The value of cryptocurrencies is in flux, often fluctuating in flow with the market. One solution to this volatility has been proposed by some major players like Facebook and JP Morgan: stablecoins. These coins are pegged to fiat currencies but maintain their own cryptocurrency economy – what’s more, they’re usually backed by actual assets like gold or other precious metals. But how secure are these coins?
The “best stablecoins” are cryptocurrencies that have been designed to be safer and more stable than other coins. They are usually pegged to the value of a fiat currency or another cryptocurrency, such as Bitcoin.
The majority of individuals who use a DEX to join crypto do so by exchanging their fiat cash for stablecoins, which can then be swapped for other tokens.
Stablecoins, on the other hand, are the backbone of the whole DeFi business, serving as a means of exchange and also being utilized for liquidity pools and yield farming, in addition to being the most crucial conduits for people to begin investing in crypto.
Classification of Stablecoins (Footprint Analytics)
Stablecoins continue to be dominated by centralized stablecoins, with USDT accounting for half of the market value. DAI, the most popular decentralized stablecoin, is ranked fourth, while UST, an algorithmic stablecoin, is ranked fifth.
Market Cap Share of Stablecoins (November 2021) (Footprint Analytics)
Tether has inevitably drawn the attention of authorities because to its tight ties to the fiat USD. There’s also growing fear that the currency that’s been collateralized is now posing a systemic structural danger.
Centralized, decentralized, and algorithmic, on the other hand, are all distinct. Do they all have the same level of instability? Is the apprehension about stablecoins justified? Could Tether knock the whole DeFi network down?
1. Stablecoins with no central authority
The leading centralized stablecoin is USDT, which has a first-mover advantage. Tether’s issuance methodology is as follows: a user submits a particular amount of USD to Tether’s bank account, and Tether transfers the same amount of USDT to that user after verifying receipt of the money.
The degree of credit recognition of the issuing corporation, the depository bank, and the USD by USDT holders drives the stablecoin’s price swings.
Tether’s concerns with transparency and compliance are ones that centralized institutions can’t solve. However, due to the large number of users and many use cases amassed by USDT, people continue to utilize it.
The market capitalization of USDT has rapidly increased, reaching as much as three times what it was at the start of the year in early November. Despite being more thorough in its disclosure, USDC, in second place, has less than half of USDT’s market valuation.
Market Capitalization of Stablecoin (Since Jan. 2021) (Image courtesy of Footprint Analytics)
To keep their initiatives afloat, centralized stablecoins depend on fiat cash. Centralized stablecoins are more susceptible to regulation than decentralized stablecoins, because fiat coins kept offline cannot be queried or restricted by on-chain protocols.
Despite blockchain’s decentralized nature, a huge number of major initiatives, such as Tether, are centralized. What makes this a problem?
Consider what would happen if the SEC filed charges against Tether, or if Tether was judged to be unable to provide adequate reserves. Losses will not be insured for USDT holders.
2. Stablecoins with Excessive Collateral
LUSD, DAI, MIM
MakerDAO, which began operations in 2018, has pioneered the idea of overcollateralized stablecoins. As a consequence, DAI has surpassed all other stablecoins in terms of market capitalization. Although Liquity, which launched in 2021, enhanced and innovated on MakerDAO, its stablecoin, LUSD, has been restricted in its acceptance because to a lack of use cases.
With its interest-bearing tokens collateral, Abracadabra, which has a concept similar to MakerDAO, has developed swiftly in two months, and the market value of its stablecoin, MIM, has overtaken that of LUSD, which was one step ahead of it.
Market Cap of Stablecoins with Excessive Collateralization (Since Jan. 2021) (Image courtesy of Footprint Analytics)
By submitting collateral worth more than $1, overcollateralized stablecoins manufacture $1 worth of stablecoins. Other tokens that are not stable in their own right, such as ETH, protocol tokens, and LP tokens, may be used as collateral. Because such stablecoins are linked to the collateral and the primary risk is the volatility of the collateral’s value, the liquidation mechanism of such protocols is critical.
Since March 2020, MakerDAO has incorporated centralized assets like as USDT and USDC as collateral, raising questions over whether DAI is sufficiently decentralized. DAI’s dangers are linked to centralized stablecoins.
Liquity, a system that uses ETH as its sole form of collateral to mint LUSD, aims to be decentralized in every way possible, with superior capital usage and liquidation methods.
While Abracadabra’s main mechanism is comparable to MakerDAO in that it allows for collateralized interest-bearing assets, it is more aggressive than MakerDAO in that it is deployed over many chains with greater collateral, enabling its stablecoin, MIM, to expand faster but also implying increased risk.
DAI’s daily trading volume vastly outnumbers that of all other stablecoins, owing to DAI’s ability to be supported on a variety of protocols as an early cultivator.
Because of its incentive structure, LUSD has over 60% of its stablecoins circulating inside its own system, allowing for fewer external use cases. MIM’s trading volume is considerably more than LUSD’s. This is primarily because Abracadabra allows users to enhance leverage via flash loans, as well as improve MIM’s liquidity on Curve by encouraging its token, SPELL.
Volume of Stablecoins with Excessive Collateralization (Since Sep. 2021) (Image courtesy of Footprint Analytics)
MakerDAO manages the supply and demand of DAI via a stability charge and the DSR (Dai Savings Rate), which has an impact on the price of DAI. These revisions, on the other hand, are based on a vote by MakerDAO’s MKR token holders. The majority of MKR is owned by early and substantial investors.
