Stablecoins: Digital Dollars Demystified

At the time of writing, there are thousands of cryptocurrencies listed at Brave New Coin. The tokens are listed by market capitalization (coin price multiplied by circulating supply), and the first two are, as expected, Bitcoin and Ethereum. But numbers 3 and 4, as well as many others in the top 100 all have something in common: they’re stablecoins.

What are Stablecoins?

Stablecoins are basically digital dollars. In simplest terms these are tokens that are valued 1:1 to a fiat currency; usually the US dollar. The idea that the coins stay close to their intended value, or peg, offers a few distinct features not found in cryptocurrencies like Bitcoin. Allow me to explain.

Stablecoins offer… well… stability.

You may have noticed that at current inflation rates there is not much incentive to save money in most savings accounts, because the money will lose buying power at a higher percentage per year than the bank will pay you for access to it.

This creates an incentive to buy other assets, including stocks, bonds, gold and other rare metals, commodities, real estate etc. This has also led many to buy Bitcoin (which is programmatically disinflationary) or Ethereum (which uses a burn mechanism called EIP-1559 to disinflate or even deflate supply as network demand increases) with the view that these can function as hard currencies.

Interestingly though, if a currency is deflationary, there is actually a disincentive to spend it, knowing that by doing so, the thing you buy may never offer equivalent value to what you spent. With that said, that’s not even the biggest concern at the moment, as institutional and retail speculation against cryptocurrencies has left them in an extended period of price discovery, making them relatively volatile. For as long as this is the case, they unfortunately do not make very good currencies.

But why?

Stability, my dear Watson

Just like deflation may disincentivize the use of a currency due to the opportunity cost of spending versus saving, volatility introduces further uncertainty into every transaction. Either the payment I gave you will be worth more than what I received, or the payment you received will be worth less when you go to spend it on something else.

These are not hypothetical scenarios either. Some businesses do accept Bitcoin, and some people do spend it. In the first Crypto Misadventures, we talked about Laszlo Hanyecz whose purchase of two pizzas for 10,000 Bitcoins in 2010 would now be worth around $300,000,000. Laszlo doesn’t regret his decision, but some might. As such, for most people, Bitcoin is viewed as a long-term investment; digital gold.

And the same people who might choose to invest in Bitcoin as a store of value might prefer to spend something less volatile, or even — dare I say — stable.

Stablecoins allow two parties to transact without the worry of sudden shifts in value. They are the most practical form of currency for everyday transactions, cross-border remittances, and for pivoting to and from more volatile assets as a part of regular trading and investing cycles.

And importantly, since stablecoins do not fluctuate wildly in price, those living in countries with capital gains taxes on cryptocurrencies can avoid triggering taxable events with every purchase.

Now that we’ve covered the reason for their existence, let’s dive deep on what is undoubtedly the most important question we can ask…

Where do stablecoins get their value?

As mentioned at the beginning of this article, there are many popular stablecoins in circulation, each claiming to be pegged to a given reference currency, but what is a peg, and how do these so-called stablecoins maintain that peg? Anyone can say “this coin is worth 1 USD” but unless there’s consensus between every buyer, seller, sender, and receiver that the coin is worth 1 USD, the whole thing falls apart. And this has happened on a few occasions, so we definitely want to do our research before converting our greenbacks to digital dollars.

So let’s take a look at exactly what underlies the most popular stablecoins. We’ll do so by breaking them into groups based on the mechanisms they use for stability.

Fiat-collateralized Stablecoins

Examples: USDC, BUSD, GUSD, TUSD, USDT

The most common way to create a trusted stablecoin is to collateralize each coin 1:1 with actual fiat, held by a trust, ideally in some sort of audited reserve at one or more banks. But that’s not always the way so-called fiat-backed stablecoins work.

You may have heard of Tether, aka USDT. Tether is basically the OG stablecoin, originally launched on the Bitcoin blockchain via the Omni protocol. Now ported to basically every major blockchain, Tether enjoys the highest level of acceptance in the DeFi space. However, not everyone trusts Tether.

In 2019, the New York Attorney General filed a lawsuit against Tether accusing the company of misappropriating funds. The lawsuit was settled out of court for $18.5M but questions have repeatedly come up about Tether’s use of debt to collateralize its issuance, as well as the inconsistent self-reporting of offshore reserves.

