Stablecoins: Everything You Need to Know
From DAI to USDT and everything in between, learn about all the major stablecoins and what makes each unique.
- Stablecoins are blockchain tokens that are designed to hold a specific value. They typically track the price of fiat currencies like the U.S. dollar.
- The most common types of stablecoins are fiat-backed, overcollateralized, and algorithmic, and there are significant differences between each of them.
- Stablecoins play a key role in the decentralized finance and broader cryptocurrency ecosystem.
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The definitive guide to the top stablecoins in use today.
What Are Stablecoins?
A stablecoin is a blockchain-based token that is designed to stay at an equal value, typically that of a specific fiat currency. The most widely used stablecoins track the price of the U.S. dollar, but stablecoins representing other currencies, such as the euro, the pound sterling, and the Mexican peso, are also in circulation.
Stablecoins have become a crucial part of the crypto ecosystem because they let investors take advantage of the price stability offered by fiat currencies. This is especially relevant to smart contract-enabled blockchains like Ethereum, the network that hosts the most stablecoins in circulation today. Instead of needing to send funds off-chain to trade them back into fiat, investors can seamlessly swap their volatile cryptocurrencies for dollar-pegged assets using decentralized exchanges like Uniswap.
Although dollar-pegged assets such as BitUSD and NuBits have a history dating back to 2014, stablecoins didn’t reach mass adoption until the summer of 2020. Known in crypto circles as “DeFi summer,” this period saw the emergence of several decentralized finance protocols that allowed Ethereum users to earn a yield on stablecoins and other cryptocurrencies. The demand for stablecoins in DeFi caused their market capitalization to soar. According to Statista data, the combined valuation for the top 10 crypto stablecoins has jumped from $10.8 billion to over $150 billion since June 2020.
This article is a definitive guide to all major stablecoins in circulation today, as well as a couple of relevant examples which have since collapsed. It will split stablecoins into three distinct classes: reserve-backed, overcollateralized, and algorithmic. While most stablecoins today fall into one of these classes, some tokens listed feature characteristics of more than one group.
Smaller stablecoins, including many that exist predominantly outside the Ethereum ecosystem, have not been included for brevity. However, with the three classes of stablecoins explained in-depth, readers should be able to apply this framework to other tokens they encounter to understand better the pros, cons, and risks associated with them.
Without further ado, let’s dig into the three classes of stablecoins, look at some notable examples, and evaluate the risks and benefits associated with each one.
Types of Stablecoin
Fiat-backed stablecoins maintain their pegs by promising that each token can be redeemed for a unit of the currency it represents with its provider. They are usually issued by a centralized provider who holds fiat money or fiat-equivalent assets such as commercial paper or treasury bonds with a value equal to or exceeding the number of stablecoins issued.
The most common fiat-backed stablecoins are pegged to the U.S. dollar due to its desirability across borders as the world’s reserve currency. However, other fiat-backed stablecoins representing the euro, the Chinese yuan, and the Mexican peso have also gained adoption in recent years.
As fiat-backed stablecoins are backed by national currency and managed by a centralized entity, their supply can easily expand. As long as an issuer has sufficient cash reserves, it can issue more tokens. This has led to fiat-backed stablecoins becoming not only the most widely used type of stablecoin but also the most widely used kind of cryptocurrency in circulation.
Since fiat-backed stablecoins can, in principle, always be exchanged for a dollar, market forces help them maintain their peg. For example, suppose a fiat-backed stablecoin pegged to the dollar were to suddenly trade for less than a dollar. In that case, entrepreneuring individuals could buy up the tokens and redeem them with their issuer for a small profit. However, while fiat-backed stablecoins all share a similar redemption method to ensure they stay pegged, there are still significant differences between issuers that make some more widely used or perceptually safer than others.
USD Tether (USDT) is pegged to the U.S. dollar and is the largest stablecoin in circulation. It’s issued by Tether Limited Inc., a subsidy of the Hong Kong-based company iFinex Inc., which also owns the Bitfinex cryptocurrency exchange.
