensured that FRAX has enough use cases on the demand side and that the net realizable value of FXS is greater than the value backed by the algorithm.
Comparison of different mechanisms
Since fiat-based fully-collateralized stablecoins directly wrap their reserve fiat currency as an on-chain asset, its stability is very robust. This can also be proven according to the recent depeg and repeg of USDT. However, the fully-collateralization results in low capital efficiency and factors such as bank custody and third-party audits make this kind of stablecoin inseparable from the help of centralized institutions. In contrast, crypto-based fully-collateralized stablecoins are more decentralized, but this mechanism requires more liquidity of crypto assets to pursue peg stability, resulting in poorer capital efficiency.
The ultimate aim for stablecoins to maintain its peg which is why capital efficiency and decentralization are secondary considerations at this stage. This explains why USDT and USDC are the most common stablecoins used by users and most algorithmic stablecoins suffer the same fate. However, with the continuous development of the crypto market, the demand for stablecoins will undoubtedly increase in the future.
Due to the limitations of asset custody supervision, the total amount of valuable crypto assets, and other factors, the issuance amount of crypto-based and fiat-based fully-collateralized stablecoins could be limited by their low capital efficiency. At that time, crypto-based under-collateralized stablecoins that perform better in terms of capital efficiency and decentralization may have a good opportunity to become major players.
Having discussed the risks of the major remaining stablecoins, we have outlined four outcomes below that might impact the near-medium term of the crypto market.
1.) USDC and USDT will continue to lead the market
Despite being the market leader, USDT showed signs of weakness as it briefly lost its dollar parity in the wake of the Terra collapse. The distrust towards USDT could be stemming from historical lack of transparency as well as concerns around its financial stability. Data has shown that large wallets have been shifting their holdings towards USDC instead. While both USDT and USDC are fiat-backed, USDC has demonstrated better peg stability historically and also greater audit transparency. As the crypto market continues to consolidate, USDC will continue to gain more foothold as the dominant choice for users.
2.) New algorithmic stablecoins will continue to chase the dream
Algorithmic stablecoins will forever be the benchmark for a crypto world with true decentralization as it is not only capital efficient but also not reliant on fiat currencies. Even faced with prior failures such as Basis Cash, Fei and now UST, the idea of creating a stablecoin without any ties to central banks and traditional finance might be too hard to ignore for good. With the demise of UST, DAI is the most decentralized stablecoin on the market. However, DAI’s overcollateralized nature makes it difficult for it to scale on the same level as USDC and USDT. Furthermore, the use of centralized collateral such as USDC for DAI is not entirely ideal. The current focus is now shifted to partially collateralized algorithmic stablecoins such as FRAX and USDD. Until the day the market can achieve a fully decentralized and scalable stablecoin, new iterations of algorithmic stablecoins will continue to emerge.
3.) Increased regulation
Stablecoins and regulation have been intertwined topics since the collapse of Terra. US Treasury Secretary Janet Yellen have publicly pushed for regulation as “digital assets may present risks to the financial system”. The U.S. Securities and Exchange Commission has started to crack down on the industry, issuing warnings and also increasing the size of its crypto enforcement wing. The European Central Bank has also maintained that it may pose risk to wider financial stability. Early proposals of legislation suggested that there might be licenses issued to “qualified stablecoins that are issued by either a federally backed bank or a non-bank that agrees to maintain at least 100% reserve assets consisting of U.S. dollars, U.S. debt or any other assets that are deemed appropriate cash collateral”
4.) Emergence of CBDCs
Even prior to Terra’s collapse, global governmental bodies have already been mulling over the idea of Central Bank Digital Currency (CBDC). For instance, China’s substantial progress towards a digital renminbi have been well documented as trials are currently ongoing in various cities. In the US, both Federal Reserve Chairman Jerome Powell and Treasury Secretary Janet Yellen have pushed for research into a digital dollar. The current focus for CBDC is on domestic and cross-border payments and it is likely that discourse will extend towards other digital financial services that is presently largely occupied by private stablecoins. While it is currently too early to argue if CBDCs will replace stablecoins or if they can co-exist, there is absolute certainty in the increasing involvement of centralized authorities in the future.