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Demystifying Stablecoins

Demystifying Stablecoins

Table of Contents

Introduction

When talking about cryptocurrency, the first association is usually crazy volatility, mad bull runs and devastating price drops. But there is a whole class of crypto coins that don’t follow this trend. Moreover, this coin class is designed to be as stable as possible. We are talking about stablecoins.

A stablecoin is a cryptocurrency that is designed to minimize volatility by pegging to a more stable asset. Fiat currency digital asset is the most popular use case for stablecoins. Fiat is the government-issued currency we are all using on a day-to-day basis. It typically tracks popular national currencies such as the US Dollar ($) and the British Pound (£), but it can track other assets as well like precious metals or even other cryptocurrencies.

The benefits of this include being able to take advantage of blockchain technology and censorship resistant peer-to-peer value transfer while not being exposed to high volatility often seen in cryptos such as bitcoin, ethereum and others. Stablecoins are a relatively new kind of technology and each of them comes with different implementations, liquidity, risks, and acceptance.

1st Gen - Custodial Stablecoins

The “oldest” type of the stablecoin is the so-called custodial Stablecoin or Fiat-Collateralized Stablecoins. These try to tackle price fluctuations by tying the value of it to other more stable assets, usually fiat currencies.

Usually, the entity behind a stablecoin will set up a “reserve” where it securely stores the asset or basket of assets backing the stablecoin. For example, the company will deposit 100 dollars in an old-fashioned bank to back up 100 units of a stablecoin. This is one-way digital stablecoins are pegged to real-world assets. The money in the reserve serves as collateral for the stablecoin – meaning whenever a stablecoin holder wishes to cash out their tokens, an equal amount of whichever asset backs it is taken from the reserve. The problem with this approach is that the users of said stablecoins have to trust the entity or company holding the reserve.

Fiat Pegged Stablecoins

Tether (USDT)

Tether is the oldest and largest stablecoin and having the first-mover advantage it is still the most popular and largest by market cap. Tether is a blockchain-based cryptocurrency whose crypto coins in circulation are purportedly backed by an equivalent amount of traditional fiat currencies and other monetary instruments, which are held in a designated bank account.
Tether tokens, the native tokens of the Tether network, trade under the USDT symbol.

The project is run by the Tether Operations Limited and was specifically designed to build the necessary bridge between fiat currencies and cryptocurrencies and offer stability, transparency, and minimal transaction charges to users. It is pegged against the U.S. dollar and maintains a 1-to-1 ratio with the U.S. dollar in terms of value. However, there is no guarantee provided by Tether Ltd. for any right of redemption or exchange of Tethers for real money.

Tether
The Tether Controversy

In November 2017, Tether was allegedly hacked with 31 million dollar worth of Tether coins stolen. In January 2018, it hit another hurdle as the necessary audit to ensure that the real-world reserve is maintained never took place. Instead, it announced it was parting ways with the audit firm, after which it was issued a subpoena by regulators. Worries about whether the company, accused of a lack of transparency, has enough in reserves to back the coin have been pervasive and continue to this day.

The company published conflicting statements at different times during the last few years, so it is very difficult to say for sure whether the accusations are justified or just gossip. If you want to learn more about this topic, we recommended checking out this podcast by Grant Williams.

Is Tether a fraud?

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USD Coin (USDC)

In 2018, following the Tether controversy the crypto community was excited when the USDC project was started by the Circle Consortium. The project was launched by the members from the cryptocurrency exchange Coinbase and Bitcoin mining company Bitmain.

Circle claims that each USDC is backed by a dollar held in reserve, or by other “approved investments”, though these are not detailed. The wording on the Circle website changed from the previous “backed by US dollars” to “backed by fully reserved assets” by June 2021.The project is still a lot more open and has a more robust auditory system employing Grant Thornton LLC., (one of the largest accounting firms in the world.) to verify the proof or their reserves.

One of the possible drawbacks of USDC is that the network is not censorship resistant as shown in 2020 when Circle confirmed freezing 100k in USDC at law enforcement request, you can learn more about it here

USD coin

Crypto Pegged Stablecoins

Crypto pegged stablecoins became popular with the rise of DeFi projects. Considering that most of the DeFi projects run on Ethereum network, the need for Bitcoin like tokens that are native on Ethereum network became apparent. And so Wrapped Bitcoin (WBTC) became the first ERC20 token backed 1:1 with Bitcoin.

I understand that it’s weird to consider a token that follows Bitcoin’s volatility as a “stable” coin, but that’s what it is. One WBTC will always be one BTC making it stable in regards to Bitcoin itself.

Wrapped Bitcoin (wBTC)

When Bitcoin is wrapped, the cryptocurrency is held in a reserve by the BitGo Trust. In an aim to be fully transparent (something that other stablecoins have struggled with) the amount of WBTC in circulation has been made public. With proof that Bitcoin, the underlying asset, is being securely held in custody.