USDT is officially supported on 12 different blockchains: Ethereum, Avalanche, Polygon, OMG Network, TRON, EOS, Liquid, Algorand, Bitcoin Cash, Solana, Kusama, and the Omni Protocol via the Bitcoin blockchain.
In the U.S., Tether is regulated as a money service business by multiple state financial services but has not yet received approval from the New York State Department of Financial Services. The company releases assurance opinions every quarter to demonstrate it holds enough cash and cash equivalents to back all USDT tokens in circulation.
During Tether’s lifetime, concerns over USDT’s backing have frequently weighed on the stablecoin. The company has come under fire from several U.S. regulators, including the New York Attorney General’s office and the Commodity and Futures Trading Commission, the latter of which fined Tether $42.5 million in October 2021 for misrepresenting the backing behind USDT.
Fears over USDT’s backing have also manifested in other ways. The top stablecoin has lost its peg several times over the years but has always returned to its targeted dollar value thanks to Tether’s redemption system. Most recently, USDT lost its peg in the wake of the Terra blockchain meltdown. After Terra’s UST stablecoin lost its peg, many investors feared that USDT could be at risk due to the stablecoin’s history of misrepresenting its backing assets. However, Tether was able to handle over $8 billion worth of redemptions and quickly returned to its dollar peg.
Tether has recently made efforts to address the longstanding issue of USDT’s backing and reassure investors that the company holds sufficient quality collateral. In June 2022, Tether released a new attestation report carried out by BDO Italia after its previous attestant, MHA Cayman, came under investigation in the U.K. over its audits of another firm. More recently, the company has promised to provide a full audit of its reserves following criticism from The Wall Street Journal.
USD Coin (USDC) is another dollar-pegged stablecoin and is currently the second-largest in circulation. USDC is managed by a consortium called Centre, which includes the stablecoin’s founder, Circle, along with members from the cryptocurrency exchange Coinbase and Bitcoin mining company Bitmain. USDC is supported on nine different blockchains: Algorand, Solana, Stellar, TRON, Hedera, Flow, Ethereum, Avalanche, and Polygon.
Although USDC is not as prolific as USDT, Circle has secured licenses to operate across several countries. In the U.S., Circle is a licensed money transmitter and holds state-specific licenses where it is required to do so. Circle is also licensed and regulated to conduct business involving virtual currency by the New York Department of Financial Services. Elsewhere, USDC is fully licensed in Bermuda under the Digital Asset Business License and holds an E-Money Issuer License from the U.K.’s Financial Conduct Authority. Circle is also seeking authorization as a payment service provider in the European Union.
USDC is often viewed as the gold standard for dollar-backed stablecoins due to Circle’s perceived trustworthiness, compliance with regulations, and transparency of its backing assets. Many times in the stablecoin’s history, it has briefly traded above a dollar during times of high market volatility. When investors fear other stablecoins such as USDT could lose their dollar peg, they often flee to USDC for safety.
To assure investors that USDC is fully backed by cash or cash equivalents, Circle releases monthly attestation reports from top-five accounting services firm Grant Thornton LLP. However, like Tether, Circle is yet to undergo a full audit of its reserves. Although Circle is committed to the transparency of its backing assets, that hasn’t stopped it from drawing the attention of regulators. In October 2021, it was revealed that Circle had received an investigative subpoena from the Securities and Exchange Commission over the firm’s holdings, customer programs, and operations.
Binance USD (BUSD) is the third-largest stablecoin in circulation and is also pegged to the dollar. It is issued by crypto exchange Binance in partnership with Paxos Trust Company, LLC.
While USDT and USDC span several blockchains, BUSD is currently only available on two networks: Ethereum and Binance’s BNB chain. However, this hasn’t stopped the stablecoin from growing. In September 2022, Binance started to automatically convert all deposited stablecoins into BUSD, making it the primary stablecoin used on the exchange. While this move has helped consolidate liquidity across different trading pairs, it has also promoted BUSD use among the exchange’s users.
