Beginner's Guide to Stablecoins
August 7, 2024
(Updated:
)
INTRODUCTION
Stablecoins are cryptocurrencies that are are pegged, i.e. fixed at the same price to a specific asset, typically the US dollar. Stablecoins are backed in different ways, generally by reserves, over-collateralized positions, or by an algorithm, in order to maintain this peg.
This article will outline:
- What a stablecoin is
- The main types of stablecoins
- How different types of stablecoins are backed
- How you can use Arkham’s tools to learn more about stablecoins
WHY ARE STABLECOINS USED?
The price of cryptocurrencies like Bitcoin is often too volatile for them be used as a medium of exchange. Fiat currencies, especially the US dollar, are generally preferred as a medium of exchange due to their perceived stability and low level of risk. However, fiat currencies do not exist on the blockchain, so they cannot be used as a medium of exchange on chain. Stablecoins attempt to bring fiat currencies (and other real world assets) on chain.
A stable price makes stablecoins useful for both transferring stable value between two parties (e.g. buying and selling goods for a fixed price), or for securing the value of capital.
A BRIEF HISTORY OF STABLECOINS
In 2014, the first stablecoin, BitUSD, was created. Instead of being backed by a corresponding US Dollar in the bank, it was backed by a token, BTS, on the BitShares blockchain. For each BitUSD that was issued, there was at least twice the value locked up in BTS in a smart contract.
Tether (USDT) also launched in 2014, acting as a competitor, and used fiat currency reserves. Tether was issued on top of Bitcoin using Omni, which at the time of writing is no longer supported.
Since then, over 100 different stablecoins have been launched, each competing to find a balance between capital efficiency, decentralization, and stable prices.
TYPES OF STABLECOINS
Stablecoins differ in how they maintain the peg. There are three main categories: fiat-backed, crypto-backed, and algorithmic.
FIAT-BACKED STABLECOINS
Fiat-backed stablecoins keep one unit of fiat cash or cash-equivalent in a reserve, like a bank, for each stablecoin that’s been issued on-chain. Stablecoins such as USDC whitelist certain institutions as issuers. When these issuers wish to mint a stablecoin, they deposit USD into a bank account equal to the amount of desired USDC to be minted. The issuer then mints the equivalent amount of the USDC stablecoin, and the institution can withdraw it to the blockchain. When the institution wishes to redeem USDC for real-world USD, the process happens in reverse. This way, the amount of stablecoins on-chain never exceeds the reserve’s value.
TETHER USD (USDT)
Tether Limited is the largest stablecoin issuer at time of writing. They issue several stablecoins, namely USDT, EURT, and XAUT, which represent the U.S. Dollar, Euro, and gold, respectively.
Tether Limited backs these stablecoins using cash and cash-equivalents. Cash equivalents are financial instruments that are very similar to cash in their stability, risk, and liquidity, and include tools such as Treasury Bills, Reverse Repurchase Agreements, and Money Market Funds.
USD COIN (USDC)
USD Coin (USDC) is the second major stablecoin. It is issued by the Centre Consortium, which is made up of Coinbase and Circle. They also issue EURC, which represents the Euro.
Centre Consortium backs these stablecoins using cash and cash-equivalents. In USDC’s case, this is primarily cash, short-dated U.S. Treasuries, and overnight U.S. Treasury repurchase agreements.
USDT VS USDC
Both USDT and USDC are fiat-backed stablecoins. Together, they make up 91% of crypto’s total stablecoin market capitalization.
USDT primarily exists on Tron and Ethereum – roughly $108B units of USDT are on both chains.
Circle provides attestations of reserve balances and supports multiple chains as well. In comparison, USDC is much more broadly distributed, with Ethereum, Arbitrum, Base, and Solana making up $31.59B units total.
While both use short-dated Treasury Bills as cash equivalents in their reserves, Tether also holds Bitcoin in their reserves. Tether, unlike Circle, is not based in the U.S., despite issuing a USD-based stablecoin – it is based in the British Virgin Islands. Circle, on the other hand, has its reserve fund managed by BlackRock.
RISKS OF FIAT-BACKED STABLECOINS
Generally speaking, fiat-backed stablecoins are often capital efficient, but are centralized by nature. This means that the issuing process (minting and burning) has a single point of failure. This presents a risk of collateral loss if the custody institution is impaired.
