Analysis: Stablecoin is not a “stable currency”, its essence is a product

introduce

It’s no secret that “stablecoin” is a misnomer in the crypto space. First, the stability of these assets varies widely. Second, the term “stablecoin” refers to many different technologies that maintain some value or “pegging” in the crypto ecosystem. Some stablecoins are backed by huge amounts of cash, while others are backed by elaborate calculations and financial engineering. Retail investors interested in stablecoins face the challenge of navigating this complex landscape. They must assess the risk with their hard-earned savings.

In such complex situations, managing this risk involves more than just information. This information is not helpful if we are not inclined to evaluate it critically. To stimulate such participation, it may be helpful to emphasize the fact that cryptographic schemes are financial products. When consumers buy a product, they can go through a series of thoughts. The researchers break down these thought processes into distinct stages: defining a buying problem, searching for product categories and information, evaluating alternatives, and more.

When we also define stablecoins as products, it may help inspire similar patterns of consumer behavior. Products competing with each other have more or less unique advantages, so these characteristics can encourage us to carefully weigh the pros and cons. This careful product evaluation happens when we buy everything from underwear to a new laptop. However, the term “stablecoin” may lead some to unfortunately miss this assessment and only dangerously weigh one function (such as interest rates on lending platforms).

The purpose of this article is to discuss various properties of stablecoins as products. I’m not as an expert in macroeconomics, but as a data scientist, consumer and market player, so I’m fascinated by this complexity. First, I share some history, and the article ends with a discussion of what the product concept means.

Definition + History

The most common is a stablecoin pegged 1:1 to the U.S. dollar. 1 unit of crypto asset equals 1 USD. The benefits of this setup are obvious – the stability of dollar transactions, and the convenience of having it exist in a particular crypto ecosystem. The first crypto stablecoins appeared around 2014, including the well-known Tether stablecoin (then known as “Realcoin”).

Analysis: Stablecoin is not a "stable currency", its essence is a product

The concept of stablecoins has been around since before all recent technological developments, as shown above in the quote from the MasterCoin white paper. In a 2012 article, George Selgin described a potential asset class that would “undertake a fully elastic supply schedule to maintain stable purchasing power.” I learned about Selkin’s paper during an interview with Nick Carter. Nick himself has an informative and detailed “crypto dollarization miniseries” on the On the Brink podcast. This miniseries explores how dollar-denominated stablecoins became the first true “killer app” for public blockchains. The miniseries covers a plethora of examples, technical details and applications.

As these discussions foreshadowed, stablecoins are now a huge part of the entire crypto space. Alex Svanevik recently observed that dollar-pegged stablecoins top the list in terms of market capitalization. Alex hilariously quipped: “3 of the top 7 cryptocurrencies are now USD.” At the time of writing, 3 of the top 5 by 24-hour volume are USD:

Analysis: Stablecoin is not a "stable currency", its essence is a product

The volume and general appeal of stablecoins is a reflection of the dollar’s strength. Traders can lock in USD and not settle in actual USD.

But what are the ingredients of stablecoins? Their internal details are very important. The recent debacle of Terra’s LUNA and UST reminds us that these different kinds of stablecoins have different characteristics, and it is necessary to thoroughly evaluate them and inform retail investors about them. Unfortunately, as an asset class, the label of stablecoins is lumped together with its most recognizable characteristic: “stability.” But there are quite a few technical details behind each stablecoin. In the next section, I’ll cite an excellent new resource designed to do this kind of educational work: stablecoins.wtf.

Major stablecoin types

An excellent resource for tracking and learning about stablecoins is stablecoins.wtf by @dennis_zoma and @mike1third. The website provides concise, clear explanations of the main categories of stablecoins. In this scheme, stablecoins are divided into three categories: fiat-backed, crypto-backed, and algorithm-backed (and possibly a fourth, a mix of these approaches).

Analysis: Stablecoin is not a "stable currency", its essence is a product

Fiat-backed stablecoins: There is a certain correspondence between a fiat-backed stablecoin and the asset (usually a USD asset) that backs it. Tether is known to back its $1 peg with a variety of assets, including other digital tokens. An ideal fiat-backed stablecoin has a ratio of at least 1:1 to reserve dollars. Stablecoin holders can be confident that 1 unit of their stablecoin will always be redeemable for $1 in the service reserve. Fiat-backed tokens: USDC (Circle), USDT (Tether), USDP (Paxos), BUSD (Binance).

Analysis: Stablecoin is not a "stable currency", its essence is a product

Analysis: Stablecoin is not a "stable currency", its essence is a product

Crypto backed: They maintain a $1 peg by holding other crypto assets and often overcollateralizing stablecoins with those assets. Think DAI, the most successful crypto-backed stablecoin. The peg of DAI is protected by a 1:1.5 collateral that uses ETH and other tokens, including other stablecoins such as fiat-backed USDC. In other words, for every 1 unit of DAI, $1.50 (or more) of crypto assets are backed as reserves. DAI does this through a contract vault-based collateral commitment. Cryptocurrency support: DAI (MakerDAO), MIM, LUSD (Liquid), RAI (Reflexer).