Like USDC, BUSD is regulated by the New York State Department of Financial Services. However, whether the stablecoin is regulated in other jurisdictions is unclear. Binance and Paxos also claim that they hold BUSD reserves in cash and cash equivalents, ensuring that investors can always exchange their tokens one-to-one for dollars. To attest to this, Binance releases monthly reports detailing its asset reserves.
As the smallest of the big three fiat-backed stablecoins, BUSD has so far evaded scrutiny from regulators. However, the same cannot be said for its issuer, Binance. In recent years, the world’s largest crypto exchange has been implicated in several scandals, including failures to address money laundering through the exchange between 2017 and 2021, a Securities and Exchange Commission probe into Binance.US’s trading affiliates, and regulatory scrutiny from numerous countries. In response, the exchange delisted products across several regions, while Binance CEO Changpeng Zhao said the exchange was pivoting to “proactive compliance.”
Currently, stablecoin regulation is still in its infancy both in the U.S. and across the globe. However, legislation is developing fast, spurred on by calls for regulation from the likes of Treasury Secretary Janet Yellen and Federal Reserve Chair Jerome Powell. Judging by Binance’s track record of failings on compliance-related issues, the exchange could face difficulties ensuring BUSD is compliant with U.S. regulations in the future.
Crypto Briefing’s Take
Fiat-backed stablecoins are often viewed as the safest to hold due to their high liquidity, one-to-one dollar backing, and proven redemption mechanisms. However, these types of stablecoins all share a significant feature that sometimes earns them a bad rap with certain groups in the crypto community.
USDT, USDC, and BUSD all have freeze or blacklist functions written into their contracts, meaning the companies who issue them have the power to freeze or even confiscate funds directly from users’ wallets. Stablecoin issuers often freeze funds to fight financial crime and ensure these stablecoin issuers comply with anti-money laundering regulations. For example, Tether froze $33 million worth of USDT stolen during the August 2021 Poly Network hack. It was later returned to the protocol.
While freeze functions can help recover stolen funds from hacks and DeFi exploits, some view such functionality as antithetical to crypto’s decentralized ethos. Ultimately, having such functions written into the smart contract code of these tokens creates a centralized point of weakness. It also requires holders to trust the stablecoin issuer not to confiscate or freeze their funds without a good reason. Recent sanctions against Tornado Cash have shown that the impetus to confiscate funds or blacklist addresses can change quickly if a government organization chooses to impose sanctions (Circle switly complied with the U.S. government’s Tornado Cash ban).
Ultimately, these freeze and blacklist functions shouldn’t be a cause for concern among the vast majority of cryptocurrency investors. The convenience these highly-liquid fiat-backed stablecoins provide should far outweigh the concerns such functionality provokes. Still, for anyone who plans to use USDT, USDC, or BUSD, it’s prudent to be aware of this risk before holding them.
Overcollateralized stablecoins are not directly backed by their fiat money equivalents but instead by a basket of different assets that must always maintain a higher market value than the stablecoin’s total circulation.
The most common way to achieve this is through a smart contract protocol directly on the blockchain. Issuing protocols let users deposit various assets into the protocol as collateral. Users can then mint and withdraw an amount of the protocol’s native stablecoin up to a certain percentage of the value of their deposited assets. This way, all the stablecoins in circulation are overcollateralized.
After taking a loan out of an overcollateralized stablecoin, users are charged a small interest fee. To ensure all stablcoins are overcollateralized, protocols employ an on-chain liquidation mechanism. If the value of a user’s collateral decreases below a certain threshold, their position automatically gets liquidated, meaning the protocol sells their deposited assets for other stablecoins or cash. This ensures the protocol always remains solvent and its native stablecoin is always backed by assets of greater value than its circulating stablecoins.
Like their fiat-backed equivalents, most overcollateralized stablecoins are pegged to the U.S. dollar. However, their supply is constrained as the amount in circulation depends on users depositing assets into the issuing protocol. As such, overcollateralized stablecoins are less efficient and less liquid than fiat-backed stablecoins but are viewed as much more decentralized.