This happened to USDC in March 2023, when one of their custody banks, Silicon Valley Bank, went out of business. Approximately $3.3B – or 8% of the funds backing USDC at the time – were held in Silicon Valley Bank, which potentially could have been lost entirely if deposits were not protected. The potential loss of backing led USDC to quickly de-peg to $0.878, an all-time low for USDC. Depositors to Silicon Valley Bank were later bailed out by the U.S. Government, which protected the backing of USDC. However this highlights the risks of even a small portion of a stablecoin’s backing reserves being lost.
Other examples of fiat-backed stablecoins include, but aren’t limited to:
- Gemini USD (GUSD)
- True USD (TUSD)
- PayPal USD (PYUSD)
- First Digital USD (FDUSD)
- Circle Euro (EURC)
- Stasis Euro (EURS)
CRYPTO-BACKED STABLECOINS
Other investors may seek to put their cryptocurrencies to work by borrowing against them. This leads us to crypto-backed stablecoins, which are also called Collateralized Debt Position (CDP) stablecoins. With a CDP stablecoin, users lock accepted collateral in a smart contract and borrow against a portion of its value, usually as a stablecoin.
For example, a protocol might accept Bitcoin or Ethereum as collateral, then allow the user locking those coins to mint stablecoins against their deposit. In order to unlock that collateral, the user must repay the amount of coins borrowed, plus any relevant fees.
A protocol can decide, usually through their DAO, which type of collateral to accept. For example, while MakerDAO (MKR) allows Bitcoin or Ethereum to mint their stablecoin DAI, they do not accept a coin like SHIB as collateral. On the other hand, a protocol like Abracadabra might allow SHIB as collateral to mint their stablecoin, Magic Internet Money (MIM). Some protocols may even allow liquidity provider (LP) position tokens to be used as collateral. Different protocols have different risk tolerances, which is shown in the range of collateral they are willing to accept.
MAKERDAO: DAI
DAI is an Ethereum-based stablecoin using cryptocurrency as backing collateral. In the MakerDAO protocol, DAI is issued whenever someone wishes to borrow against their deposited collateral.
DAI allows users to hedge against their collateral’s volatility, or simply access a line of credit in the form of stable coins. DAI maintains stability by adjusting the interest rate on loans – otherwise the “stability fee” – based on the supply and demand of DAI.
RISKS OF CRYPTO-BACKED STABLECOINS
Users primarily assume smart contract risk, or the risk that faults in the smart contract that could lead to exploits. Users also assume risk associated with the collateral assets. This can include volatility risk, which may lead to liquidation of the crypto-backed position, but also includes depeg risks associated with coins like USDC, which is often accepted as collateral in these types of protocols.
To be sure, one should always see what is accepted as collateral in a protocol. For example, liquid-staking tokens like Lido Staked Ether (stETH) may be accepted as collateral in some protocols. This means that a user’s token can be earning yield while it’s being borrowed against. However, if stETH de-pegs from ETH on the downside, the protocol will require the user to add more collateral to be added, if the user has not already been liquidated.
CDP stables are not always the most capital efficient because they require extra assets to be locked up. However, it allows users to access capital using those assets for other use.
Some other examples of crypto-backed stablecoins include:
ALGORITHMIC STABLECOINS
Algorithmic stablecoins are defined as having a set of calculable rules which determine the peg mechanism and backing collateral (or lack thereof). These rules vary between stablecoins, allowing for some ‘creative’ designs of maintaining peg and backing.
However, any flaws in those rules may lead to the collapse of the peg, and it’s difficult to foresee every scenario that would test the backing algorithm As a result, algorithmic stablecoins are generally considered a risky subset of stablecoins, and historically have depegged or failed much more often than fiat-backed or crypto-backed stablecoins, often in catastrophic fashion.
THE FRAX SUITE: DEFINING ALGORITHMIC STABILITY
Frax Finance currently issues three stablecoins which represent a few different ways algorithmic coins can be pegged: against a fiat currency, against a price index, and against a volatile currency.
FRAX
The first coin is FRAX, which is pegged to the US Dollar. FRAX uses Algorithmic Market Operation (AMO) smart contracts. AMOs are a way of employing different market “strategies” to maintain the FRAX coin peg. Even though it is algorithmic, the protocol attempts to collateralize FRAX at a rate of 1:1 using collateral that exists outside of its platform. Some examples of AMOs used include Curve and Convex liquidity tokens and using Frax Shares (FXS) to maintain stability.