For this reason, many people prefer to bypass Tether in favour of some of these other options:

USD Coin, aka USDC is the second most popular stablecoin by market capitalization. Like Tether, it is fiat-collateralized; unlike Tether it is backed only by USD cash and cash-equivalents, is held in custody in the United States in a fully audited and monitored account, and is redeemable 1:1 for US dollars via Circle’s website, Coinbase, and many other exchanges.

Binance USD aka BUSD is the third largest stablecoin in terms of market cap. It is a 1:1 USD-backed stablecoin approved by the New York State Department of Finance Services (NYDFS), issued in partnership with Paxos. For those heavily invested in the Binance ecosystem, this is probably going to be the preferred option, even though most other stablecoins have been ported to Binance Chain as well. One of the key features of BUSD is that Binance does not charge a fee to convert from BUSD to USDT, USDC, TUSD, or USDP (Paxos’ other near-identical stablecoin).

The Gemini dollar, aka GUSD is yet another fiat-backed stablecoin to come out of a crypto exchange. Gemini being perhaps the most regulatory compliant and trusted cryptocurrency exchange in North America, their stablecoin is exactly as compliant as you’d expect. Like Binance, Gemini’s coin is approved by the NYDFS, but unlike BUSD and USDC, GUSD reserves include FDIC insurance of up to $250,000 per user. This is a nice perk, but it hasn’t been enough to get GUSD into the top 100 coins by market cap.

Fiat-backed stable coins are popular, especially amongst users in the United States (and lawmakers), and something like USDC is going to be preferable, especially for institutions settling large dollar sums, but this type of coin does suffer from one particular flaw…

Stablecoin Centralized Risk

Above, I mentioned that Gemini’s USD reserves are insured. Probably the money in your bank account is insured too. In fact, it’s insured from the bank itself.

FDIC insurance exists because banks can go out of business. But when they go out of business, what happens to the funds? The answer before the 1930s was that all your money was gone. And gone it was for many during the great depression. The solution came from Franklin D. Roosevelt with his inauguration of the Federal Deposit Insurance Corporation. The FDIC, like the CDIC in Canada, has banks pay a form of insurance on deposits they hold, such that a reasonable amount is protected for every depositor. Here’s an interesting anecdote from a 1998 FDIC report: A Brief History of Deposit Insurance in the United States.

Federal deposit insurance became effective on January 1, 1934, providing depositors with $2,500 in coverage, and by any measure it was an immediate success in restoring public confidence and stability to the banking system. Only nine banks failed in 1934, compared to more than 9,000 in the preceding four years.

9000! So, the mere existence of deposit insurance helped to provide a tremendous amount of stability to the financial system, to the benefit of many Americans. And yet ironically, trust in financial institutions today is getting lower and lower. This is due largely in part to the disenfranchisement of many communities, high administrative fees, and scandal after scandal from greedy bankers.

Clearly, insurance is not a solution to all the problems of the current financial system. This has led many to want to opt out of this system altogether. That is one reason cryptocurrencies exist: to provide financial sovereignty and freedom from banks.

Since cryptocurrencies on public blockchains are censorship-resistant and immutable, governments and banks can’t control the flow of dollars. This is a laudable goal for those that favour the rights of the individual, and correspondingly, it is the reason for the development of cryptocurrencies’ evil twin: Central Bank Digital Currencies (CBDCs) like China’s Digital Yuan.

CBDCs are inherently problematic, and, if hosted on government-controlled blockchains, or worse, non-public databases, would constitute the most problematic overreach imaginable: revokable money, social credit scores, and the ability to exclude people from participation in society entirely. It’s right out of a Black Mirror episode.

The worry then with fiat-collateralized stablecoins is that the US government may decide they don’t want their CBDCs to have to compete with cryptocurrency stablecoins, and since the stablecoin reserves are typically custodied on US soil, they’re easy targets.

To extrapolate this further, let’s imagine non-governmental stablecoins issued in countries like Russia, China, or Saudi Arabia. In this example, it’s easy for anyone to see that these coins would be at very real risk of government interference. And risk is the enemy of stability. So what are the alternatives?

