Know Your Stablecoins: Are They Really Stable?

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Attempting to gain an overview of all the different stablecoins on the market may feel overwhelming, and with good reason. In March 2022, US$65 billion worth of stablecoins were traded in a single day, representing 92 different coins, and dispersed on more than 340 crypto exchanges worldwide. To understand where the space is now, and where it is heading, it is important to comprehend where it began.

Stablecoins explained

The original purpose of stablecoins was to create an on and off-ramp by providing a frictionless flow between fiat and crypto. Stablecoins additionally aimed to mitigate the volatility of the crypto market, thus creating a stable haven where investors could park their funds while tactically considering their next move. Stablecoins were also seen as a key factor in facilitating crypto adoption. 

In basic terms, stablecoins are digital assets on the blockchain that track the value of an external, non-crypto asset, such as fiat or real-life commodities. There are a few exceptions to this, such as crypto-collateralized, and algorithmic stablecoins, which will be discussed later in the article. 

Most stablecoins can be categorized as blockchain deployed digital IOUs. In theory, the stablecoin issuer should hold the actual collateral on a one-to-one basis – in either a financial institution or a traditional bank. In the unlikely event that absolutely everyone decides to cash out simultaneously, this would ensure that funds are liquid and available.

The unpleasant reality is that most stablecoins can be minted out of thin air. This creates a high degree of risk and liquidity issues, and has also given rise to a variety of eccentric stablecoins such as the Coffin Dollar (COUSD), traded on the Decentralized crypto exchange SpookySwap. Furthermore, with limited regulatory oversight, many stablecoins are not audited and regulated. 

Therefore, it is important to understand the critical attributes of any stablecoin before deploying funds into them, especially for longer periods of time. Such criteria include the background of the issuer, country of registration, level of auditing, statistics of the backing, and how they are pegged. 

Stablecoins issued by centralized entities

Bitcoin, and by extension blockchain technology, was originally created in response to the financial crisis of 2007-2008. Following the crisis, the sentiment towards governments, regulators, banks, and investment firms was low.  

There was simply a complete lack of transparency, and mistrust was rampant. Therefore, the crypto space emerged as a form of anti-government, anti-regulation, censorship-resistant, peer-to-peer monetary system, requiring no intermediaries and enabling individuals to remain anonymous. As a result, many within the crypto space firmly opposed any level of centralization within blockchains, stablecoins, and other financial products.

However, this has left stablecoins in a precarious position. The vast majority of stablecoins are issued by private companies, therefore reverting to the need for intermediaries and the need to trust. This essentially means that although blockchains are, in many instances, created to be decentralized, it requires interaction with a centralized entity (stablecoin issuer) to use many of the services provided on the blockchain. In addition, when converting crypto or stablecoins back into traditional fiat, a centralized entity is needed once more. This often requires KYC (Know Your Customer) verification, which again means handing over sensitive personal information.

Although stablecoins issued by centralized companies are connected to the legacy system and open to censorship, they are by far the most traded and provide the best user experience. Many feel that the external auditing requirements and single entity accountability secure the investment implications and the future of coins. One could perhaps also argue that human beings tend to lean towards some form of regulated and secured assets, and when things go wrong, “everyone needs a neck to choke.”

ARYZE Blog — Top 5 Stablecoins Market Capitalization 2022
Market capitalization breakdown of top 5 stablecoins (information source: CoinMarketCap)

Fiat-backed stablecoins

The most popular fiat-backed stablecoins are Tether (USDT), USD Coin (USDC), Binance USD (BUSD), and Terra USD (UST). Some of these coins are thoroughly backed and audited, and a full list of all 92 stablecoins can be found on Coingecko, including links to their websites and whitepapers.  

Tether (USDT) is issued by Tether Limited, a Hong Kong Company. It is the oldest stablecoin and has been trading since 2014. It has one of the highest transaction volumes, with approximately US$80 billion per day as of April 2022. This stablecoin giant has raised questions about the possible systemic risk it may have to the cryptocurrency ecosystem, should a liquidity grab or “run on the banks” occur.

Tether has made the headlines several times over the years due to the nature of the USDT backing. On numerous occasions, the company has fought back by publicizing 3rd party reserve attestations, which are not to be confused with audits. These reports show that the company holds a significant portion of its worth in repo notes, treasury bills, and commercial papers, all with maturity dates ranging from 0 to 365 days. Their website states that USDT is 100% backed by “a matching fiat currency “. In addition, Tether has also been under scrutiny for its controversial direct ties to the Bitfinex crypto exchange, with has led to speculation of market manipulation.