Algorithmic Stablecoin (or “minting”): An algorithmic stablecoin can be defined as a currency that remains pegged to some external value (such as the U.S. dollar) through the use of algorithms within the crypto ecosystem, without the need for collateral. For example, an on-chain algorithm could pair a stablecoin with another asset. The second asset is the native asset of an ecosystem of which stablecoins are a part (such as UST and Terra’s LUNA) and are in a minting and burning relationship with stablecoins. When a holder wants to exchange 1 unit of the stablecoin (UST), they receive $1 in the native asset (LUNA). Conversely, if LUNA holders want some UST, they can burn $1 of LUNA to get 1 UST. This can be maintained through on-chain arbitrage, which happens entirely within the blockchain (like Terra). For example: IRON (Iron Finance), UST (Terra), FEI (Fei Protocol).

fluctuating prices? An important observation is that the price of all stablecoins fluctuates. The market price of stablecoins depends in part on the behavior of traders on exchanges. USDC is backed 1:1 by U.S. dollar holdings, but trading in USDC can cause its exchange rate to fluctuate around 0.1% per day. This is because there is a process of arbitrage trading. Arbitrage participation with balanced incentives maintains the peg. But stablecoin projects sometimes have other ways to adapt. For example, MakerDAO voted to adjust its collateralization ratio to lower the price of DAI, which rose rapidly on exchanges during the 2020 cryptocurrency crash (more on this below).

Trilemma: Efficiency, Stability, Decentralization

Analysis: Stablecoin is not a "stable currency", its essence is a product

The three types of stablecoins are often compared using the trilemma. Stablecoins can only optimize two of three criteria: capital efficiency (how easy an asset is to create), price stability, and decentralization. For example, fiat-backed stablecoins are highly centralized because they rely on holdings by one or a few specific organizations (like USDC), but this makes them highly efficient. Cryptocurrency-backed stablecoins are more decentralized but less capital efficient because they often rely on their pegged overcollateralization (like DAI). Algorithmic stablecoins are both decentralized and efficient because they rely on automated on-chain algorithms — but this makes them significantly more risky and volatile.

These tradeoffs are easy to see in the data. I pulled a history of fiat-backed stablecoins (USDC) and crypto-backed stablecoins (DAI) indexed by Coin Metrics, and some data from CoinMarketCap’s algorithmic UST. In the graph below, the red dots reflect the number of days when the coin deviates from the $1 peg by 0.5% or more. DAI is the most well-known cryptocurrency-backed stablecoin, and we can see some instability during the 2020 crypto crash. This is explained in the April 2021 State of Web Money Metering.

Analysis: Stablecoin is not a "stable currency", its essence is a product

Coin Metrics, CoinMarketCap (UST)

The so-called “death spiral” of stablecoins is an extreme embodiment of this trilemma. Recently, both UST and LUNA fell to around $0. At the time of the crash, this represented over $40 billion in capital — it was like the market for two or more Ethereum NFTs completely disappeared in a day or so.

As mentioned above, UST and LUNA are in a minting and burning relationship on-chain in the Terra ecosystem. The carry trade maintained the peg, but in some cases the peg was unsustainable and the death spiral resulted in erratic hyperinflation of LUNA supply and the collapse of the UST peg. Simply put, as the spiral started, the owners of UST panic-sold (burned), causing LUNA to be minted, but this caused the price of LUNA to fall too quickly (and panic-selling on exchanges, bringing the market price of LUNA greater pressure). The result is a feedback loop, and LUNA cannot maintain the peg. As the supply of LUNA increases, its value decreases, causing more LUNA to be minted and holders to flee UST. Nansen has written a detailed analysis of this decoupling event, as well as the real collapse of the entire Terra ecosystem, which may be the biggest so far in crypto history.

Analysis: Stablecoin is not a "stable currency", its essence is a product

In a recent article on stablecoins, Vitalik Buterin shared important points about understanding the limitations of these assets. Developers should think more carefully about their designs — thinking carefully about how the coin would react in extreme cases, like what to do when there are no users or numbers. He describes that in this case, the LUNA/UST pair can easily collapse. He thinks a major detail is how the stablecoin ecosystem can be drawn elegantly, and RAI is more flexible in this regard because it has on-chain collateral (ETH).

many other products

Stablecoins pegged to the U.S. dollar are the best known. But there are many other examples of stablecoins, including those pegged to other cryptoassets. The biggest example is probably WBTC. Bitcoin owners can participate in the Ethereum ecosystem by locking their Bitcoins to the WBTC service. When they do, the corresponding amount of WBTC is minted on their ERC-20 contract. Interestingly, the total locked value of WBTC may represent one of the largest sums of Bitcoins held. Now, owners of BTC can use their BTC as an asset to participate in the DeFi ecosystem on Ethereum. Another example is the ptoken project allowing cross-chain assets to be pegged to BTC and many other assets.