Overcollateralized (Crypto-backed) Stablecoins

Examples: DAI, LUSD, agEUR

What if anyone in the world could mint their own stablecoin? This was the question that MakerDAO was seeking to answer with the creation of the Dai Stablecoin.

Maker allows users to deposit Ether into a vault to create an overcollateralized loan against which DAI is minted and borrowed. This over-collateralization allows Maker to ensure that DAI can hold its peg even through wild swings. In March of 2020, as a global pandemic was declared, extraordinary market volatility caused a deleveraging spiral that allowed DAI to briefly reach $1.11 causing loan liquidations for a number of users. MakerDAO responded quickly with changes to how the protocol handles liquidations and with the new Multi-Collateral Dai (MCD) system which allows for collateral supply of other cryptocurrencies, including other stablecoins.

Because DAI is minted by a smart-contract, the risk of interference by outside parties is very low and even changes to the protocol, like which cryptocurrencies can be accepted as collateral, are governed in a decentralized way. MakerDAO is, as its name suggests, a decentralized autonomous organization (DAO) and holders of the MKR token must vote on any proposed changes.

Let’s look at the strengths and weaknesses of DAI, since it is by far the most popular overcollateralized stablecoin (most of these qualities can be extrapolated to tokens using the same design, like LUSD, or the popular Euro stablecoin, agEUR).

Benefits of Dai

• Dai can be minted by anyone, anywhere, without opening accounts or doing KYC. We take it for granted in North America, but in many parts of the world anonymous access to cryptocurrency could be the only option to avoid persecution by oppressive governments, cartels, or extremist groups.

• Your collateral, not theirs. Unlike fiat-backed stablecoins, you don’t rely on a centralized holder of the currency. In the case of Gemini for example, you buy GUSD, then they deposit an equivalent amount in a bank account, and that bank holds it until such time that you sell GUSD back to Gemini. That level of abstraction (or “middlemen”) is what peer-to-peer cryptocurrencies and Decentralized Finance (DeFi) aim to eliminate. Dai is created through a smart contract. Your loan is not held by individuals at MakerDAO, it is held in a protocol on the blockchain.

• Dai is infinite. Because you’re not worrying about exceeding the FDIC insurance cap, or trading dollars 1:1, you can create as much Dai as you want. And one day if the reserve currency of the world is no longer the US dollar, a stablecoin that pegs to something else (like what RAI is trying to do) would be able to operate using the same mechanics.

Weaknesses of Dai

• Dai is not 1:1 collateralized. As I mentioned above, Dai is minted via an overcollateralized loan. This means that unlike USDC, for example, where you convert $1 (USD) to 1 USDC, with Dai, you will technically be putting in more collateral than the value of what you get out. Of course, you can get back your collateral by repaying the loan—in fact, some use this as a way to borrow stable assets against their Ether to go long— or you can also trade or borrow DAI as you would any other stablecoin.

• Deleveraging risk. Although the protocol has been changed to dramatically reduce the risk of a deleveraging spiral like the one from March of 2020, the risk is not entirely eliminated. Those who prefer a 1:1 collateral ratio (based on fiat which is less volatile), may prefer to opt for fiat-backed stablecoins.

• Multi-collateral Dai can be backed by other, more centralized stablecoins. Some users prefer to reduce their risk of liquidation when minting DAI by using other stablecoins, like USDC. At one time over 50% of MCD backing was made up of USDC, creating a centralized risk vector, though it has since shifted back towards a backing of predominantly Ether. In any case, decentralization purists may take issue with this.

• Dai is not the most popular stablecoin. Due in large part to institutional adoption of USDC and the popularity of Tether outside of the United States, the market capitalization (at the time of writing) of Dai is about 10 times less than that of USDC, and about 12 times less than USDT. This might lead some to choose not to invest in Dai, resulting in lesser demand. In the world of DeFi where much of the returns are based on trading fees or loan interest, demand is key to maximizing returns.

There is at least one place to get great rates on DAI though, and that’s on Notional Finance. (Notional is actually the creator of this post). They are also an innovative DeFi platform for earning stable returns when lending, and locking in stable rates when borrowing.

Notional allows stable rate crypto lending and borrowing of four assets. Ether, Wrapped Bitcoin, USDC, and DAI. So if you’re looking for a way to earn yield on your stablecoins, look no further.