Bitcoin Forum

When asked what stablecoins are, both crypto newbies and veterans would give a straightforward answer — easy, the stablecoin is a token with stable prices, that’s it. However, there is a very interesting story behind the creation of stablecoins.

The cryptocurrency was created to give rise to a “decentralized” and “free-flowing” currency. How did it turn out? Though a global consensus was put into place, cryptocurrencies suffer from severe volatility as they lack intrinsic value, endorsement, regulatory intervention, and circulation adjustment. Nearly every holder of cryptocurrency sees it as a store of value rather than a means of payment. Additionally, there is much room for speculation in the crypto market. Stable token prices elude most cryptocurrencies, including the first cryptocurrency Bitcoin, the smart contract backed Ethereum, and the new payment method Ripple.

This brings a major paradox: Despite their purpose of becoming global currencies, cryptocurrencies may never achieve extensive circulation because as it gains more recognition and usage, the token price will inevitably rise and fluctuate, or in the opposite scenario, approach zero. In short, cryptocurrencies can never maintain stable prices. Instead, stablecoins anchored to fiat currencies are needed to achieve price stability. It seems a bit absurd, doesn’t it?

Such is the current dilemma facing the crypto community. However, this paradox has also reflected the huge prospects of stablecoin, which is why it was created. That said, how many stablecoins are there? What is their stability mechanism? Are they all safe?

The crypto market abounds with stablecoins, such as USDT, DAI, and lesser-known tokens like PAX, TUSD, HUSD, GUSD, etc. To sum up, stablecoins fall into three categories: fiat-backed stablecoins, crypto-collateralized stablecoins, and non-collateralized algorithmic stablecoins.

1) Fiat-backed stablecoins (e.g. USDT)

Fiat-backed stablecoins refer to stablecoins anchored to fiat currencies at a 1:1 ratio, with real fiat currency to back them up and stabilize the prices. Are these stablecoins secure?

In the case of USDT, if Tether plans to issue 1 USDT, ideally, it must make a bank deposit of $1. As investors buy USDT, Tether can deposit their payment and issue more USDT, and so on and so forth. In such a virtuous circle, the market cap of USDT grows together with the number of users. Meanwhile, Tether charges certain fees for USDT transactions, and the payment for USDT deposited into banks also generates interest. This model of stablecoins is secure as along as Tether brings convenience to users and the market while acting by the rules.

Yet, as a private company, Tether lacks third-party oversight and sound mechanisms for transparency. For users, there is no definite way to confirm whether their payments are really deposited to cope with on-demand redemption. The transparency of Tether has been repeatedly questioned. In February, it was alleged that Tether used $900 million worth of USDT to make up for the losses of its affiliated company Bitfinex.

In light of such risks, the market has been in search of more secure, decentralized, and transparent stablecoins, which brought about the second type of stablecoins — crypto-collateralized stablecoins.

2) Crypto-collateralized stablecoins (e.g. DAI)

To avoid the misappropriation of funds, these stablecoins collateralize tokens through smart contracts. For instance, to issue stablecoins, DAI collateralizes crypto assets through smart contracts running on Ethereum and allows users to create collateralized debt positions (CDP). Since it was launched in 2017, DAI has been anchored to the US dollar at a 1:1 ratio. How did DAI achieve this?

For the average investor planning to rely on DAI as a stablecoin, they can simply make a purchase on exchanges. However, thanks to CDP, there are more advanced uses of DAI.

For example, what would you do if you want more liquid assets without selling your ETH holdings? The answer is to deposit ETH using DAI’s smart contracts. Considering the high volatility of crypto assets, DAI has set a risk parameter: the asset to loan ratio must be higher than 1.5:1. In other words, if a user plans to generate 1,000 DAI, then he must deposit at least $1,500 worth of ETH. Once the DAI tokens are generated, the user will be able to use them for investments, and if he wishes to redeem the DAI into ETH, the 1,000 DAI should be repaid together with certain interests.

The above process resembles real estate mortgages. The difference is that the DAI repayments are burned to keep the supply-demand balance of DAI. The key question here is how DAI keeps token prices stable. Here is how:

I. DAI is fully collateralized. When the ETH price drops, if the borrower fails to make more deposits or repay DAI in time, the smart contract will sell the ETH automatically when its value plunges below the liquidation ratio of 150%.

II. DAI manages supply and demand through interest rates. When the demand rises, the DAI price will also increase, which means that DAI can lower the interest rate to motivate more users to generate DAI by depositing collateral.

On the other hand, when faced with declining demand, DAI can discourage users from generating DAI by raising the interest rate. Additionally, for stablecoins like DAI whose value is 1:1 pegged to the dollar, arbitrageurs will flatten the price curve in times of fluctuations. Hence, the DAI approach is a secure mechanism that keeps the price stable, decentralizes, and avoids the misappropriation of funds by centralized institutions. If the crypto-collateralized stablecoin DAI holds all these merits, why does it have a much lower market cap than the centralized fiat-backed stablecoin USDT?

The answer is that despite all these merits, the cost of issuing DAI and arbitrage is too high due to the 150% deposit rate.

3) Non-collateralized algorithmic stablecoins

These stablecoins have far lower market shares and popularity. The only non-collateralized algorithmic stablecoin worth mentioning is AMPL, the first-generation algorithmic stablecoin. At the time of writing, the market cap of AMPL stands at $112 million, ranking 269th among all tokens. How does AMPL work? The answer is simple — AMPL regulates its holding through Rebase. In other words, when the AMPL price exceeds $1, it increases the holding; and when the price is less than $1, it reduces the holding. In this way, AMPL can adjust its supply and demand and keep the price stable.

However, when we look at the long-term price changes of AMPL:
https://miro.medium.com/max/2100/1*LviuVzptJbnVWdlyePkKIg.png


It is clearly too volatile to be categorized as a stablecoin that meets the expected stability. In addition to AMPL, other algorithmic stablecoins include ESD, BASIS, FRAX, etc. To address the issue of the 1:1 exchange ratio with the U.S. dollar, these stablecoins developed more tools, including additional issuance, deflation, bonds, and dividends. However, none of them have made it. Why is that?

Because though maintaining the token price through adjustments of supply seems reasonable, in reality, algorithmic stablecoins are founded on “consensus” just like other cryptocurrencies. When there is more consensus (more users), the token price will go up. It is easy to cope with an increase in the token price: issue more tokens to lower the price. However, raising the token price after a decline is hard.

A decline undermines the market confidence for holding the token. Without the support of physical assets or value, the token price may drop to zero even if the supply is reduced. Therefore, confronted with market sentiments and human emotions, the seemingly logical algorithmic stablecoins have a tough time controlling the token price, let alone keeping it stable.

Though plenty of stablecoins have been launched due to concerns for fiat-backed stablecoins, all of them are flawed to some extent. In comparison, fiat-backed stablecoins remain the most reliable, convenient, and common out there. This might be the reason why USDT, a fiat-backed stablecoin, gained increasing momentum — When all stablecoins are more or less flawed, users tend to choose the most prominent one as it is more credible.