FPI
The second coin is FPI, which is a stablecoin pegged to a basket of consumer goods: the Consumer Price Index (CPI). This is a category of coins sometimes referred to as “flatcoins,” which attempt to provide stability to dollar inflation or the cost of living. Flatcoins are backed in various ways, but act as a way to denominate against inflation.
frxETH
frxETH, or Frax Ether, acts as a 1:1 backing of Ether using a Frax smart contract. For each ETH locked in the smart contract, the user receives 1 frxETH. This “wrapped” Ethereum can then be staked with Frax to earn yield or used normally. This is one of the many examples of a stablecoin being non-dollar denominated, and it is one of many examples of how on-chain applications keep stability using a smart contract.
"INTERNET BONDS" OR "STRATEGY" STABLECOINS
“Strategy” stablecoins are another type of algorithmic stablecoin. Protocols issuing algorithmic stablecoins can use a “strategy” to maintain their coin’s peg.
After the spectacular collapse of TerraUSD (UST/USTC) in May 2022, protocols became more careful about labeling their tokens as stablecoins if they anticipate a higher level of risk. Ethena, for example, refers to their product, USDe, as an “internet bond.”
USDe
USDe is an algorithmic stable token by Ethena. The protocol accepts a cryptocurrency as a deposit – in this case, Ethereum – and then shorts the same amount on a perpetual exchange. Then, they can issue USDe, which is designed – but not guaranteed – to be stable. These stablecoins are backed by the cryptocurrency deposited. To add an extra layer of insurance, Ethena also uses BTC as a backing asset.
This captures what is called the basis, which is “the difference between the spot price of a commodity and a futures contract that expires two or more months later” (Investopedia, 2024). If you’re unfamiliar with shorting, you can read our article on derivatives trading. This algorithm, or ruleset, allows the coin to be delta neutral – or, in other words, relatively stable, but with no guarantees.
RISKS OF ALGORITHMIC STABLECOINS
Some of the main risks with algorithmic stablecoins are smart contract risk and algorithm risk. An algorithm, being a ruleset, does not necessarily guarantee stability. If there are edge cases where the algorithm does not work, or where its rules can be exploited, it can lead to the full devaluation or extraction of capital from the protocol. This is in part due to the undercollateralized nature of most algorithmic stablecoins.
Historically, some failed algorithmic stablecoins include (but not limited to):
The space is still being explored, however, and some other stablecoins that are algorithmic and are currently keeping their peg at time of writing include, but aren’t limited to:
USING ARKHAM FOR STABLECOINS
You can use Arkham’s platform to find basic information on stablecoins. You can also use Arkham to track the inflows and outflows of stablecoins from different addresses, their movements, and who holds the most of each.
However, you might want to be more specific about the information for a particular purpose. One example of how we can simplify this process on Arkham is by using the dashboard toolset.
In the dashboard toolset, we can either create our own dashboard, or access dashboards created by other users in the ‘Arkham Dashboards’ or ‘Community Dashboards’ sections.
For example, we can use one of Arkham’s premade dashboards if we’re interested in holistic information about the stablecoin market:
Or try creating a custom dashboard which tracks the price of most major stablecoins to be on alert for arbitrage opportunities.
CONCLUSION
There are a vast amount of stablecoins on the market currently, each with its own peg mechanics, and type of backing. Riskier stablecoins, with new or untested peg mechanics, are used more by traders with higher risk tolerances and a deeper understanding of DeFi. Alternatively, traditional fiat-backed stablecoins are often more accessible for traders seeking a stable way of preserving their capital. However, as new financial products on the financial frontier, all stablecoins arguably carry a significant level of risk
Some important takeaways:
- There are three main types of stablecoins: fiat-backed, crypto-backed, and algorithmic.
- Fiat-backed stablecoins keep cash or cash-equivalents as reserves for each one issued.
- Crypto-backed stablecoins over-collateralize their stablecoins with various tokens (which differ by protocol)
- Algorithmic stablecoins use a custom, specific ruleset to maintain peg and backing, and are often undercollateralized by design.
Stablecoins are an important element of many blockchain ecosystems, and provide a less volatile way of transmitting and trading assets on-chain.