This, together with the market’s rapid growth, has led to governments globally initiating work on regulatory frameworks for stablecoins. One such initiative is the recent report publicized by The Presidents Working Group on Stablecoins, aiming to address the risks to users and ways to guard against “stablecoin runs”. The report covers creation, redemption, transfer, storage, use, DeFi, risk, regulatory gaps, and other. 

The second-largest Stablecoin USD Coin (USDC) was launched in 2018 by Circle. It is generally viewed as a safer option by those in the crypto space and used by retail and businesses of all sizes. Due to its popularity, it is catching up with Tether’s market share fast, with some predicting that it will soon overtake it. The USDC is regulated in The United States of America, currently has a circulating supply of 51 billion coins, and is fully US$ backed, meaning it is always redeemable. This is achieved through a supply and demand mechanism, where the company issues and burns tokens whenever there is a deposit or a redemption event. 

Having acknowledged the major friction points within this space, ARYZE is launching its full-reserve and fully solvent eEUR stablecoin. The stablecoin will maintain a one-to-one basis price between fiat and Digital Cash (for example, USD and eUSD or EUR and eEUR). This will ensure that the Digital Cash is not only based on a full-reserve backing model, but that it is always redeemable to traditional fiat. 

ARYZE Digital Cash - Full-reserve and Fully Solvent Stablecoins

Commodity-backed stablecoins

One of the main benefits of a commodity-backed currency is its ability to regulate the process of inflation. Stablecoins backed by fiat are essentially at the mercy of the same forces that govern the value of the currency it is pegged to.

Commodities such as gold and silver have been used as an accepted medium of exchange for centuries, and have been the peg for traditional currencies for decades.

During the era in which the British Pound functioned as the world reserve currency from 1815 until 1920, the phrase “sound as a pound” was commonly used due to the integrity of the silver content in the pound coins.

Similarly, the 1944 Bretton Woods Agreement saw the creation of The Gold Standard, a system that pegged the US$ to the value of gold and pegged other currencies to the value of the US$. One of the main aims of the Gold Standard was to create a framework that minimized the international currency exchange rate volatility. However, in the early 1970s, President Richard M. Nixon announced that the U.S. would no longer exchange gold for U.S. currency.

Fast forward 50 years, and with worldwide inflation on a rampage, commodity-backed stablecoins are gaining traction fast. Examples include PAX Gold (PAXG) and Tether Gold (XAUT), which are backed by certified physical gold reserves. Gold is, however, not the only commodity used in stablecoins.

The Agrotoken stablecoin is grain-backed and tracks the market price of various grains (soy, corn, wheat). In December 2021, they raised US$5 million during their seed funding round, and in March 2022, they partnered with Santander Argentina to provide loans backed by Agrotoken. It is projected that many more commodity classes will be added as collateral options for stablecoins in the future.

Decentralized stablecoins

There are two main types of decentralized non-custodial stablecoins, which are crypto-collateralized and algorithmic. Due to their complex nature, they are more frequently used by crypto-savvy individuals as they tend to have some level of game theory involved. It is also commonly accepted that the risks involved with trading these coins are much higher. However, they are an option for those opposed to any type of regulation looking for censorship-resistant coins.

The crypto-collateralized stablecoins are backed by other cryptocurrencies, and smart contracts on the Ethereum blockchain automatically stabilize their value. DAI is an example of such a stablecoin governed by the Decentralised Autonomous Organisation MakerDAO.

Algorithmic stablecoins are more complex and have no underlying assets or collateral backing them. In basic terms, an algorithm creates rules for supply and demand contractions and then creates the stable state of the coin. This means that if the value of the coin increases, the algorithm mints more coins – and when the price decreases, the algorithm burns coins. Examples of such coins include Ampleforth (AMPL), Empty Set Dollar (ESD), and Dynamic Set Dollar (DSD).

Conclusion

One could argue that just as the internet evolved from its originally decentralized nature into a semi-centralized space, so too will the projects, coins, and financial products running on decentralized blockchains. Some level of consumer protection and regulation is likely required for mass adoption to occur. And until then, know what you hold.

The views and thoughts expressed herein are those of the author taking part in the ARYZE Ambassador Program. They do not necessarily reflect the views of ARYZE or its employees.

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