Stablecoins are one of the key elements of the cryptocurrency industry. Assets like USDT, USDC and DAI serve as an effective medium of exchange and store of value, and are actively used in DeFi protocols.
The segment is growing rapidly — since the start of the year, the total market capitalisation of stablecoins has risen more than fivefold (from $29.3bn to $147.47bn as of 8 December).
The segment is dominantly led by centralized coins such as USDT, USDC and BUSD.
However there are decentralized alternatives such as DAI from Maker and MIM from Abracadabra. The field is actively developing algorithmic stablecoins aimed at capital efficiency and fast, inexpensive transactions. One of these projects is Terra, whose native token recently breached the top-10 by market capitalisation.
ForkLog has delved into the peculiarities of the technologies behind various stablecoins, weighing their strengths and weaknesses.
Key Points
- Algorithmic stablecoins are a relatively new phenomenon in the cryptocurrency market. They are an alternative to time-tested centralized assets like USDT and USDC.
- The segment of new “stable coins” is actively evolving, but not all projects manage to prove their viability.
- Among algorithmic stablecoins, an obvious leader is UST from the Terra project. Its market capitalisation has already reached $8.6bn.
Drawbacks of popular stablecoins
Long-standing demand for stablecoins has been a significant driver of crypto industry development and broad adoption.
Viable “stablecoins” must possess mechanisms to dampen price volatility over short periods, which is particularly relevant during periods of strong demand fluctuations.
Such mechanisms are meant to encourage market participants to perform low-risk arbitrage operations, bringing the price of stablecoins closer to the target peg. This occurs through expanding or contracting the supply of coins when they trade above or below the peg, respectively.
Beyond rapid and efficient price stabilisation, other properties matter:
- Collateralisation — market participants must be confident that stablecoins are backed by a substantial amount of fiat and other assets.
- Capital efficiency — essential for scaling the ecosystem and broad adoption.
- Decentralisation, implying transparency and no single point of failure.
There is the so-called «stablecoin triangle» — it is extremely difficult to build a system that possesses all of these properties.
The most widely used fiat-backed stablecoins include Tether (USDT) and USD Coin (USDC). The market-cap weight of top-10 coins has surpassed $100bn.
USDT and USDC have a centralised issuance and redemption mechanism to maintain price stability. The latter resemble promissory notes — their redemption yields the right to the corresponding amount in dollars.
If the token price falls below $1, arbitrageurs can buy USDC for less than $1 per token, then convert USDC to dollars on a 1:1 basis on Circle.
If the price rises above $1, arbitrageurs can issue stablecoins (1 USDC = $1) and sell them on the open market for a profit.
Different stablecoins may differ in such mechanisms. A common requirement is a KYC process to redeem tokens. In the case of Tether, investors must pay 150 USDT for account verification. Centralised stablecoins also carry counterparty risk — users must trust the issuer to back the tokens with reserves held by a reputable custodian.
“Stablecoins” may not be 100% backed by fiat — some issuers include in reserves bonds and other highly liquid securities. Lack of transparency among centralised stablecoins invites abuse.
In August, Tether published an audit report by Moore Cayman, which confirmed 100% backing of USDT by assets. However cash and bank deposits accounted for 10%, and 49% consisted of commercial paper.
Hindenburg Research questioned the accuracy of Tether’s reserves and even offered a $1m reward for disclosures of new information.
Much of the stablecoin supply appears concentrated among large players. Protos analysts concluded that about $60.3bn, or nearly 55% of USDT’s market value from 2014 to October 2021, was issued at the behest of market makers Cumberland Global and Alameda Research, linked to Sam Bankman-Fried.
Additionally, a central issuer can block movements on certain addresses if on-chain activity is deemed suspicious. The blacklist of addresses continues to grow.
Stablecoins are increasingly under regulatory scrutiny, including from the United States, the United Kingdom and the EU. As a result, issuers must contend with tightening rules.
For example, in November the USDC issuer Circle backed the Biden administration’s plan to regulate stablecoin issuers as banking institutions.
DAI: over-collateralisation at the expense of capital efficiency
An alternative to the simple centralized systems is DAI from MakerDAO, backed by a mix of crypto assets.
MakerDAO is a smart-contract platform on Ethereum that allows the issuance of DAI stablecoins backed by various high-liquidity and relatively low-volatility assets.
There are various Vault types enabling participants to mint DAI. These Vaults may carry different parameters, including liquidation ratios and stabilization fees.
For example, the ETH-A vault with a 145% liquidation ratio requires at least $1.45 of collateral for each $1 of generated DAI.
DAI tokens are effectively debt obligations backed by collateral. The system is characterised by low capital efficiency since collateral exceeds the loan size. In other words, to mint some amount of DAI, a much larger amount of other crypto assets must be locked up. No interest is earned on collateralized funds.
So far DAI is the most popular over-collateralised stablecoin. But its market share is modest relative to centralized rivals — just over 6%.
abracadabra approach: Abracadabra uses a borrow-and-stablecoin model; instead of DAI, it issues MIM and offers yields on collateral assets including yvYFI, yvUSDT, yvUSDC and xSUSHI.