Ensuring an overcollateralized stablecoin maintains its peg requires a similar process to fiat-backed coins. However, instead of the issuer manually redeeming tokens for dollars, overcollateralized stablecoins can be automatically burned through their issuing protocol in exchange for the vault assets backing them. Like with other stablecoins such as USDT, buying overcollateralized stablecoins below their peg nets a small profit, incentivizing arbitrageurs to shore up their peg.
DAI is a dollar-pegged, overcollateralized stablecoin issued by the Maker protocol on Ethereum. It’s currently the largest overcollateralized stablecoin in circulation. The protocol was envisioned by Danish entrepreneur Rune Christensen in 2014 and went live on Ethereum on December 18, 2017.
Maker lets users deposit various assets into vaults and borrow the protocol’s DAI stablecoin against them. The protocol currently allows deposits of volatile assets such as ETH, BTC, LINK, UNI, YFI, MANA, and MATIC, stable assets like GUSD, and Uniswap and Curve liquidity positions.
The minimum collateralization ratio for each asset differs, as does the interest charged for using them as collateral. Additionally, a single asset can have multiple vaults with various collateralization ratios. ETH currently has three vaults offering ratios of 130%, 145%, and 170%. For example, at a collateralization ratio of 170%, a user could borrow approximately 100 DAI after depositing $170 worth of ETH. When a user repays a DAI loan and its accrued interest, the returned stablecoins are automatically burned, and the collateral is made available for withdrawal.
Maker’s governance token holders, a collective formally known as MakerDAO, decide the assets that can be deposited to mint DAI and what the collateralization ratio for each should be. Anyone who holds the protocol’s MKR governance token is eligible to vote on proposals and can help shape its future by creating proposals on the MakerDAO governance forums.
Although Maker operates as a decentralized entity, the protocol has come under pressure over the composition of the tokens backing DAI. One common criticism is that over half of all DAI is backed by Circle’s USDC stablecoin. This is due to a feature introduced in 2020 called the Peg Stability Module (PSM). To protect DAI against high market volatility, Maker started to allow users to exchange other fiat-backed stablecoins such as USDC, USDP, and GUSD for DAI at a one-to-one ratio. Since the PSM was introduced, the amount of USDC backing DAI has ballooned to 53.6%.
This is a problem because it introduces a significant counterparty risk to those holding DAI. If Circle were to become insolvent or deny the Maker protocol from redeeming its USDC for dollars, it would result in DAI becoming undercollateralized and likely cause a price crash. To address this issue, Maker co-founder Rune Christensen and several other MakerDAO members, have proposed various ways to mitigate the counterparty risk, including having Maker take on more Real World Asset-backed loans, using protocol fees to buy ETH to replace the USDC collateral, and even potentially allowing DAI to drift from its dollar peg to become a free-floating asset.
GHO is an overcollateralized stablecoin set to launch in the coming months. It will be managed by the team behind the decentralized lending protocol Aave and is one of a new wave of stablecoins that will eventually include a similar overcollateralized stablecoin to fellow DeFi protocol Curve Finance.
Similar to Maker, Aave is governed by a DAO structure where holders of the protocol’s AAVE governance token are able to vote on community proposals. The proposal for the GHO stablecoin was first introduced in early July 2022 and successfully passed a governance vote at the end of the month.
Aave’s GHO token will share many similarities with Maker’s DAI—both will be trustlessly controlled by smart contracts and use liquidation thresholds to ensure price stability. However, GHO improves on DAI by introducing several new features. Instead of needing to lock a specific asset in a vault as Maker requires, GHO can be collateralized using multiple different assets at once, as long as there is a lending market for them on the Aave platform.
Additionally, GHO introduces the concept of Facilitators, protocols and entities that have the ability to trustlessly generate and burn GHO tokens up to a certain limit. This will allow trusted entities to issue and burn GHO themselves instead of having to route through Aave’s contracts. Other features include discounted interest rates for AAVE token stakers that will eventually be decided through a governance vote. While GHO will initially launch on Ethereum, Aave has plans to expand the stablecoin to Layer 2 networks with cheaper gas fees.
