Stablecoins are one of the key elements of the cryptocurrency industry. Assets like USDT, USDC and DAI serve as an effective means of exchange and value preservation, and are also actively used in DeFi protocols.
The segment is growing rapidly – since the beginning of the year, the total capitalization of stablecoins has increased more than five times (from $ 29.3 billion to $ 147.47 billion as of December 8).
The segment is completely dominated by centralized coins like USDT, USDC and BUSD.
However, there are also decentralized alternatives like Maker’s DAI and Abracadabra’s MIM. Algorithmic stablecoins aimed at capital efficiency, as well as fast and inexpensive transactions, are also actively developing. One of these projects is Terra, whose native token recently broke into the top 10 in terms of capitalization.
Cryplogger has figured out the features of the technologies of various stablecoins, comparing their strengths and weaknesses.
Key
- Algorithmic stablecoins are a relatively new phenomenon in the cryptocurrency market. This is an alternative to time-tested centralized assets like USDT and USDC.
- The segment of new “stablecoins” is actively developing, but not all projects manage to prove their viability.
- Among the algorithmic stablecoins, there is an obvious leader – UST from the Terra project. Its capitalization has already reached $ 8.6 billion.
Disadvantages of popular stablecoins
The significant demand for stablecoins observed for several years has become a significant factor in the development of the crypto industry and mass adoption.
Viable “stablecoins” should have mechanisms for leveling price volatility in a short period of time, which is especially important during periods of strong fluctuations in demand for such assets.
Such mechanisms are designed to motivate market participants to perform low-risk arbitrage operations that bring the rate of stablecoins closer to the target mark. This happens due to the expansion or reduction of the supply of coins when they are traded above or below a given rate, respectively.
In addition to fast and effective price stabilization, other properties are also important:
- Security – Market participants should be confident that stablecoins are backed by a sufficient number of fiat and other assets.
- Capital efficiency is essential for scaling the ecosystem and mass adoption.
- Decentralization, which implies transparency and the absence of a single point of failure for the system.
There is a so-called “trilemma of stablecoins” – it is extremely difficult to create a system that has all these properties.
The most widespread fiat-backed stablecoins are Tether (USDT) and USD Coin (USDC). The value of the market offer of coins included in the top 10 by capitalization exceeded $ 100 billion.
USDT and USDC have a centralized mechanism for issuing and redeeming tokens to maintain price stability. The latter are similar to IOUs – their repayment gives the right to the corresponding amount in dollars.
If the price of a token drops below $1, arbitrageurs can spend less than $1 to purchase each of the USDCs. Market participants can then convert USDC tokens into dollars in a 1:1 ratio on circle’s website.
If the price of the coin is above $ 1, arbitrageurs can issue stablecoins (in the ratio of 1 USDC = $ 1), and then sell them on the open market with a profit.
Different stablecoins can have significant differences in such mechanisms. The common thing is usually that to repay tokens, market participants need to go through the KYCprocedure. In the case of Tether, investors need to pay 150 USDT for account verification.
Centralized stablecoins are characterized by counterparty risk – users are forced to trust the issuer, relying on the fact that the tokens issued by it are provided with reserves from a reliable custodian.
“Stablecoins” may not be 100% backed by fiat currency – some issuers include bonds and other highly liquid securities in reserves. The opacity of centralized stablecoins contributes to abuse.
In August, Tether published a report by the audit firm Moore Cayman, which confirmed 100% collateral for USDT assets. However, the share of cash and bank deposits in reserves was 10%, and 49% of them consisted of commercial papers.
Bloomberg found in the provision of the stablecoin short-term loans to large Chinese companies and loans to crypto-landing platforms.
The research firm Hindenburg Research questioned the reliability of information about tether reserves and even offered a reward of $ 1 million for disclosing previously unknown information about them.
A significant part of the supply of “stablecoins” can be concentrated in large players. Protos analysts concluded that the equivalent of $60.3 billion, or nearly 55% of the market value, USDT between 2014 and October 2021 was issued at the request of market makers Cumberland Global and Sam Bankman-Freedom-linked Alameda Research.