An Abracadabra version allows farming and staking the native SPELL token. Besides Ethereum, the platform also operates on BSC, Fantom, Avalanche and Arbitrum.
Algorithmic stablecoins: capital efficiency tested by time
In response to the risks and inefficiencies of centralized and over-collateralised stablecoins, algorithmic stablecoins have emerged.
These projects resemble automated central banks, using algorithms to manage the supply of assets and the underlying economy.
In terms of collateral, algorithmic stablecoins fall into two categories:
- unsupported (ESD, AMPL and BAC);
- partially or fully collateralised by native tokens (FRAX, sUSD and UST).
The main distinction between algorithmic and over-collateralised coins lies in the type of collateral. The latter are backed by assets from other projects like ETH, WBTC and USDC.
Unlike DAI, Terra’s UST is collateralised by the native LUNA token. This model opens the door to algorithmic influence on UST’s price.
Ampleforth (AMPL) is one of the pioneers in algorithmic stablecoins. Its standout feature is the Rebase model, which controls token price by adjusting monetary supply.
“The AMPL protocol automatically aligns supply with demand. When the price is high, wallet balances increase. When the price is low, wallet balances decrease,” said on the project site.
Thus the token supply is tightly controlled. Depending on market conditions, AMPL can be inflationary or deflationary.
Rebalances occur every 24 hours. With a fixed interval, users can take advantage of periods between rebalance events to buy or sell AMPL.
Many algorithmic stablecoin projects employ a sine model — a form of seigniorage. It includes a system of rewards that influence market dynamics. For example, if the price is above the peg, new tokens are issued to liquidity providers, increasing supply.
If the price is below the peg, token issuance is halted, preventing supply from expanding. Users can buy coupons that burn the underlying coins and remove them from circulation. These coupons can later be redeemed for tokens when the price returns to the peg.
A prime example is Empty Set Dollar (ESD), which uses a seigniorage model with a single token.
Users provide liquidity to the DAO through the protocol’s native token ESD. The token acts as both the stablecoin and governance token.
At the start of each 8-hour epoch, the system calculates the time-weighted average price (TWAP) of the token. If the TWAP is above $1, the protocol enters an inflationary phase and issues coins as rewards to stakers and liquidity providers (LPs). If the price falls below $1, the protocol enters a contraction phase and rewards cease.
During the contraction phase, users can buy coupons by burning ESD. These coupons can later be redeemed for native tokens during the inflationary phase at a profit.
However, coupon validity lasts only 30 days. That means buyers risk getting nothing if the contraction phase lasts longer than a month.
A chart below highlights the price trajectory of this alt-stablecoin. It shows a steady decline in ESD’s price since the start of the year.
In another project — Basis Cash — the seigniorage model with two tokens (the stablecoin BAC and the native asset BAS) is used.
As with ESD, Basis Cash relies on a TWAP mechanism. This mechanism issues or halts BAC supply when its price is above or below $1 respectively. The project also has its own coupons — Basis Bonds. These can be used to redeem BAC when the protocol returns to inflationary mode.
The epoch length for Basis Cash is 24 hours. However, unlike ESD coupons, Basis Bonds have no expiry date.
The price trajectory of the alog stablecoin from Basis Cash resembles the price path of ESD from Empty Set Dollar.
The project Frax Finance uses a modified seigniorage model. The stablecoin (FRAX) is backed by two types of collateral:
- centralised “stablecoin” USDC;
- the project’s native token — Frax Share (FXS).
Unlike Basis Cash or ESD, Frax Finance employs a partial-reserve system. Collateral parameters are governed by the Proportional Integral Derivative (PID) mechanism and depend on the ratio of FXS liquidity to the total FRAX supply.
When FRAX trades above $1, the PID lowers collateral requirements; when the price is below $1, it raises them.
Arbitrageurs can buy or mint FRAX to help peg it to $1.
The developers have launched the veFXS system, under which a portion of the revenue from the Algorithmic Market Operations Controller is distributed to FXS stakers.
The chart below shows that FRAX’s price remains relatively stable (especially compared to the algostablecoins discussed).
Fei Protocol — a relatively new project that began operating in early 2021. It employs a partially backed system under the Protocol Controlled Value (PCV) concept. The idea is that Fei Protocol buys ETH with freshly minted stablecoins (FEI) and then uses ETH to provide liquidity in pools.
When FEI trades above $1, the protocol allows users to mint new stablecoins at a discount using ETH as payment. Traders then use arbitrage to push the price back toward the peg.
When FEI trades below $1, the protocol taxes FEI holders, with proceeds burned, rewarding buyers with extra tokens.
In stressed times, if the price remains well below the peg, Fei Protocol can withdraw PCV liquidity from Uniswap and buy FEI on the open market. Bought FEI is then burned. After price recovery, liquidity can be returned to Uniswap.
There is also a native token TRIBE that gives holders governance rights over the protocol, including PCV parameters.