These improvements should help improve the efficiency of capital deposited into Aave and other DeFi applications while providing substantial gas savings compared to the Maker protocol. Aave’s strong reputation in DeFi should help GHO gain traction once it launches, allowing it to compete with DAI and offer more choice to crypto users.
Decentralized USD (USDD) is a hybrid overcollateralized and algorithmic stablecoin issued by the TRON Foundation. It launched on May 2, 2022, in response to the popularity of Terra’s now-collapsed algorithmic UST stablecoin. USDD is native to the TRON network and is also available on BNB Chain, Ethereum, and several centralized exchanges such as Poloniex, Huobi, and MEXC Global.
USDD is similar to Maker’s DAI in that it is overcollateralized—the TRON DAO Reserve, an organization set up to ensure the USDD maintains its dollar peg, currently holds assets with a market value of 289.35% of the $779 million USDD stablecoins in circulation. USDD also uses a Peg Stability Module, which lets users instantly swap USDD for USDT, USDC, or TUSD at a one-to-one ratio.
However, the main way USDD maintains its dollar peg is through an algorithmic relationship with the Tron Network’s native TRX token. When USDD trades under $1, arbitrageurs can burn it and receive $1 worth of TRX. Conversely, when USDD trades above $1, arbitrageurs can swap $1 worth of TRX for one USDD, earning a small profit and increasing its supply.
It’s worth noting that USDD’s peg mechanism closely resembles the now-defunct UST algorithmic stablecoin. USDD’s peg was tested shortly after its launch when UST lost its dollar peg and entered a death spiral, wiping out over $40 billion of value. Since USDD and UST use a similar mechanism to maintain their value, many believed that the intense market volatility would cause USDD to follow UST’s collapse.
Despite spending several days well under parity with the dollar, USDD eventually returned to its peg. The main reason its outcome differed from UST is that the TRON DAO Reserve held assets well in excess of USDD’s market capitalization, while Terra’s Luna Foundation Guard did not. This, combined with the Peg Stability Module, allowed arbitrageurs to shore up USDD’s peg without applying excessive selling pressure to TRX.
Although USDD claims it is decentralized in its name, it does not share the same level of decentralization as other overcollateralized stablecoins like DAI. The TRON blockchain and its products all fall under the direct control of the TRON Foundation, a non-profit organization incorporated in Singapore. The entities that make up the TRON DAO Reserve are venture capital funds, market makers, and centralized exchanges such as Poloniex with prior connections to the TRON Network. The TRON Foundation controls entry into the DAO, and the decision-making process for updates to USDD is completely opaque.
Crypto Briefing’s Take
Overcollateralized stablecoins offer a decentralized alternative to their fiat-backed counterparts. Control is distributed among token holders or a DAO collective, and stablecoins like DAI and USDD do not include freeze or blacklist functions in their code. For individuals concerned about being unfairly targeted by centralized issuers such as Circle and Tether, tokens like DAI provide the assurance that the tokens in their wallets will always be theirs.
However, this characteristic has made stablecoins like DAI popular with cybercriminals as there is no risk of their funds being frozen. While many value overcollateralized stablecoins over centralized alternatives because their funds can not be frozen, their decentralization may bring negative consequences in the future. As governments step up crypto regulation efforts, DAI and other decentralized stablecoins could face pressure from authorities to implement anti-money laundering measures or face sanctions.
Another problem with overcollateralized stablecoins is that they are often predominantly collateralized by fiat-backed tokens like USDC. Having a decentralized stablecoin backed by a centralized stablecoin runs counter to why such projects were first envisioned and subjects holders to various counterparty risks.
Around 53.4% of all DAI is currently backed by Circle’s USDC, while about half of USDD’s collateral comprises USDC and USDT. When it is eventually launched, it’s likely that Aave’s GHO stablecoin will also end up having a large portion of its backing denominated in centralized, fiat-backed stablecoins.
