Overview
This article provides investors who are new to the crypto space with the most relevant information on stablecoins, which are a crucial component of the crypto ecosystem. It explains the difference between redeemable and algorithmic stablecoins and highlights the dominance of redeemable stablecoins, particularly Tether’s USDT, in the current market. We also discuss the regulatory uncertainty surrounding stablecoins in the United States and the potential risks associated with their use, including the vulnerability of stablecoins to the collapse of payment gateways and the potential depegging of a major stablecoin.
Key Insights
- As of June 2023, Tether’s USDT vastly dominates the stablecoin sector by trading volume with 74.2% and 66.1%. The second largest stablecoin is Circle’s USDC with 10.7% of the trading volume and 22.3% of the market cap.
- While USDT is predominantly used to facilitate trades on CEXs for spot and derivatives trading, USDC is more commonly used in DeFi and therefore has historic dominance when it comes to on-chain transactions. However since the March 2023 banking crisis and the consequent of USDT, the volume of on-chain transfers has roughly equalised.
- Stablecoins currently face significant regulatory uncertainty in the United States due to the SEC’s unclear position on the status of cryptocurrencies as securities or non-securities
Concept
Definition
A stablecoin is a fungible token on a smart contract blockchain whose value is pegged to that of a fiat currency. Stablecoins form the backbone of the alternative financial system that the crypto industry has created. Given that crypto companies still have difficulties in accessing banking services , trades and evaluations of crypto assets against fiat currency would not be possible without them. While no stablecoin offers direct yields to holders, there is a multitude of ways to earn interest on stablecoins through liquidity provision and decentralised lending. However, this usually means depositing funds to a multisignature wallet, which implies additional counterparty or at least smart contract risk.
Redeemable versus Algorithmic coins
There is a useful distinction to be made between redeemable and algorithmic stablecoins. A redeemable stablecoin maintains its peg by giving market participants the ability to both mint and redeem coins. Minting is performed by depositing collateral, while the redemption of a coin releases collateral back to the holder. When a stablecoin trades slightly above its peg, this gives arbitrage traders an economic incentive to mint new stablecoin and thus increase the supply and restore the peg. If it trades below its peg, users are incentivised to redeem coins to release the underlying collateral for arbitrage, which will decrease the supply and restore the peg.
An algorithmic stablecoin on the other hand does not offer such a mechanism. Instead, it has an algorithm that engages with the open market to restore the peg. The algorithm buys back stablecoins with deposited collateral or by issuing debt shares when the coin trades below its peg. It mints new stablecoin when it trades above its peg. In theory, this mechanism has the same net effect as that of a redeemable stablecoin. Real implementations of stablecoins differ in the exact details of how these two processes are implemented.
The dominant players
In fact, the stablecoins that are dominant in today’s crypto ecosystem are redeemable stablecoins run by companies and all claim to be fully backed by US Dollars and equivalent reserves. The first stablecoin to ever exist was Tether’s USDT, which was first issued in 2014 on the Omni Protocol — an early Bitcoin L2. Ever since, it has retained its dominant market position, overwhelmingly leading the market both by trading volume and by market capitalisation.
It is only in DeFi that Circle’s USDC has been able to eke out a dominant position. This can be seen through its much higher number of on-chain transactions.
It is worth noting that even decentrally governed stablecoins such as MakerDAO’s DAI are heavily dependent on the integrity of assets such as USDT and USDC, as such centralised stablecoins usually constitute large parts of their treasures. If one of the major stablecoins depegs, as was the case for USDC on 12 March 2023, this has historically also led to a depegging of DAI. Undercollateralised algorithmic stablecoins would fare no better in case of a black swan event for a major stablecoin, as the large outflows from DeFi protocols would also lead to a depegging.
Risk
Along with fiat gateways, stablecoins are the Achilles heel of the crypto ecosystem. The depegging of a large stablecoin would almost wipe out the value of most DeFi protocols. If USDT depegged, all other cryptocurrencies would experience a liquidity crunch given that they are frequently traded against the stablecoin. While such a scenario appears far-fetched, it cannot completely be ruled out as of now.
The integrity of Tether’s reserves have historically been questioned. Tether has so far only published attestations of its reserves (despite them being labelled audits), whereas Circle provides full, periodic audits. As of May 9th, Tether claims to have USD 81.8 B in assets, backing USD 79.5 B in liabilities. It therefore claims to be over-collateralised by around 3%. Circle has attested, USD 30.49 B in liabilities and USD 30.54 B in assets, making for an over-collateralisation by 0.17 %.
Stablecoins are currently under regulatory scrutiny by the United States where at the time of writing, there is no comprehensive stablecoin regulation enshrined in law. Earlier in 2023, Paxos, issuer of Binance’s BUSD stablecoin had received a Wells notice from the SEC, announcing the latter’s intention to file a lawsuit against them for unregistered securities offering.
Prima facie, there is no expectation of profit when holding a stablecoin, which would mean that that it does not satisfy the third arm of the Howey test. However, Gary Gensler, the head of the SEC repeatedly insisted that “synthetic exposure” to securities through money market funds is enough for the asset to be classified as a security. It has also been argued that it creates an expectation of profit trough arbitrage opportunities.
Besides direct legal action by regulators, payment gateways used by stablecoin issuers are also a vulnerability. These payment systems are essential for stablecoins to maintain their peg outside of banking hours. It has been widely speculated whether stablecoins will come under attack because they are competition to state-run digital payment systems such as Fed Now or planned CBDC projects. The collapse of signature bank in the US also saw the shutdown of its Signet payment system earlier this year. USDC subsequently turned to Customers Bank and its CBIT tool. However, with its assets and legal entities located in the United States, it is unclear for how long Circle can escape the ongoing regulatory crackdown.
Conclusion
Stablecoins, while themselves uninteresting as an investment are deeply connected to the health of the industry. Every crypto investor, especially those involved with DeFi projects ought to have a lookout for this sector of the market and monitor the risks that large stablecoin issuers are facing. A sustained depegging of either Tether USD or Circle USD would be a highly adverse event for the space.
This article is for information purposes only and represents neither investment advice nor an investment analysis or an invitation to buy or sell financial instruments. Specifically, the document does not serve as a substitute for individual investment or other advice.