Analysis: Stablecoin is not a "stable currency", its essence is a product

RAI is sometimes considered a stablecoin, but it has more complex dynamics and is not tied to a specific external value or asset. RAI is backed by ETH, and ETH is deposited to create RAI. RAI uses a contract-based adaptive mechanism to keep its market price and exchange price close to each other. RAI’s creators jokingly call it “the first true stablecoin,” and its technical details are fascinating. Introducing control theory mechanisms into smart contracts helps stabilize relative market and exchange prices. So, while the value of the stablecoin fluctuates, you can exchange it in the market for roughly the same price. The initial value of RAI was $3.14, and it is still fluctuating around $3.

In the future, innovative solutions may be devised for stablecoins that represent more complex asset portfolios. Of course, this mechanism is well known in traditional finance. The very popular exchange-traded funds (ETFs) bear a strong resemblance to this idea. It is interesting to imagine how cryptographic systems and innovative financial engineering could create new types of stablecoins in the future. In our imagination, we could envision an asset called “$BASKET” that utilizes an oracle and allows commodity-denominated donations to charitable services or aid programs based on the average price of household groceries fluctuating . Or “$TUITION”, a coin that fluctuates with the value of 1 year of education at a university or other institution. Parents or relatives can gradually invest $TUITION over time until they receive 4 $TUITION tokens in the future.

This is not an ICO-designed game, at least not quite. The fundamental difference here with hollow ICOs is that external goods, services or other assets, pegged, linked to other things as the primary value mechanism.

Stablecoins as financial products

Tascha from Tascha Labs has an interesting idea on Terra and UST, here is a tweet of hers describing stablecoins as a “product”:

Analysis: Stablecoin is not a "stable currency", its essence is a product

Her thesis is that the assets backing stablecoins should generate true network effects in a way that is independent of stablecoins. Terra and UST are too closely intertwined, and there is not enough diversity of activity on the Terra (ecosystem) chain. Vitalik noted that RAI is backed by ETH, a cryptocurrency with potentially the greatest network effects and diverse applications. For this reason, the demand for ETH will be less correlated with the demand for stablecoins (like RAI) collateralized by it. This means that RAI is less likely to be caught in a death spiral, or a nasty feedback loop, because it has enough other economic activity to support it.

This actually brings more complexity: we not only have to focus on the stability mechanism, but also have to evaluate the characteristics of the stablecoin ecosystem. In fact, some argue that stablecoins could grow so fast that they could affect the wider macroeconomic system in traditional finance. In a recent podcast discussion with David Beckworth and Manmohan Singh, Manmohan described some of the potential touchpoints between the wider financial system and stablecoins.

Ross Stevens, Nick Carter, and Alan Farrington discussed various DeFi restrictions in a just-released report. The report details Terra and the algorithmic stablecoin, describing a purely in-house minting system as “alchemy”: the magic it promises is tantalizing, but simply impossible to deliver. The report also sharply criticized DeFi on Ethereum and other broader smart contract chains. As we discuss here, they also warn that misleading terminology can “maliciously prevent” important research. They concluded the report with the idea of ​​“LiFi,” which is clearly a new DeFi-like model in the Lightning Network. Regardless of one’s opinion on this new framework, one should ask probing questions about all EVM-based DeFi and this newfangled LiFi.

  • Reliability of product benefits. If I get something from here (like interest), where does it come from? Is it true, sustainable growth in supply from the ecosystem? Or is it an unsustainable feedback loop of recursive re-staking?
  • The adaptability of the system. How unstable is the peg and/or the ecosystem, and how many tools does the ecosystem have to accommodate shocks? Does it have significant on-chain or off-chain reserves to maintain the peg?
  • Refund Policy. If the market value of the stablecoin collapses, can I still redeem the pegged units?
  • Vitalik’s conundrum. What if I suddenly became the only person in the ecosystem? Or, what if everyone in the crypto space asked to join? What if everyone suddenly decided to leave?
  • Centralization and control. After considering all these factors, can the operators of this stablecoin simply change the policy without my knowledge? Will a sudden change in policy or implementation change the above product evaluation?

     

We haven’t discussed lending platforms (like Anchor). There are also impressive potential applications in some stablecoin projects, such as USDC’s API.

All of these complexities suggest that stablecoins should be considered product categories like “electric drills,” “desktop computers,” or “cars.” On the surface, each is designed to perform a specific set of functions. Electric drills are narrowly used, and desktop computers are more widely used. But when we, as an interested buyer, take a closer look at these products, we take the time to read reviews, evaluate product features, and identify the differences between instances of these categories, and stablecoins are no exception.

For example, in the UST mania, many investors were too focused on a single variable – the Anchor rate. They don’t consider other potential product features that make UST a riskier bet.

The concept of “product” is quite simple, but a way to gain a broader understanding of the strengths and weaknesses of crypto projects (especially stablecoins). The “stablecoin” label has the potential to make these products too homogenous. This brings deeper risks.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/analysis-stablecoin-is-not-a-stable-currency-its-essence-is-a-product/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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