The $1 question on everybody’s lips
Despite the crypto slump, there are still stablecoins out there that provide security and have a reputation of trust. Nonetheless, the reputation of stablecoins has taken a serious dent, and arguably the downfall of Terra USD pushed mass adoption of decentralized finance back a few years.
According to CoinGecko data, there are currently 84 stablecoins in circulation with a combined market capitalization of more than 163 billion dollars. The majority of these are pegged to the US dollar and, like other cryptocurrencies, need to be considered investments and they have the potential to fail. Even if you feel confident you won’t lose your investment, be prepared to lose whatever money you put in. Moreover, the point of this article is to identify stablecoins with solid fundamentals and the least chance of failure.
Why we need to talk about stablecoins
Over the last few weeks, the rapid downfall of one of the biggest US dollar-pegged stablecoins, Terra USD, has shone a bright light on the stability of an industry segment worth an estimated $162 billion. In the fallout of the UST debacle, other stablecoins started losing their respective pegs, calling for a broader review of the market and a deeper understanding of what stablecoins are and how they work.
Recent events with UST have shown us that some stablecoins have restrictions. Terra’s native token LUNA, one of the most valuable assets in the market, collapsed to near zero on May 12 after plummeting 99% in 24 hours after the network’s stablecoin TerraUSD (UST) lost its dollar value. This then started a crypto bank run during which users sold large chunks of LUNA as fear of a collapse arose. Now, UST is worth less than $0.10, while LUNA has lost 99.99% of its value in a week.
How stablecoins work
Stablecoins are digital currencies designed to maintain a one-to-one peg to a more stable underlying asset, like a national currency—some of the most popular stablecoins on the market peg to the U.S. dollar. Moreover, stablecoins can help manage the volatility and retain value within the crypto market.
They grew in popularity and utility during the summer of DeFi in 2020 as stablecoins allow market participants to move in and out of crypto trades easily, improving the usability of volatile cryptocurrencies and creating more liquidity in the crypto market. The direct peg to a more stable asset allows market participants to use stablecoins when crypto price fluctuations become too difficult to predict.
The different types of stablecoins are labeled according to their underlying collateral design, fiat-backed, crypto-backed, commodity-backed, or algorithmic. Terra USD or UST is what is known as an algorithmic stablecoin. Unlike USDT, BUSD, and USDC, which hold fiat assets in reserve to back their tokens, UST relied on a complex set of codes, coupled with a LUNA token, to balance supply and demand and stabilize the price.
In essence, UST was an experiment to test the effectiveness of using crypto assets to back a stablecoin. The experiment has failed, but it shouldn’t cause broader concern for the other leading stablecoin projects supported in different ways.
Which stablecoins are trustworthy?
We can look at the structure and financial backing of the leading stablecoins. This helps investors understand the risks more deeply, as we can consider stablecoins backed by regulated government assets as safer options, compared to those supported by crypto assets. Transparency is essential here, and arguably, USDC is the most transparent as it publishes monthly reports on the state of its reserves backing the stablecoin.
USDC is fully backed by cash and short-dated U.S. government obligations so that it is always redeemable 1:1 for U.S. dollars. Each month, they publish attestation reports by Grant Thornton regarding the reserve balances backing USDC.
USDT, or Tether, is a cryptocurrency stablecoin pegged to the U.S. dollar and backed “100% by Tether’s reserves,” according to its website. While this has been debated openly, there is still nothing to prove Tether doesn’t have the reserves it states it holds to back USDT.
DAI is a decentralized stablecoin running on Ethereum that attempts to maintain a value of $1.00. Unlike centralized stablecoins, DAI isn’t backed by US dollars in a bank account. Instead, it’s backed by collateral on the Oasis DeFi platform, which was conceived by the same people behind the Maker and DAI project.
BUSD is 100% backed by reserves held in either or both fiat cash in dedicated omnibus accounts at insured U.S. banks and U.S. Treasury bills. This would also include repurchase agreements and money-market funds invested in U.S. Treasury bills.
Stablecoins in the market
Looking at the top ten stablecoins by market capitalization is an excellent place to begin. You are zoomed in on the stablecoins that have the most usage and are traded on the most exchanges. As seen, USDT trades on 335 exchanges while USDC trades on 284. Below that line, we see only BUSD and DAI trading on more than 100 exchanges at writing. Exchanges are putting their faith in these four stablecoins, and the trading volume seen below for each confirms that traders trust those stablecoins more.
Those significant peaks on May 11 stem from the UST fallout as investors got spooked and started shifting vast amounts of stablecoin assets out of markets. On the other side, a lot of arbitrage trading by opportunists trying to make profits on the tiny differences between stablecoins over the last week has pushed trading volume up. Nonetheless, the bulk of stablecoin usage relies heavily upon these four, and there is a lot of liquidity within their respective ecosystems.
Why does it matter?
Firstly, over $15 billion in value has been wiped out by the demise of LUNA and UST, while tweets and reports of LUNA holders keep arriving that talk of self-harm and savings being wiped out. A lot of people got financially hurt in the collapse. Moreover, it’s not confined to the Terra ecosystem. Some UST and LUNA holders may have been forced to liquidate other holdings to make up for the shortfall, leading to selling pressure and potentially bringing the whole market down.
Secondly, and the reason for this article, the event raises questions about other stablecoins. UST was unusual because it was an algorithmic stablecoin, unlike USDT and USDC. But if UST was attacked, then a blueprint now potentially exists to go after other algorithmically pegged stablecoins. Indeed, DAI had a similar debacle back in 2020, but the strength of its community and liquidity carried it through.
Finally and most importantly, for a few reasons depending on how you feel about regulation. The collapse of UST has caught the attention of politicians, regulators, and industry spectators en masse. While BTC and ETH made big drops in value during the week, the headlines were all about Terra. On Tuesday, Secretary of the Treasury Janet Yellen said that UST’s de-pegging “simply illustrates that stablecoins are a rapidly growing product and there are rapidly growing risks.”
The future of stablecoins
It’s reasonably safe to say that regulation will be a strong theme for stablecoins in 2022. Like other cryptocurrencies, stablecoins operate outside the U.S financial system, and officials have repeatedly highlighted concerns about crypto assets slipping through regulatory cracks.
Federal authorities, among others, are primarily concerned about stablecoins because they hold the most potential for future use by everyday customers and shoppers to buy things, which is a highly positive thing despite many people’s fear of regulation. It will clean up the space and make things more transparent for investors. Moreover, it will legitimize a billion-dollar industry further and potentially bring it out of the shadows.
Areas ripe for development in a bear market seek to add value and, most importantly, deliver services at a lower cost than legacy services. Think about NFT event tickets, NFT-infused marketing campaigns that drive brand interaction, point-of-sale infrastructure using stablecoins, and more. Because of that, expect to see and hear continued conversations about stablecoin regulation this year and possibly even legislation.
The old saying ‘you have to break some eggs to make a cake’ fits here. Many forget that DeFi as an industry is a little more than three years old. Some of us probably had sneakers for longer. Working models have come and gone, and arguably DeFi is due another wave of innovation since Compound introduced their DeFi governance token back in 2020. Despite much negativity and fear-mongering, we at DappRadar are genuinely excited to witness the evolution of dapps and their underlying mechanics at arguably a pivotal moment.