Holding Steady: The Rise of Stablecoins
Michael Zhao
Last Updated: 3/17/2023 | 27 min. read
In 1976, economist Friedrich Hayek wrote a paper titled “The Denationalization of Money,” where he argued that allowing private currencies to compete with each other would create a more stable monetary system. Hayek reasoned that, unlike technology, the organic evolution of money was interrupted by the emergence of government-controlled currencies, and that government intervention in the system has led to instability and inflation. Hayek imagined a world with a competitive market for private currencies, each backed by a variety of assets; a world where the value of each currency would be determined by supply and demand rather than the decisions of various sovereign entities.
Today, proponents of Bitcoin like to reference Hayek. After all, the introduction of Bitcoin partially represents a move in the direction of what Hayek may have envisioned: a denationalized currency that isn’t directly subject to control of a centralized entity, with a value determined by supply and demand. Though, critics note that Bitcoin’s volatile nature makes Bitcoin less than ideal in supporting a user’s daily purchasing power.
Instead, we might argue that Hayek’s vision aligns closer to that of stablecoins.
The Holy Grail
So, why do stablecoins’ value continue to grow?
Since inception, stablecoins have been one of the few token categories that have maintained market capitalization in both bull and bear markets, even when other major cryptocurrencies, like Bitcoin and Ethereum, have fluctuated wildly (Figure 1). Most cryptocurrencies tend to correlate in terms of market capitalization – but stablecoins aren’t like most cryptocurrencies. The relatively steady market capitalization of stablecoins potentially indicates that most users are not redeeming their stablecoins for fiat. Rather, they are more likely to keep stablecoins within the crypto ecosystem.
Figure 1: Stablecoin Market Capitalization vs Bitcoin and Ethereum Market Capitalization
Source: Coinmetrics, Grayscale Research, “Stablecoins” Market Cap comprises of USDT, USDC, BUSD, DAI, GUSD, HUSD, PAX, SAI, TUSD, and USDK, data as of 3/9/23
In fact, stablecoins are gaining momentum; they now represent a significantly larger portion of the BTC and ETH market cap, surging from under 1% at the start of 2017 to over 20% as of March 2023 (Figure 2). This growth reflects the rising appeal of stablecoins in comparison to their larger cryptocurrency counterparts.
Figure 2: Stablecoin Market Cap as a % of BTC + ETH Market Cap
Source: Coinmetrics, Grayscale Research, “Stablecoins” Market Cap comprises of USDT, USDC, BUSD, DAI, GUSD, HUSD, PAX, SAI, TUSD, and USDK, data as of 3/9/23
So, why are stablecoins so popular?
Figure 3: Stablecoin Market Cap vs BTC/ETH trading volume
Source: Coingecko, Grayscale Research, as of 3/11/2023
Figure 5: Share of <$1K crypto transaction volume made up of stablecoins
Source: Chainalysis, Grayscale Research, data measured from July 2021 – June 2022
Next, we’ll take a quick tour of the three primary designs for stablecoins, and explore some of the current challenges facing them. Then, we’ll consider the likely trajectory of stablecoins over the near term.
When the first stablecoins were issued in 2014, experimentation with various designs happened almost immediately. In this section, we’ll review the most popular stablecoin design mechanisms, feature some notable projects from each design, and provide an update on the market landscape of each.
Source: Coinmetrics, Grayscale Research, as of 3/2/2023
Tether’s USDT and Circle’s USDC
At a high level, crypto-collateralized stablecoins are stablecoins minted against overcollateralized loans. For example, assume that a user has $150 of ETH. If the user wanted to unlock $100 of liquidity from ETH without losing their ETH exposure, the user could find a stablecoin protocol that offered 150% collateralization ratio, deposit their $150 of ETH, and receive $100 of stablecoins as a form of a collateralized debt position (CDP). However, if the collateralization falls below 150%, the protocol partially liquidates the underlying crypto collateral (ETH) to bring the collateralization ratio back to 150% (Figure 8).
