Stablecoins and How They Work

Stablecoins and How They Work

Nahid Ibrahimzade

Nahid Ibrahimzade

MELD Ambassador

July 14, 2022

The recent crash of LUNA and its stablecoin of UST have brought a lot of attention to stablecoins. In fact, we saw that not all of them are actually as stable as their name suggests. Though the former Fed chairwoman, Yellen, stated that the fall of Luna did not cause systemic risk, certainly, it impacted the crypto market in a broader way. In this article, I will dive into the definition of stablecoins, why we need them, how they work, and which alternatives are available.

What is a stablecoin?

Stablecoins are a type of cryptocurrency which are pegged to a fiat currency. For example, USDC and USDT are examples of stablecoins that are pegged to the US Dollar. Also, there are alternatives to different fiat currencies as well. Overall, the main idea is that these coins should track the underlying currency on the blockchain they operate on.

Why do we need stablecoins?

There are several reasons why we need stablecoins. Firstly, they allow one to make a transaction in a less-volatile pegged currency and bring stability to the ecosystem. As fiat currencies are not possible to be used as a medium of exchange on blockchain, one would need in the first place, usually at a centralized exchange, to purchase a stablecoin via fiat currency. Then, the stablecoin can be withdrawn from the exchange to the relevant blockchain network and can be used as a medium of exchange. Secondly, some DEXs offer a higher rate of return on stablecoins to attract investors and increase their liquidity pools to minimize slippage loss. Additionally, stablecoins can be used in borrowing and lending protocols to be lent to others and earn a passive income. Thirdly, they are fast and accessible to everyone at all hours.

How do they work?

There are 2 main types of cryptocurrencies. The first group is usually collateralized via different assets and is redeemable. For this group of stablecoins, a basket of assets: fiat, crypto, or precious metals are used as a backing. Fiat-backed cryptocurrencies are vastly used since the volatility of crypto and precious metals cannot be higher compared to fiat-backed ones. The second group of stablecoins is algorithmically managed, and a predefined logic is used to keep the stability of the stablecoin. The governing protocol usually achieves this by minting (issuing more governance tokens) or burning (taking the governance token out of circulation) tokens.

The issue with the first group is that the collateral might not be enough for the whole supply of the stablecoin. Meaning that if everyone would like to redeem, there would not be enough collateral to pay everyone back. Hence, in the case of “bank runs”, these types of currencies are poised to fall. The issue with the algorithmic stablecoins is that the underlying logic might not work in extreme market conditions, as we saw in the case of UST. Once it was de-pegged, restoring back might not be possible. And if the trust is lost in the stability of the “stable” coin, it cannot sustain longer in the market. As a specific example, before you need to buy UST, one has to mint some. To do so, one would purchase LUNA. The protocol takes those LUNA and burns them, which diminishes the supply of LUNA and makes the price of LUNA go up just a bit. The same worked in reverse as well; to mint LUNA, one needed to convert UST stablecoins. Those get burned and the price of UST goes up ever so slightly. However, the inherent flaw is that in the bull market, the market price of LUNA went up, making the underlying governance token higher in value. In a bear market, the market price of LUNA went down significantly, causing panic among users, hence, de-pegging and fall of the governance protocol token – LUNA. 

Which alternatives are available?

USDT (Tether tokens) is one of the well-known stablecoins. It achieves its stability via having collateral. According to the Tether website, all tether tokens are pegged at 1-to-1 with a matching fiat currency and are backed 100% by Tether's reserves. However, the recent figures show that the underlying collateral has decreased significantly, the company’s commercial paper holdings decreased from $24.2 billion to $20 billion last quarter. In the recent report, published by an independent accountant, MHA Cayman based on Cayman islands, consolidated total assets amount mentioned to be at least  $82,424,821,101. However, the report mentions that “The reporting date is limited to a point in time as of 31 March 2022 at 11:59 PM UTC. We did not perform procedures or provide any assurance at any other date or time in this report”. It basically means that the holdings could be different at other times, or simply put, they are not checked on a continuous basis. It is a question mark. Additionally, not all assets that are in Tether’s reserves can be liquidated easily. Overall, my sentiment towards Tether is from somewhere average to negative. It might not be as “stable” as it sounds.

USDC (USD Coin) is another well-known stablecoin that was created by Circle group. According to the official website, 53.5 billion of total USDC are in circulation. In the past year, the total circulation amount went from just over 20 billion to over 50 billion. Attestation reports by an independent firm are available for each month. Reserves of USDC are much easier to understand compared to USDT. According to the figures mentioned on its official website, $53.0B are noted as total reserves, of which $12.8B are in cash and $40.2B are short-duration U.S. Treasuries. Easily availability of key figures is another plus for USDC. Overall, my sentiment towards USDC is somewhere from neutral to positive. However, one needs to be always careful before purchasing any cryptocurrency.

Djed is the new generation algorithmic stablecoin that will be offered by COTI on Cardano. According to the official publication, Djed is a stablecoin based on an algorithmic design. It uses smart contracts to ensure price stabilization, and the coin will be useful for decentralized finance (DeFi) operations. Eventually, it is also aimed to become the ultimate coin with which Cardano’s entire network transaction fees will be paid. At glance, it makes sense, because it would be too volatile if transaction fees are paid in ADA (Cardano’s native token). In order to achieve stability, the fees must be paid in a stablecoin. 

Djed notes that to mint the Djed stablecoin, users will need to interact with the smart contract by sending $ADA to its address, then the contract will send Djed back to the user. The price of Djed will aspire to be $1. However, $ADA is also traded, hence, using it as collateral might lead to huge fluctuations in reserves. As there can be fluctuation in the $ADA price, there might not be enough $ADA in the contract to give back to the Djed holders. That’s why they plan to introduce $Shen into the equation. By minting $Shen, its holders provide the service of stability to $Djed users. In order to do so, they won't be able to burn $Shen for $ADA for as long the reserve ratio is below 400% because stablecoin users have priority to burn their stablecoins into a stable USD equivalent value paid in $ADA from the reserve. The smart contract also won’t allow the purchasing of $Shen once a reserve ratio gets to 800% in order to avoid too much risk or rewards.

From their promise we can see that to overcome the issue of instability of the coin, over-collateralization is offered. In this way, they assert that in the case of “bank runs”, there will always be enough assets to pay the holders back. Worth noting that after the fall of LUNA, one must be cautious about the algorithmic stablecoins. At this point, DJED seems like the next step but needs to be stress-tested in extremely volatile market conditions. Once available, I will be able to measure its stability more, however, its mechanism to function seems like a complex one.

Conclusion

In this article, the definition of stablecoin is provided, it was argued that stablecoins can offer various utilities to their users. Additionally, two types of mechanisms were outlined: collateralization and algorithmic stablecoins are mentioned. The fall of LUNA and its “stablecoin” UST were briefly mentioned, along with USDT and USDC and their reserves. Finally, the algorithmic stablecoin on Cardano, DJED was brought to the attention of the reader.

Disclaimer

The opinions shared within this article are those solely of the MELD Ambassador. Note that the content within should not be considered financial, legal, or tax advice. Neither the author nor MELD Labs PTE Ltd. are financial, legal or tax advisors. None of this content should be used to make any form of financial, tax, or legal decisions. Do your own research and consult professionals as needed for official policies, restrictions, and requirements in your jurisdiction.

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Tags
Blockchain Basics
Economics & Tokenomics
defi

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