Among other things, a centralized issuer can block the movement of coins at certain addresses if it considers on-chain activity suspicious. The “black list” of relevant addresses is constantly expanding.
Stablecoins are increasingly in the crosshairs of regulators, including those from the US, THE UK and the EU. As a result, issuers have to put up with constantly tightening requirements.
For example, in November, the main operator of the USDC stablecoin, the American company Circle, supported the intention of the administration of President Joe Biden to regulate issuers of stablecoins as banking institutions.
DAI: over-reliance at the expense of capital efficiency
An alternative to relatively easy-to-understand centralized systems is MakerDAO’s DAI, backed by various crypto assets.
MakerDAO is an Ethereum-based smart contract platform that allows you to issue the DAI stablecoin secured by various highly liquid and relatively low-volatile coins.
The Abracadabra project has a slightly different approach. It also uses the model of super-secured debt positions. The difference is that Abracadabra users can earn income from collateral assets including yvYFI, yvUSDT, yvUSDC and xSUSHI.
Instead of the native DAI stablecoin for MakerDAO, users of the new protocol issue a MIM token (Magic Internet Money). As the value of collateral increases over time, the risk of liquidating positions decreases.
Abracadabra has implemented the possibility of pharming and staking the native asset SPELL. In addition to Ethereum, the platform runs on BSC, Fantom, Avalanche and Arbitrum.
Algorithmic Stablecoins: Timeless Capital Efficiency
In response to the above risks and inefficiencies of centralized and super-secured stablecoins, algorithmic “stablecoins” began to appear.
Projects that are something like automated central banks use algorithms to flexibly manage the supply of assets and the underlying economy.
In the context of provisioning, such stablecoins can be divided into two categories:
- unsecured (ESD, AMPL and BAC);
- partially or fully secured by a native token (FRAX, sUSD and UST).
It is in the type of collateral that the main difference between algorithmic stablecoins and super-secured coins like DAI lies. The latter is supported by the assets of third-party projects such as ETH, WBTC and USDC.
Unlike DAI, Terra’s UST stablecoin is backed by a native LUNA token. Such a model opens up the possibility of algorithmic influence on the price of UST.
The Ampleforth Project (AMPL) is one of the pioneers of the algorithmic stablecoin segment. Its key feature is the “rebalancing model” (Rebase model), which controls the price of a token by changing its monetary mass.
“The AMPL protocol automatically aligns supply with demand. When the price is high, wallet balances increase. When the price is low, the balances of wallets decrease, “the project’s websitesays.
Thus, the supply of tokens is tightly controlled. Depending on the market situation, AMPL can be both an inflationary and a deflationary asset.
Rebalancing takes place every 24 hours. Since the interval is fixed, users can use the periods between rebalancings to buy or sell AMPL profitably.
Many algorithmic stablecoin projects use the seigniorage model. It involves a system of rewards that affects the dynamics of the market. For example, if the price is above the target mark, new tokens are issued in the form of accruals to liquidity providers. As a result, the supply of coins increases.
If the price is below the target mark, the emission of tokens stops, not allowing the offer to expand. Users can buy coupons that burn the underlying coins and thus withdraw them from circulation. These coupons can be redeemed in the future for tokens, when the price of the latter returns to the target mark.
An example of the embodiment of such a model is the Empty Set Dollar (ESD) project. It uses a seigniorage model using a single token.
Users provide liquidity in the DAO through the native token of the ESDprotocol. The latter acts both as a stablecoin and as a management token.
At the beginning of each 8-hour epoch, the system determines the time-weighted average price (TWAP) of the token. If the TWAP is above $1, the protocol enters an inflationary phase and issues coins as rewards for stakers and liquidity providers (LPs). Conversely, if the price falls below $1, the protocol goes into a reduction phase and users stop receiving rewards.
During the reduction phase, users can buy coupons by burning ESD. These coupons can then be repaid with a profit for native tokens during the inflationary phase.
However, the coupon is only valid for 30 days. This means that buyers risk getting nothing if the reduction phase drags on for more than a month.