WBTC can be wrapped (and unwrapped) in wallets such as those provided by CoinList. Until we get a real “bridge” between all the different blockchains this seems like a perfect way to use DeFi platforms while holding Bitcoin.

Metals Pegged Stablecoins

Tether Gold (XAUt)

Tether Gold is another product by the Tether corporation. is a digital asset offered by TG Commodities Limited. One full XAUt token represents one troy fine ounce of gold on a London Good Delivery bar.

The XAUt token can be transferred to any on-chain address from the purchasers’ Tether wallet where it is issued after purchase. A specific gold bar will be associated with each on-chain address where Tether Gold is held.

Paxos Gold (PAXG)

Paxos is a trust company and custodian, regulated by the New York State Department of Financial Services. PAXG is also approved and regulated by the DFS and fully-backed by allocated gold held in the most secure, leading vaults in the world. A nationally ranking auditor will attest to the matching supply of PAXG tokens and underlying gold every month.

PAXG is an ERC-20 token running on the Ethereum blockchain. It is very similar to Tether Gold, even though considering the Tether controversy PAXG is probably more trustworthy.

2nd Gen - Decentralized Stablecoins

Instead of being pegged to fiat (dollar, euro) or exchange-traded commodities (gold, silver) crypto-collateralized stablecoins or decentralized stablecoins are backed by a combination of cryptocurrencies.

In order to account for the price-volatility of the collateral backing the stablecoin, stablecoins use the over-collateralized method. For example, we can deposit 100€ of ETH in a smart contract and receive 50€ worth of stablecoins. This means that the coin is 200% collateralized or so called over-collateralized. Hence if the price of ETH falls by 25% there is still 75€ worth of ETH backing your stablecoins and the price will remain stable.

Maker DAO (DAI)

Maker DAO/DAI is a decentralized system using smart contract technology and Ethereum’s value to achieve stability of DAI token which aims to target the value of one US dollar . Users do not purchase DAI, but instead create it in exchange for Ethereum (ETH) as a CDP (“collateralized debt position”) locking up their ETH within the Maker smart contract system.

The Maker Protocol is one of the largest dapps on the Ethereum blockchain and was the first decentralized finance (DeFi) application to see significant adoption. The protocol is managed by people around the world who hold its governance token, MKR. According to the whitepaper; “through a system of scientific governance involving executive voting and governance polling, MKR holders govern the Protocol and the financial risks of Dai to ensure its stability, transparency, and efficiency”. One MKR token locked in a voting contract equals one vote.

The Dai stablecoin is a decentralized, collateral-backed cryptocurrency soft-pegged to the US Dollar. Dai is held in cryptocurrency wallets or within platforms, and is supported on Ethereum and other popular blockchains.

Synthetix (SNX)

Synthetix

Synthetix is more than just a stablecoin. It’s a software that allows users to trade and mint new crypto assets (Synths) that mimic real-world currencies (like the U.S. dollar), crypto assets (like Bitcoin), traditional investment assets like equities (TSLA and AAPL) and even commodities (like Oil and Gold).

Synthetix is a derivatives liquidity protocol that is based on the Ethereum (ETH) network and that allows users to trade and exchange a wide range of assets. The system is overcollateralized by 750% over the value of the underlying asset in a similar manner to Maker DAO. If a user wants to mint Synths, then it is necessary to use SNX tokens as collateral.
Users that stake SNX tokens will be rewarded with part of the fees paid by the users that trade using this platform. The larger the network and the users in it, the higher the value of the SNX cryptocurrency.

3rd Gen - Algorithmic Stablecoins

As mentioned before both 1st Gen and 2nd Gen stablecoins use some kind of collateral to back the value of the coin. Algorithmic stablecoins (or “non-collateralized stablecoins”) work differently. Instead, these coins stabilize through the mechanisms of buying and selling the referenced asset or derivatives of such.

Different projects use different algorithmic mechanisms to achieve this. So in the simplest terms an algorithmic stablecoin system begins life by generating a number of digital tokens, or stablecoins, out of thin air. If the stablecoin trades above $1, then the system automatically creates new stablecoins until the price falls back to $1.Alternatively if the stablecoin falls below $1, things are a bit trickier. To restore the peg, an algorithmic stablecoin system must reduce the supply of stablecoins. This is a bit trickier and different networks will have different solutions to the problem.

Terra USD (UST)

TerraUSD is one such project that uses profit incentive to keep the peg stable. If the price is above 1$ UST works similar to central banks printing banknotes to maintain value (of course, in a completely decentralized way).

TerraUSD is backed by the buyer of Terra’s native coin, LUNA, and works like this: first arbitrager buys 1 UST for the value of $0.9, then by burning 1 UST, $1 worth of LUNA token is minted and finally $1 of LUNA is then sold for $0.05 profit. As you can see, the UST peg is held by the current LUNA buy orders. Theoretically, if there were no buy orders for LUNA, then nothing is stopping UST from losing its peg.