In their simplest interpretation, algorithmic stablecoins are fiat-pegged assets that rely on an algorithm to help them maintain their peg. More specifically, most attempted algorithmic stablecoins are undercollateralized, meaning that the entity that issues them does not hold enough assets in reserve to allow holders to redeem them for real dollars in the event of a bank run.
To date, the most common way algorithmic stablecoins have tried to hold parity with fiat currencies is through an exchange mechanism with a volatile token. For example, several projects introduced the ability to mint dollar-pegged stablecoins in exchange for a dollar’s worth of another token from the same issuer. This relationship also works in reverse, allowing anyone who holds one of these algorithmic stablecoins to redeem it for a dollar’s worth of the volatile token. Other algorithmic stablecoins have used a combination of fiat-backed stablecoins and volatile assets in varying ratios to mint their fiat-pegged tokens.
Algorithmic stablecoins should be viewed as highly experimental—previous iterations have a bad track record of losing their peg during periods of high market volatility. Despite this, not all are necessarily doomed to fail. Some have managed to maintain their peg over long periods of time by finding a sweet spot of partial collateralization. Such fractional algorithmic stablecoins hold a healthy amount of collateral to reassure holders during periods of high market volatility. They also benefit by needing less collateral to expand their supply when demand for stablecoins increases.
TerraUSD (UST) is a now-defunct algorithmic stablecoin developed by Terraform Labs. It ran on the Terra blockchain and maintained its peg through an algorithmic relationship with Terra’s native LUNA token.
The algorithm worked by allowing Terra users to mint one UST by burning a dollar’s worth of LUNA. Conversely, UST holders could also burn it to receive back a dollar’s worth of LUNA in return. This mechanism harnessed market forces to keep UST anchored to its peg. If demand for UST increased and pushed its value over a dollar, arbitrageurs could exchange a dollar’s worth of LUNA for UST and then sell it on the market for a small profit. On the other hand, if UST dropped below its dollar peg, it could be bought and exchanged for a dollar’s worth of LUNA, also netting a gain.
While this algorithmic relationship backing UST may look sound on paper, in practice, it proved fatal. UST infamously collapsed in May 2022 after market volatility caused it to decouple from the dollar. An imbalance between UST and other stablecoins in a decentralized trading pool caused it to start losing its peg. In response, arbitrageurs started buying UST for less than a dollar to exchange it for LUNA.
However, this added immense selling pressure to LUNA, causing it to drop in value as its supply suddenly expanded. As the value of LUNA plummeted—at some points so fast that those attempting to shore up UST’s peg weren’t able to sell it at a profit—it created a negative feedback loop that caused confidence in UST’s peg to plummet. UST holders rushed for the exit as they realized there was nothing material backing the stablecoin. A week after UST first broke parity with the dollar, it traded hands for less than $0.10. LUNA, meanwhile, dropped from around $80 to fractions of a cent. Neither have recovered anywhere close to their former value and are generally regarded as “dead” tokens (Terraform Labs has since launched a new Terra blockchain and relabeled the original UST and LUNA as TerraClassicUSD and Terra Luna Classic, but the new venture has failed to gain meaningful adoption).
UST and LUNA’s death spiral wiped out more than $40 billion of value from the cryptocurrency market. A major reason behind the brutal collapse was the demand for UST created by Terraform Labs’ Anchor Protocol. UST holders could deposit UST into Anchor and earn an outsized return of between 15% and 20% on their stablecoins. However, this yield, and the growth it inspired, were not organic. The majority of the interest depositors were earning was subsidized by Terraform Labs instead of being generated by borrowers. As the crypto market fell throughout the first half of 2022, demand for Anchor’s guaranteed yields soared, causing UST’s supply to balloon to over 10 billion. As the UST market cap edged closer to that of the LUNA token, it became only a matter of time before disaster struck.
IRON is an algorithmic stablecoin minted through Iron Finance. Initially launched on BNB chain in March 2021, Iron Finance aimed to create a stable, partially collateralized algorithmic stablecoin and build an ecosystem around it. Users could mint the dollar-pegged IRON stablecoin by depositing $0.75 of BUSD and $0.25 of Iron Finance’s native STEEL token into the protocol.