The serious disadvantages of this model are evidenced by the graph below. It shows a steady drop in the price of ESD since the beginning of the year.
Another project, Basis Cash, uses a seigniorage model with two tokens (the BAC stablecoin and the BASnative asset).
As with ESD, Basis Cash relies on a TWAP mechanism. The latter issues or terminates the issue of BAC when its price is higher or lower than $ 1, respectively. The project also has its own coupons – Basis Bonds. They can be used to repay the BAC when the protocol re-enters the inflationary phase.
The duration of the epoch for Basis Cash is 24 hours. However, unlike ESD coupons, Basis Bonds do not have an expiration date.
The trajectory of the price movement of the algostablecoin from Basis Cash resembles the dynamics of the market value of ESD from Empty Set Dollar.
The Frax Finance project uses a slightly modified seigniorage model. In it, the stablecoin (FRAX) is supported by two types of support:
- a centralized “stablecoin” USDC;
- the native token of the project is Frax Share (FXS).
Unlike Basis Cash or ESD, Frax Finance uses a fractional reserve system. Collateral parameters are controlled by the Proportional Integral Derivative (PID) mechanism and depend on the ratio of FXS liquidity volume and the total supply of the FRAX stablecoin.
When FRAX trades above $1, the PID lowers the collateral ratio, and when the price is below $1, it rises, respectively.
Arbitrageurs can buy or issue FRAX, helping to peg it to the target mark of $1.
The developers launched the veFXS system, according to which part of the income of the Algorithmic Market Operations Controller is accrued to FXS stakers.
The chart below shows that the FRAX rate is relatively stable (especially in comparison with the algostablecoins considered).
Fei Protocol is a relatively new project that began work in early 2021. It involves a partial collateral system within the framework of the concept of Protocol Controlled Value (PCV). The latter involves the purchase of ETH by the Fei Protocol project through freshly released FEI stablecoins. The Fei Protocol then uses ETH to maintain liquidity in the pools.
When the FEI price is above $1, the protocol provides users with the ability to issue new stablecoins at a discount, using ETH as a means of payment. Then traders with the help of arbitrage operations “knock down” the price to the target mark.
When the PRICE of the FEI is below $1, the protocol imposes a kind of tax on FEI sellers (the corresponding proceeds are then withdrawn from circulation through incineration), rewarding buyers with additional tokens “in the load”.
In emergency situations, when the price of a stablecoin is long below the target mark of $ 1, the Fei Protocol can extract PCV liquidity from Uniswap and acquire FEI on the open market. The purchased tokens are burned. After the recovery of the exchange rate, the Fei Protocol can return liquidity to Uniswap.
There’s also a native TRIBE token. The latter allows its holders to control the protocol by changing, for example, the PCV parameter.
Amid raising $1.3 billion in April, the Fei Protocol ran into trouble due to a massive conversion by FEI users to TRIBE and the subsequent purchase of ETH.
Success of TerraUSD
TerraUSD (UST) from the Terra project can rightly be called the most successful algorithmic stablecoin, both in terms of capitalizationand in the context of exchange rate stability. This is largely due to a relatively simple mechanism for maintaining a link to the target mark, high demand and the development of the ecosystem.
In early December, the native token LUNA reached a maximum above $ 78, and the amount of blocked funds (TVL) in DeFi applications exceeded $ 14 billion.
The Terra project was founded in 2018 by TicketMonster President and Founder Daniel Shin. The company is one of the leading in the e-commerce market of South Korea.
In July, Terraform Labs, the company behind Terra, raised $150 million for an ecosystem-focused investment fund.
The project supports stablecoins pegged to the U.S. dollar, south Korean won, Mongolian tugrik and SDR. The LUNA token is used to manage and ensure the stability of the prices of assets issued on the network. Users themselves issue “stablecoins”, while burning native tokens.
When the price of a stablecoin is above the target mark, its supply is too low relative to demand. In such a situation, it is profitable for users to issue relatively expensive tokens. The monetary mass of the latter begins to grow, and the ratio of supply and demand is approaching the equilibrium value.