Even with these MKR non-centralized holdings, such changes are analogous to central bank monetary policy—for example, altering reserve ratios, benchmarking interest rates, and so on—except with a lower voting threshold. This has generated concerns about the fairness and prudence of the governance paradigm.
Liquity keeps the price of LUSD stable by employing a “hard anchor” that enables users to mint LUSD at $1 and burn LUSD at $1 at any time, as well as a “soft anchor” that allows users to mint LUSD at $1 and burn LUSD at $1 at any time.
The minting rate is used to regulate the cost of funding MIM, thereby affecting the supply and demand balance. Abracadabra’s stabilization currency, MIM, is similar to DAI in terms of stabilization mechanism, and the minting rate is used to regulate the cost of funding MIM, thereby affecting the supply and demand balance.
We can observe that DAI is the most steady in terms of price variation using Footprint Analytics data. Except for a brief period when the price was somewhat higher when it first went online, the LUSD has been pretty constant. Between $0.97 and $1.01, MIM is likewise reasonably steady.
Price of Stablecoins with Excessive Collateralization (Since Jan. 2021) (Image courtesy of Footprint Analytics)
3. Stablecoins based on algorithms
FRAX, UST, FEI
Algorithmic stablecoins maintain their value by encouraging market participants to bet on tokens based on their own protocols. The upside is that the uncollateralized technique allows for more capital use, but it may quickly shift the price out of anchor if the market does not arbitrage as intended by the protocol.
Terra’s stablecoin UST stands out among algorithmic stablecoins. Terra has a dual token format, with Luna serving as a governance, staking, and verification token, and UST serving as a native stablecoin linked to the US dollar. Luna backs UST, and for every UST generated, one dollar of Luna must be destroyed, and Luna preserves UST’s USD anchoring via an arbitrage mechanism.
Fei Protocol, which broke the DeFi funding record, is also notable. It rose to a market valuation of $2.4 billion in one week after launching, but plummeted to $500 million in three months. Stability is maintained via the Fei anchor adjustment method, which is based on PCV (protocol controlled value) and Ethereum’s redemption process. The Fei Protocol was created to address the inefficiency and difficulty of expanding over-collateralized stablecoins, but community criticism has compelled it to make regular changes to its process since its introduction. It now employs a system similar to DAI’s Peg Stability Module.
Market capitalization of algorithmic stablecoins (Since Jan. 2021) (Image courtesy of Footprint Analytics)
In terms of trading value, UST outperforms other algorithmic stablecoins, however it still behind the overcollateralized stablecoin DAI. In terms of market capitalization, UST is currently equivalent to MIM.
The fact that the Terra system is built on its original stablecoin accounts for the majority of UST’s active volume. Since its conception, Terra’s protocol has included UST transaction scenarios, and UST may be linked to offline payments, which increases demand for UST use.
Volume of algorithmic stablecoins (Since Sep. 2021) (Image courtesy of Footprint Analytics)
UST is effectively backed by the promise of Luna rather than being an overcollateralized stablecoin since its stabilization mechanism is based on the promise to pay out with Luna. Arbitrageurs will safeguard the stability of UST via arbitrage behavior based on faith in Terra as a whole. If the price of Luna falls dramatically, users will lose trust in the market value of Luna, resulting in an anchoring crisis.
The price of UST has been largely constant, with the exception of a de-anchoring in May when the token’s worth dropped. This contrasts positively with Fei, which has been operational for almost a year and has seen two major de-anchors. The first time this happened, in early April, when Fei initially came to life, Fei’s use scenario was insufficient to sustain the needed minting, resulting in a supply-demand mismatch. The de-anchoring in May was primarily caused by a significant decline in token prices, which sparked user skepticism.
Price of algorithmic stablecoins (Since Jan. 2021) (Image courtesy of Footprint Analytics)
The three varieties of stablecoins each have their own set of benefits and drawbacks.
Stablecoins with a central authority:
- Advantage: Largest market capitalization, resulting in relative stability and a diverse set of applications.
- Disadvantage: Because of the centralized security and lack of transparency, the system is vulnerable to massive misuse, posing a systemic danger to the whole system.
Stablecoins with excessive collateralization:
- Advantage: Due to over-collateralization, there is a relative price stability.
- Low capital usage is a disadvantage.
Stablecoins based on algorithms:
- Advantage: Maintain stability by rewarding the market to arbitrage the stablecoin, so resolving the capital allocation issue.
- In times of uncertainty, there is a risk of volatility.
As a means of trade between assets, stablecoins are an important aspect of DeFi. Because they lack the same solid backing as fiat currencies, you should examine their security, stability, and breadth while deciding whether to utilize them.
The preceding information reflects the author’s own thoughts and opinions and is not intended to be taken as investment advice. Feedback is requested if there are evident flaws in understanding or data.
Footprint Analytics is the source of this report.
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Posted in: Stablecoins, Analysis
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The “what is the risk of stablecoin” is a question that many people ask. The answer to this question depends on who you ask and what they’re looking for. Some say that the risk is low while others say it’s high.
Frequently Asked Questions
Is it safe to invest in stablecoins?
A: It is safe to invest in stablecoins. In fact, investing in a cryptocurrency with a USD value will also usually have a stability token that can be used as an investment vehicle unto itself
What are the risks of stablecoins?
A: Stablecoins offer a lot of benefits to traders and investors, as they eliminate some risks tied with traditional cryptocurrencies.
How do stablecoins stay stable?
A: The key to stablecoins is that they are collateralized by a basket of cryptocurrencies. This means theres an equal amount of crypto on the other side, meaning it takes two coins for every dollar you want to withdraw or invest.
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