Initially, IRON appeared to work as intended. Although it broke parity with the dollar a few times during its first months in circulation, it successfully regained its peg on several occasions. After proving the concept worked, the protocol was later deployed on Polygon in May 2021. This time, IRON was minted using USDC instead of BUSD and a STEEL equivalent token called TITAN.
The influx of liquidity from the Polygon launch drove yields for IRON trading pairs to dizzying heights. At one point, yield farmers could earn 500% APR by providing liquidity for the IRON/USDC trading pool and around 1,700% APR on more volatile pairs like TITAN/MATIC. In turn, demand for IRON soared as DeFi users could earn huge returns by holding a perceptually stable asset. Due to the increased demand, TITAN, the volatile token needed to mint IRON, jumped 3,700% from $1.68 to over $64 between June 2 and June 16.
IRON also got a publicity boost when celebrity entrepreneur Mark Cuban revealed in a blog post that he was a liquidity provider on the Polygon decentralized exchange QuickSwap for the DAI/TITAN pair. Many onlookers took this as Cuban’s endorsement of Iron Finance, fueling a new wave of IRON minting mania.
However, calamity struck less than a week after Cuban’s post. With the TITAN token trading at such an inflated value, many users who had bought it early decided to start cashing out. Several whales started to remove liquidity from IRON/USDC pools, while others sold IRON for USDC instead of redeeming it through the protocol. The immense selling pressure caused IRON’s value to drop under its dollar peg.
Once IRON’s peg broke, it threw the value of TITAN—which made up 25% of each IRON token’s value—into question. A bank run ensued as investors sold out of TITAN and IRON for safer assets. Arbitrageurs also stepped in to buy IRON below its peg and redeem it for $0.75 of USDC and $0.25 of TITAN, immediately selling the TITAN for a small profit. This situation created a death spiral that caused TITAN’s value to plummet. While IRON only briefly dropped below $0.75 due to its USDC backing, TITAN had no such price floor. TITAN plummeted as it soared, eventually bottoming out at a fraction of a penny.
The Iron Finance fiasco marked one of crypto’s first major bank runs. At its peak, the protocol held over $2 billion in total value locked, much of which was erased during the death spiral. Aside from showcasing the unreliability of algorithmic stablecoins, the incident also highlights how blindly following celebrities into their investments is incredibly risky. In the aftermath of IRON’s collapse, Cuban admitted that he had not done his homework on the protocol and called for increased regulation in the crypto industry going forward.
Despite the bad track record of algorithmic stablecoins, one token has managed to find a sweet spot between relying on an algorithm to secure a stable value and overcollateralization. FRAX is a part algorithmic, part fractional reserve stablecoin issued by Frax Finance. The protocol is permissionless, open-source, and entirely on-chain, meaning it requires no centralized authority to manage FRAX. Since launching in late 2020, FRAX has risen to a market cap of over $1.3 billion and has rarely deviated more than a couple of percent from its dollar peg.
The FRAX stablecoin is backed partially by hard collateral, primarily USDC, and partly by Frax Finance’s native governance token, FXS. The protocol decides the precise ratio between the external and internal backing using a PID controller, which adjusts the collateral ratio based on demand for the FRAX stablecoin and external market conditions.
To ensure FRAX’s peg is stable, the protocol lowers the collateral ratio so that less USDC and more FXS is needed to mint or redeem the stablecoin when there is increased demand for it. Conversely, if demand for FRAX starts to drop, the protocol reacts to market conditions and increases the amount of hard collateral needed to mint it. This important feature helps prevent the FXS token from entering a death spiral if FRAX were to drop below a dollar.
The ability to dynamically adjust the collateral ratio based on real-time market conditions gives Frax Finance a significant advantage in scalability and capital efficiency over its competitor Maker, which has fixed collateralization ratios. For Maker’s DAI, minters assume the protocol’s debt through overcollateralized borrowing. However, thanks to Frax Finance’s fractional reserve system, the protocol is responsible for this debt, making it much more efficient to mint FRAX than other decentralized stablecoins on the market.