If the price of the stablecoin is below the target mark, it means that the supply of the token exceeds the volume of demand. It becomes profitable for users to burn stablecoins for the release of LUNA. The decrease in the supply of Terra creates a deficit, the price of the token rises until it reaches parity with the corresponding fiat currency.
For example,UST is trading at $1.01. In this case, users can use the exchange function in the Terra Station app to convert LUNA worth $1 to 1 UST.
During this operation, the corresponding amount of native token is burned. By selling UST, market participants will receive one cent of profit from every dollar. Arbitrage operations will be profitable to perform until parity with the US currency is established.
“The more Terra is used, the higher the cost of LUNA,” the project website says.
The native token can also be used for protocol management, staking, liquidity mining, and payment of transaction fees. The maximum supply volume of LUNA is 1 billion tokens.
Terra uses the Proof-of-Stake consensus algorithm using Tendermint technology.
Funds for rewarding Terra validators come from two sources:
- Gas fees for transaction processing;
- Stabilization commissions,which are of two types: Tobin tax for each exchange transaction between Terra stablecoins; spread commission when converting Terra to LUNA and vice versa (the minimum value is 0.5%).
The price of Terra’s largest algorithmic stablecoin, UST, has been relatively stable since launch.
The market capitalization of the stablecoin since the beginning of the year has grown 48 times – from $ 180 million to $ 8.6 billion.
The project team is actively developing a DeFi ecosystem based on Terra, attracting investments from major players like Galaxy Digital and Coinbase.
The leading protocols on Terra are Anchor and Lido. The first allows the use ofbonded assetsto secure the borrowing of stablecoins issued on the Terra network. The income rate on escrowed UST is 19.59% as of 12/12/2021. The second offers the ability to unlock the SOL, ETH and LUNO coins involved in staking for further use.
The Terra ecosystem surpassed Avalanche, Solana, Tron and Polygon on TVL, second only to Ethereum and Binance Smart Chain.
The growth of the project was facilitated by the integration of the Inter-Blockchain Communication Protocol (IBC) from Cosmos at the end of October 2021. The solution allows you to transfer messages between different blockchains. As a result, the UST stablecoin and the LUNA token appeared on the Cosmos network.
1/ Proposal 128 to initiate IBC on Terra has passed, meaning that IBC is now live on the Terra mainnet 🙂https://t.co/4aIjkdDBBH
— Terra (UST) 🌍 Powered by LUNA 🌕 (@terra_money) October 21, 2021
Stay tuned for once the relayer channels are set up, and users can begin transferring tokens between Terra and the Cosmos ecosystem from Station.
Another important factor was the activation of the Columbus-5 update, which includes a model of deflationary pressure on LUNA. Previously, the management tokens used to issue stablecoins were transferred to the community pool. After the hard fork, the algorithm began to burn them.
In November, the Terra community also decided to retire 89 million LUNA (~$4.5 billion at the time) in its pool.
Findings
Since 2020, all new algorithmic stablecoins have appeared on the market. However, despite the loud statements of the developers and sonorous slogans on the sites, many projects did not meet the expectations of market participants.
This is noticeable in the steadily falling rates of “stablecoins”, which is due to low demand and imperfection of mechanisms for managing the supply of tokens. Only a few managed to keep a peg to the underlying asset, including Synthetix (sUSD stablecoin), Frax Finance (FRAX) and Terra (UST). The capitalization of the latter is several times superior to competitors.
Many stablecoin systems are characterized by a lack of liquidity. Some platforms try to solve this problem with the help of liquidity mining programs. However, such campaigns attract mainly “algofarmers” who are not particularly loyal to the projects. The latter often seek only to get a quick income and then get rid of tokens before the start of potential massive sales. Such situations contribute to volatility and do not always create sufficient initiatives for price stabilization.
Algorithmic stablecoins can also attract interest from regulators, who are increasingly looking more closely at their centralized counterparts. Thus, the US Senate in September stated the need to fully provide stablecoins with cash and their equivalents, as well as the advisability of regular audits. This can jeopardize the segment, since algostablecoins are either not provided or are backed by native and other highly volatile tokens.