Figure 8: Example of how DAI’s collateralization works
Source: hackernoon.com, @kermankohli, Figure is for illustrative purposes only
Rune Christensen founded MakerDAO in March 2015, with the initial goal of creating a stablecoin built on Ethereum, which would later become the DAI stablecoin (DAI). The project was first announced on Reddit under the name
DAI’s stability mechanisms are complex. In addition to automatic liquidations that occur when the borrower goes under a certain collateral threshold, DAI also features both a “Stability Fee” and a “Savings Rate” that impact the DAI supply and demand curves, respectively, in order to maintain its peg.
1. The Stability Fee represents the interest rate charged to the borrower for taking out a DAI loan, which helps to regulate DAI’s supply.
For example, if DAI demand is low, MakerDAO needs to shift the supply curve left by decreasing supply in order to maintain the peg. MakerDAO does this by increasing its Stability Fee, making it more expensive for users to borrow DAI, and incentivises them to pay back their DAI loans.
2. The Savings Rate represents the interest rate DAI depositors receive, which helps MakerDAO regulate DAI demand. The higher the Savings Rate, the more demand there will be for DAI, which shifts the demand curve left.
For example, if DAI’s supply increases, MakerDAO could increase its Savings Rate to increase DAI demand.
DAI’s underlying collateral is diversified, as well. While initially the protocol only accepted ETH as collateral, MakerDAO has expanded to accept other collateral, including USDC, wrapped Bitcoin (wBTC), Compound (COMP), Chainlink (LINK), and even real world assets — each with their own collateralization ratios. Despite initial volatility in its early years, DAI has become more stable over time, even with higher fluctuations in ETH’s price action (Figure 9).
Figure 9: DAI’s price vs ETH’s price
Source: Coingecko, Grayscale Research, as of 3/9/2023
Algorithmic stablecoins are not backed by any assets or cryptocurrencies, but are instead pegged through a seigniorage algorithm that incentivizes arbitrage. Seigniorage — a concept that stems from the issuance of currency — historically refers to the monetary gain that governments reap in the issuance process. When it comes to cryptocurrency, seigniorage mechanisms are used to uphold the stability of a stablecoin’s value by tweaking its supply in response to demand.
In essence, a seigniorage mechanism operates by adjusting the supply of a stablecoin contingent on its current market value. If the stablecoin’s worth exceeds its intended value, the mechanism intervenes to increase its supply by minting new tokens, which are then put up for sale in the open market. The increase in the number of tokens theoretically results in a decrease in the price, ultimately bringing the value of the stablecoin back down to its desired level. On the flip side, if the value of the stablecoin is below the target value, the mechanism adjusts the supply by purchasing tokens from the market, thus reducing the number of tokens in circulation and, correspondingly, theoretically increasing the price to bring the stablecoin’s value back up to its intended level (Figure 10). Ultimately, the peg is maintained via arbitrage opportunities instead of collateralization.
Figure 10: Theoretical example of how an algorithmic stablecoin burns supply to return to peg
Source: Grayscale Research, For illustrative purposes only
Terra Luna
The now infamous Terra network was launched in January 2018, and Terra’s stablecoin, UST, was launched in 2020. UST aimed to maintain its 1:1 parity with the U.S. dollar through a dynamic relationship with Terra’s native cryptocurrency, Luna.
At the heart of this Luna-UST relationship was an arbitrage opportunity that arose every time UST deviated from its peg. When UST supply was low and the demand was high, its price surpassed $1 to a price like $1.01, for example. To bring UST back to its peg, Terra permitted users to burn 1 USD of Luna and mint 1 UST, which could be sold for $1.01, providing a profit of 1 cent. Users could create as much UST as necessary by burning Luna until UST returned to $1.
Conversely, when the supply was excessive and the demand was low, the opposite was incentivized. If the price of UST fell below $1 to a price like $.99, for example, Terra allowed users to purchase 1 UST for $0.99, then trade 1 UST for 1 USD of Luna. This trade burned 1 UST and minted 1 USD of Luna, resulting in a profit of .01 USD. While seemingly insignificant, these earnings could accumulate with large-scale trades.
