Stablecoin Market Analysis
Jan 17, 2024
Note from the author: these thoughts are my own and should not be interpreted as financial or legal advice. No AI was used in the making of this blog.
When we think about stablecoins, we think about the first part of that word: stable. Digital currency can fluctuate pretty dramatically, and for many who want to use cryptocurrencies for payments, money transfers, or lending/borrowing don’t necessarily want to take on the risk of their money being worth drastically less tomorrow than today. Stablecoins provide a vehicle for value stability in a few different ways, all increasingly complex but innovative. They can create anchor assets for countries whose currencies are volatile, provide a pipeline of USD access in places where that is scarce, and are easily accessible by anyone, even those who are unbanked. Because of this, they are the only usable form of cryptocurrency for non-speculators and can provide a foundation for the global financial future. Let’s dive into why.
There are three types of stablecoins, each of which controls its stability in a different ways. First, there are fiat-backed stablecoins, which are the most popular and well known. These tokens’ value is secured by fiat, treasuries, or other low or zero-risk assets. Minters make money from interest on the backing assets, partnerships, or arbitraging exchange rates. For every token they mint, they ensure they have fiat, securities, or something stable backing it. The most popular of these are USDT and USDC, minted by Tether and Circle, respectively. Both are pegged to the US dollar and always maintain that value. Both have massive volumes and have cemented themselves as major players in the crypto space.
One major issue, however, is ensuring these tokens are still trusted. Both undergo regular audits and reveal the assets backing their tokens, but they still often draw scrutiny due to the volatile nature of crypto. Tether has also run into some legitimacy issues, having never undergone an audit by one of the Big 4 audit firms. However, the underlying concept of maintaining accounts with assets backing stablecoins does seem to be the most reputable and secure way of ensuring stablecoin value. These two companies dominate the stablecoin market, as illustrated below:
Second, there are collateralized debt positions. Users can leverage a smart contract to deposit cryptocurrency assets into a vault, which they can use to back a stablecoin that they generate. The most important thing with CDPs are that the collateral ratio is maintained. Users should not be able to over-borrow, and rules are built in to maintain the collateral ratio if those asset prices dip significantly. While DAI (formerly SAI) is the primary token that embodies CDP as its stability mechanism, it is not used as much outside of DeFi due to its risky nature.
The final type of stablecoin is an algorithmic stablecoin. This is an undercollateralized stablecoin that is not backed by any underlying assets; instead, an algorithm is built to ensure that the value remains stable. A popular model to accomplish this is the seigniorage style. This involves creating and destroying stablecoins or other tokens to manage supply and demand. Profit generated from issuing new coins (when the demand is high) is called seigniorage. This profit can be used in various ways, such as funding development or redistributing to token holders. Many algorithmic stablecoins also use a dual-token system, where one token serves as the stablecoin and another token absorbs the price volatility and participates in the governance or stabilization process. This is a very complicated way to maintain value stability, but it can work… if everyone has confidence in the stablecoin. We saw this issue break the Terra stablecoin in 2022, taking a massive $60B market cap between LUNA and UST down to zero. While this is a great way for stablecoins to function, it’s still very new and it is a very complicated structure that hasn’t been perfected yet.
This background is really important because, while none of these methods are perfect, it shows that there are many different ways to approach stablecoins, and many different ways that they can be used and scaled. While Tether and Circle employ the safest backing of their tokens, CDPs can enable individuals to borrow against their existing assets in new ways, expanding their ability to invest and gain leverage. Algorithmic stablecoins, while not perfect, are still a good way to build a set of assets that can grow without capping growth with collateral requirements. In a sense, this is what the US government does already.
These experiments (USDT, USDC, DAI, Terra, etc) have taught us a lot about what the possibilities of providing stable value are in the crypto world. Stable is relative, of course; fiat currencies also fluctuate. However, when pegged to a dominant global currency, we can expect to have significantly more stability than most other assets. This makes it much more usable for the everyday person, who just needs money to live their day to day life.
About 58% of adults in the United States are invested in the stock market or any other assets. Globally, that percentage is much smaller. The vast majority of people do not use (and do not WANT to use) their money for speculative purposes. They need money to function exactly as it is supposed to; as a stable way to transact goods and services. Because of this, they don’t want the value to change; they want it to be worth the same yesterday as it is today, and the same tomorrow. Stablecoins have the potential to become a global currency for the world, being more reliable than many local currencies (just look at Venezuela, Zimbabwe, Turkey, Argentina… the list goes on).
This is an opportunity for the world to unite around a single universal currency, stable in value and usable globally. This is what the vast majority of people want; very few people actually want complex DeFi tools or speculative assets. Most people just want to live their lives and make or spend a currency they can trust. Stablecoins can play that role.