Crypto Briefing’s Take
Algorithmic stablecoins have gotten a bad wrap—and in most cases, for good reason. After multiple failed attempts to create a stable, unbacked asset, it seems apparent that such efforts will invariably fail. Regardless of how well an algorithm appears to be holding up, destabilization can quickly occur when large holders decide to exit their positions. If there is no guarantee that an algorithmically-backed asset can be redeemed one-to-one with a stable currency, market forces alone will not be sufficient to prevent a crash.
So far, FRAX has proven itself as a rare exception by successfully adjusting its collateral ratio in response to changing market conditions. However, it’s worth considering that Terra’s UST also appeared stable until it ballooned to a market cap of over $10 billion. Weaknesses in Frax Finance’s algorithm could be revealed if its market capitalization hits early 2022 UST levels in the future.
The Future of Stablecoins
While the three types of stablecoins discussed in this article are currently the most prevalent and widely used, there are other unexplored possibilities for creating stable fiat-pegged assets. One possibility is to create a Bitcoin-backed stablecoin using a delta-neutral derivatives strategy. An issuer could hold a combination of Bitcoin-backed BTC/USD futures contracts to create synthetic USD stablecoin. Such a strategy would earn a small positive yield year after year and would be mathematically impossible to be liquidated to the upside.
The main risks involved with implementing a Bitcoin derivatives-backed stablecoin would be the counterparties from which the issuer would use to open its derivative positions. If, for example, one of these centralized entities were to face insolvency, it could default on its derivatives contract payouts. And if the issuer didn’t have enough collateral in reserve to plug the hole in its accounts left by this counterparty default, it could spell disaster for its stablecoin.
However, like with overcollateralized stablecoins, this approach would involve locking up large amounts of Bitcoin to back such a coin. This could become problematic as the Bitcoin network will increasingly need assets to move between parties to generate transaction fees that pay for its upkeep and security. Therefore, as it currently stands, a Bitcoin derivatives-backed stablecoin does not appear to be a strong long-term solution.
Another avenue to transfer value on blockchains without locking up increasingly large chunks of assets is central bank digital currencies—or CBDCs. Rather than private stablecoin issuers like Circle or Tether creating stablecoins pegged to various currencies, central banks could issue fiat money directly on blockchains, controlling supply and demand in much the same way as they do in the real world with national currencies today.
CBDCs eschew the problem of collateralizing stablecoins since central banks directly guarantee their value. However, as many in the crypto space have frequently pointed out, the implementation of a CBDC could violate vital tenants of the crypto ethos such as privacy and decentralization. While several nations such as France and Brazil have said they are experimenting with the idea of a central bank digital currency, few major central banks have plans to release a universal CBDC anytime soon.
Centralized stablecoins currently dominate the market today, and while there are drawbacks to offerings like USDT and USDC, they’ve become ubiquitous in the DeFi ecosystem. It’s therefore unlikely that they will disappear anytime soon.
While centralized stablecoins comprise the bulk of the market, demand for more decentralized alternatives like DAI remains high. The recent stablecoin developments from DeFi staples like Aave and Curve hints that many more decentralized stablecoins will emerge in the future, potentially grabbing market share from DAI. Other products like Reflexer Finance’s RAI, which is backed entirely by ETH, further points to how the decentralized stablecoin space could evolve in the future.
Algorithmic stablecoins have been under the crypto spotlight in 2022, not least since TerraUST’s spectacular collapse in May. The numerous failed attempts at algorithmic stablecoins have drawn the attention of regulators worldwide, suggesting that new attempts to create an algorithmic stablecoin may face significant regulatory hurdles in the future. However, projects like Frax Finance show that innovation in the algorithmic stablecoin space has not yet died.
While there are many types of stablecoin on the market today and each has its own benefits and drawbacks, one thing is certain: stablecoins will form a core part of the cryptocurrency ecosystem for many years to come.
Disclosure: At the time of writing this feature, the author owned ETH, BTC, SOL, and several other cryptocurrencies.