In April Fei Protocol raised about $1.3bn, but faced issues after mass conversion of FEI to TRIBE and subsequent ETH purchases.
However, as the chart shows, FEI price recovered by the end of May and did not exhibit further sharp moves.
TerraUSD success
TerraUSD (UST) from the Terra project can rightly be considered the most successful algorithmic stablecoin, both by capitalisation and by price stability. This has largely been achieved thanks to a relatively simple mechanism for keeping it pegged to $1, strong demand and a developing ecosystem.
In early December the native token LUNA reached above $78, and the amount of funds locked in DeFi applications (TVL) surpassed $14bn. The rally helped the token enter the list of the ten largest digital assets.
The Terra project was founded in 2018 by Daniel Shin, president and founder of Ticket Monster. The company is one of the leading players in Korea’s e-commerce market.
In July, the Terra entity Terraform Labs raised $150m for an ecosystem development fund.
The project supports stablecoins pegged to the US dollar, the South Korean won, the Mongolian tugrik and SDR. The LUNA token is used for governance and price stability of assets issued on the network. Users themselves issue “stablecoins” by burning native tokens.
When the price of a stablecoin is above the peg, supply tends to be too low relative to demand. In such a situation, users find it advantageous to issue relatively expensive tokens. The monetary mass grows and demand-supply balance moves toward equilibrium.
If the price of a stablecoin is below the peg, supply exceeds demand. Users burn stablecoins to mint LUNA. The reduction in Terra’s supply creates a deficit, and the token price rises until it reaches parity with the corresponding fiat.
For example, UST trades at $1.01. Users can use the Terra Station app to swap $1 worth of LUNA for 1 UST. This burns the corresponding amount of the native token. Selling UST yields a one-cent profit per dollar. Arbitrage will remain profitable until parity with the dollar is achieved.
«The more Terra is used, the higher the value of LUNA», — shown on the project site
The native token can also be used for governance, staking, liquidity mining and paying transaction fees. The maximum supply of LUNA is 1 billion tokens.
Terra uses a Proof-of-Stake consensus with Tendermint technology.
Validator rewards come from two sources:
- Gas fees for processing transactions;
- Stabilisation fees, which come in two forms: a Tobin tax on Terra’s exchange operations; swap spreads when converting Terra to LUNA and back (minimum 0.5%).
Terra’s largest algorithmic stablecoin, UST, has remained relatively stable since launch.
Since the start of the year the market capitalisation of the stablecoin grew 48-fold — from $180m to $8.6bn.
The Terra team actively develops a DeFi ecosystem on Terra, attracting investments from major players like Galaxy Digital and Coinbase.
Leading Terra protocols include Anchor and Lido. The former leverages bonded assets (bonded assets) to back minting of stablecoins, with a deposit yield on UST of 19.59% as of 12.12.2021. The latter unlocks staked tokens such as SOL, ETH and LUNA for further use.
Terra’s ecosystem, by TVL, has surpassed Avalanche, Solana, Tron and Polygon, second only to Ethereum and Binance Smart Chain.
The rise of Terra was spurred by the integration of the Inter-Blockchain Communication Protocol (IBC) from Cosmos in late October 2021. It enables message passing between different blockchains, allowing the UST stablecoin and the LUNA token to appear on the Cosmos network.
1/ Proposal 128 to initiate IBC on Terra has passed, meaning that IBC is now live on the Terra mainnet 🙂https://t.co/4aIjkdDBBH
Stay tuned for once the relayer channels are set up, and users can begin transferring tokens between Terra and the Cosmos ecosystem from Station.
— Terra (UST) 🌍 Powered by LUNA 🌕 (@terra_money) October 21, 2021
Another notable factor was the activation of Columbus-5 upgrade, which includes a deflationary pressure model on LUNA. Previously governance tokens used for minting stablecoins were moved to the community pool. After the hard fork the protocol began burning them. In November the Terra community also decided to burn 89 million LUNA (~$4.5bn at the time) held in its pool.
Conclusions
Since 2020, new algorithmic stablecoins have continued to emerge. Yet despite bold promises and catchy slogans, many projects have fallen short of expectations.
This is evident in the steadily falling prices of many stablecoins, driven by weak demand and imperfect token-supply management. Only a handful have managed to maintain a peg to the underlying asset, including Synthetix (sUSD), Frax Finance (FRAX) and Terra (UST). Terra’s market cap dwarfs that of its rivals.
For many stablecoin systems, liquidity remains a challenge. Some platforms try to address this via liquidity mining . However, such campaigns tend to attract users seeking quick profits who may exit before mass selling ensues. Such dynamics contribute to volatility and do not always foster stability.
Algorithmic stablecoins may also attract regulatory attention as authorities scrutinise centralised peers. In September, US lawmakers called for full fiat backing and regular audits of stablecoins, a stance that could constrain the segment if algostablecoins prove under-collateralised or backed by volatile native tokens.
New stablecoins still must prove their viability, particularly in a bear market that will eventually arrive.
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