Stablecoins – An Answer to Cryptocurrency Volatility?

by Zachary Campbell for the Carl Kruse Blog

Cryptocurrency is fast becoming a popular investment vehicle for both seasoned and amateur investors. Stories of overnight wealth conjure images of a digital gold rush, and many investors have generated large returns in far shorter time frames compared to traditional holdings. The ease of transaction for cryptocurrencies (avoiding the need for costly and time-consuming escrows, and other frictions), confidentiality in financial proceedings, and universal standardization liken it to a money-making machine with few drawbacks. This, however, can be an expensive misconception. The reason cryptocurrency can yield tremendous gains is its inherent volatility. This same quality can also lead to tremendous losses, as has become evident during Bitcoin’s market plunges, as well as crashes in other major cryptocurrencies, like Ethereum and EOS. So-called “crypto winters” can instantly evaporate gains. In order for crypto to compete with fiat currencies and other financial instruments, it must find a way to temper this volatility.

Enter stablecoins, a way for crypto investors to shelter profits while remaining within the crypto ecosphere.

Stablecoins are a form of cryptocurrency that seek to minimize volatility by backing each unit with a “stable” asset or assets. These range from traditional fiat currencies to hard assets like gold, or even other cryptocurrencies. In practice, the overwhelming majority of stablecoins peg themselves 1:1 to the dollar, or other dollar-equivalents. Stablecoins allow an investor to maintain proximity to the crypto market whilst alleviating the volatility that comes with doing so. They also eliminate the need for intermediary groups that exchange crypto into fiat currencies, like traditional banks and companies like SWIFT. These tokens are not perfect stores of value, however, and can be subject to the same inflationary and deflationary pressures of the assets they are pegged to.

An Overview of Stablecoins

There are three main categories of stablecoins: fiat-backed, crypto-backed, and fully algorithmic stablecoins. Fiat-backed stablecoins are the most stable since every token offered is (in theory) backed by reserves of a fiat currency. Given the preeminence of fiat currencies, it is not surprising that the stablecoins with the highest market cap are fiat-backed, like Tether, USDC, and TrueUSD (TUSD). Tether in particular has become synonymous with stablecoins, and its market cap alone accounts for more than half of the total market cap for all stablecoins. The major issue with Tether is that there must be a centralized organization that holds the reserves, thus abandoning basic blockchain tenets of trustlessness and decentralization. Tether exemplifies this as well, as for the past two years Tether (via its parent company Bitfinex) has been under investigation by the New York Attorney General’s Office for covering up losses amounting to $850 million. While this case was settled out of court, new federal allegations of money laundering have recently been levied against another stablecoin, BUSD (Binance’s stablecoin), cementing fears in the crypto community that these large fiat-backed stablecoin companies have fallen prey to the very weaknesses that cryptocurrency was meant to circumvent. The advent of digitally-issued fiat currencies by Central Banks, the so called Central Bank Digital Currencies (CBDC’s) and possible regulatory action from governments, raise further questions as to the future of fiat-backed stablecoins.

Symbols for some of the more popular stablecoins.

Crypto-backed stablecoins seek to uphold the tenet of being trustless, but in order to do so they cannot hold traditional fiat currencies, and thus must be collateralized with other crypto. They must be overcollateralized, however, in order to maintain a stable peg in the event that the market value of crypto assets plummet. There are many of these stablecoins on the DeFi sphere, like DAI, sUSD, LUSD, and Origin Dollar. Overcollateralization, however, does not always prove effective. With collateral based entirely on cryptocurrency, any major price drop can outpace the collateralization algorithm, causing the peg to drop. This can lead to what is known as a “death spiral”, where the peg drops below 1:1 and users leave to protect their funds, causing the peg to fall further. Many crypto-collateralized stablecoins have fallen victim to this problem, with even DAI (the oldest and largest crypto-backed stablecoin) having spent considerable periods of time trading under the 1:1 peg. They are not the only form of stablecoins, however, to suffer from this issue.

Algorithmic-backed stablecoins do not use any form of collateral, but are reliant on algorithmic protocols to determine their peg. These protocols will accordingly raise or lower the supply of tokens to account for changes in the peg using governance tokens. Though the raw number of tokens is subject to fluctuation, the percentage of the supply that a user owns remains constant. The most well-known algorithmic stablecoin is AMPL, but the new stablecoin UST has grown exponentially in a short period of time. Unfortunately, these algorithmic stablecoins tend to be even more unstable than crypto-backed stablecoins, and many of them have proved useless at regaining lost pegs. Former algorithmic trailblazer ESD is now trading at 4 cents per unit at the time of writing.

There are other stablecoin variants, still in their infancy, which nonetheless show great potential for the future. One such variant are hybrid stablecoins, which combine different types of collateral backing (fiat, crypto, and/or algorithmic) to create a more stable asset base. These types of stablecoins seek the advantages of diversification, thus avoiding the drawbacks that come from relying too heavily on one asset type. The processes that govern hybrid stablecoins are much more complex, however, sometimes to the point of convolution for many users.

Stablecoins to Watch

Certain hybrid stablecoins have the potential to revolutionize both the stablecoin and cryptocurrency markets. One such token is FRAX, the first stablecoin to be collateralized by a mix of assets and algorithmic processes. This stablecoin, founded by software programmer Sam Kazemian, is decentralized with all reserve asset transactions happening on the blockchain. It is also noncustodial, giving FRAX owners control and protection from centralization. FRAX incorporates the stable peg of a custodial fiat-based stablecoin with the highly trustless, decentralized model of algorithmic stablecoins. The ratio of algorithmic backing to hard collateral backing is dependent on the peg. If the peg drops below $1, collateral backing increases, and if it goes above $1 algorithmic backing increases. While algorithmic-backed stablecoins struggle with extremely high volatility, and fiat-backed stablecoin companies have been awash in uncertainty and fraud allegations, FRAX has been able to maintain a stable peg while remaining completely trustless. During the major cryptocurrency drop in May 2021, the FRAX peg remained quite stable, even as other major cryptocurrencies such as Tether and DAI saw fluctuations as high as 8 cents above or below the 1:1 ratio. At the current moment, FRAX is one of the best options for a stablecoin operating on the original cryptocurrency ethos of decentralization.

Another stablecoin that has been turning heads is Origin Dollar (OUSD), which gained acclaim for being the first stablecoin to earn a yield while in a user’s wallet. The APY from minted OUSD, while constantly fluctuating, is rarely lower than 6% and can be as high as 40-50%. When staking OUSD, it must be locked for periods of one, two, or twelve months, with each period earning a higher APY (7.5, 12, and 25% respectively at the time of writing). While other services offer competitive APYs, users of other stablecoins must decide to either hold the coins or put them into smart contracts. When doing so, however, they must contend with ever-increasing Ethereum gas prices every time the stablecoin is moved from one wallet to another, not to mention the additional removal fees charged by many lending pools. Created by Origin Protocol, an established name in DeFi circles, OUSD is perhaps one of the best stablecoins for earning consistently high yields while maintaining independence.

Conclusions

While cryptocurrency’s potential for reshaping the financial landscape is vast, its high degree of volatility scares many away from its benefits. More than a safe place to park crypto profits, stablecoins have the potential to ground the cryptocurrency sphere, providing safety, stability, and confidence within a new and intimidating financial marketplace. Stablecoins could well form the catalyst that allows cryptocurrencies to compete with traditional financial products.

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