The Trilemma
Each of these stablecoin designs has its own unique flaw. In the industry, these tradeoffs are often referred to as the “Stablecoin Trilemma,” as it is impossible to achieve all three features at once. The current understanding is that stablecoin projects can only prioritize two of the following three features:
In other words, in order to excel in two areas, stablecoin projects must inevitably make some compromises in the third area. In summary:
Asset-backed stablecoins, like USDC and USDT, are known for their stability and capital efficiency, with a 1:1 collateralization, but each has centralized control that poses a dependency risk, as we saw with USDC’s exposure to Silicon Valley Bank.
Crypto-collateralized stablecoins, like DAI, offer stability and decentralization, but they require a higher collateralization ratio for minting, making them less capital efficient than other options.
Algorithmic stablecoins, like UST, are decentralized and capital efficient, with a unique peg maintenance mechanism, but each lacks the operating history and its mechanism has inherent issues that pose a risk of potential price instability.
Despite the current dominance of asset-backed stablecoins, which rely on centralized institutions, decentralized stablecoins that operate on incentive structures and underlying crypto prices are making headway. As the crypto ethos gains traction, we believe decentralized solutions will gain even more popularity.
New Developments
Creating a stablecoin that solves “the Trilemma” is a complex and challenging task. Despite the complexities, protocols are continually exploring and piloting new approaches – and regulators and policymakers around the world are more actively involved in stablecoin development. Each presents new opportunities and challenges to navigate.
There are more than a few notable projects that are experimenting with various stablecoin mechanisms.
Source: Dune, @SebVentures, as of 3/9/2023, holdings subject to change
Other stablecoin projects are opting for completely new models in tackling the stablecoin trilemma. UXD protocol, which launched in late 2021, initially started as a decentralized stablecoin project on the Solana ecosystem. Instead of relying on crypto collateral or algorithmic mechanisms, UXD’s stablecoin was backed by a delta neutral position consisting of a collateral and a short perpetual futures position. To achieve the delta-neutral position, an investor could hold a long Solana spot position and a short Solana perpetual futures position. If the price of Solana increases, the value of the long Solana spot position held by the investor will rise while the value of the short Solana perpetual futures position will decrease. Nevertheless, the underlying value of the delta-neutral position will remain constant. Because the value of the position is balanced by a long and short position, the value remains stable despite any underlying changes to the asset price. While it’s still too early to tell if this design is sustainable, the novel experimentation contributes to advancing the technology.
Figure 13: BUSD Market Capitalization during NYDFS and SEC actions
Stablecoins offer some refuge in a world of crypto volatility. However, optimizing their design is a complex and challenging task, requiring developers to address issues like liquidity, collateralization, regulation, and algorithmic stability.
Nonetheless, stablecoins continue to capture interest and gain adoption across various sectors. Asset-backed stablecoins, like USDT and USDC, continue to maintain dominance, while experimentation and development of new stablecoins and CBDCs continues.
While increasing regulatory scrutiny in the crypto industry may impact the development and adoption of stablecoins in the short term, we believe their unique features and benefits make them a valuable asset long term in the digital economy. As innovation continues in the cryptocurrency space, the potential for stablecoins to disrupt certain sectors of the traditional financial system remains significant.
[1] Measures the relationship between the changes of two or more financial variables over time
[2] “Burning” in the context of cryptocurrency typically refers to when a user takes a specified amount of cryptocurrency out of the circulating supply
[3] Every Ethereum block has a base fee. When the block is mined this base fee is “burned”, removing it from circulation.
[4] The ERC-20 is a standard for fungible tokens on Ethereum. In other words, they have a property that makes each token be exactly the same (in type and value) as another token. E.G. 1 USDC = 1 USDC
[5] As of 3/7/2023 according to ultrasound.money
[6] As of February 2023
[7] As of February 2023
[8] As of February 2023
[9] A bank run is a situation where a large number of depositors withdraw their funds from a bank at the same time due to concerns about the bank’s solvency or ability to meet its financial obligations.
[10] A black swan event refers to a rare and unexpected occurrence that has a significant impact on society or the economy
[11] As of 3/7/23 based on https://makerburn.com/#/rundown
[12] A “Wells Notice” is a correspondence that the SEC sends informing the recipient of accusations that it plans to level against them and gives the recipient the chance to correct their behavior and provide a written response.
[13] As of 3/7/2023 according to Coingecko
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