So, what’s keeping the LUNA buy orders flowing? Luckily, Terraform Labs thought of that while creating the algorithm. The answer is incentive. LUNA stakers are rewarded with a fraction of the revenue that is made on any transactions over the Terra blockchain. The fraction that stakers are paid is proportionate to the amount of LUNA an investor has staked. Therefore, there are very high incentives to keep buying and staking LUNA. In summary you could say that UST is an algorithmic stablecoin that is backed by transactions on the Terra blockchain.

RenBridge (renBTC)

The Ren protocol (previously Republic Protocol) is designed to provide interoperability by allowing people to transfer cryptocurrency across different blockchains. It lets anyone lock cryptocurrencies such as Bitcoin (BTC), Bitcoin Cash (BCH), and Zcash (ZEC) into the Ren software and mint the ERC-20 equivalent tokens RenBTC, RenBCH, and RenZEC in a 1:1 ratio on Ethereum.

The Ren protocol relies on the Ren Virtual Machine (RenVM), which is powered by a decentralized network of machines called Darknodes. These machines contribute their computing power and storage space to the virtual machine in exchange for fees, which enables the movement of cryptocurrencies across blockchains.

RenVM is a sort of trustless custodian – every RenBTC token you mint is backed by an equivalent BTC stored in the RenVM. In order to facilitate this, achieve decentralization and protect privacy, the RenVM makes use of some pretty advanced algorithms.
Darknode operators receive the fees generated from facilitating exchanges, which are paid in the token being converted rather than in REN coins.

If you want to dive deeper in Ren protocol here is a detailed guide.

Haven (XHV)

Haven Protocol is a very interesting project combining the utility of stablecoins with the privacy of the Monero network. It was originally started as a fork of Monero, one of the most highly regarded privacy-focused coins in the space.

Haven is an untraceable cryptocurrency with a mix of standard market pricing and real world asset-pegged value storage. It achieves this via a ‘mint and burn’ process within a single blockchain. In the simplest case, users can burn Haven (XHV) for the equivalent USD value worth of Haven Dollars (xUSD). Or, to restore to a volatile state, the user can equally burn xUSD for $1 USD worth of XHV. Most major fiat currencies including GBP, EUR and CNY, as well as Silver, Gold and Bitcoin can all be minted in the Haven Vault.

Haven uses a system called “mint and burn” to maintain its value relationship against its asset pegs. In practice, using the synthetic U.S. Dollar (xUSD) as an example, this works as follows: User decides he wants to put 200 of his Haven (XHV) into Haven Vault. When users put XHV into Haven Vault, they are burning XHV coins and minting the current value of those XHV as new xUSD. Haven Vault determines the current market value of that Haven tokens (in xUSD) based on a weighted average of volume across supported exchanges. This is done using a pricing oracle (decentralized Chainlink network) to retrieve pricing data for the full Haven ecosystem and create pricing records. If the current value of Haven is $1 USD, offshore storage will burn the user’s 200 XHV by constructing a special transaction where the 200 XHV that was sent is then burned into xUSD and the total supply of XHV decreases. If the market price of XHV then moves to $2 USD and user decides to access his offshore storage, he will be returned 100 XHV (100 * $2 = $200 USD as per original value). If the opposite occurs and the price of Haven halves to $0.50, then 400 XHV will be minted and sent to User (400 * $0.50 = $200 USD as per original value).

Clearly, the use of mint and burn therefore alters circulating supply of the underlying assets in a dynamic manner. If you are intrigued by this you can find more information in the Haven’s whitepaper.

Do stablecoins have any disadvantages?

As outlined in some of the sections above, with stablecoins you are trusting that the provider of the stablecoin will not default on the reserves and will not print more tokens than they have backing for. In many cases you cannot redeem your stablecoins directly for dollars( see tether ) but instead have to convert to a cryptocurrency like Bitcoin before converting to Fiat if you need to – this can open up volatility risk.

Furthermore, algorithmic stable coins are open to the risk of a smart contract hack or badly written code that can cause the value to crash or deviate in edge cases – see the case of
MakerDAOs DAI loss of the peg during the May 2020 black Thursday crash.

Lack of volatility is also a potential disadvantage for some people. For traders and investors that seek out the highly volatile crypto market, the stability that is built into these tokens may not be attractive.

Conclusion

We hope this article helped demystify the world of stablecoins. With the increase in DeFI and regulators taking a greater interest, it’s clear that stablecoins are an important component of the crypto space.

They provide users with a stable place to store value and often a cheaper means of transferring value in times of market volatility. This can also be attractive to businesses that are using them for trade instead of speculative or investment purposes.

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Ozzak

Ozzak

Ozzak discovered blockchain technology in early 2017 and decided that this is exactly what he wants to do with his life. In 2018 he was accepted in the Computer Science course at University College Cork. He's now in his 3rd year working for Boinnex as a part of his internship. As you may imagine he's deeply passionate about everything blockchain. Ozzak's other interests include calisthenics, blues harp and Austrian economics. He also has an impressive collection of tarantula spiders.

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