17 Nov, 2022
5 min read
As the decentralized finance (DeFi) ecosystem grows, stablecoins are becoming increasingly popular with each emerging use case. According to a recent report from Binance Research, stablecoin market capitalization grew by more than 3,000% between January 2020 and January 2022—with the most rapid growth from 2020 to 2021.
Unlike other cryptocurrencies, stablecoins are pegged to the value of another currency, commodity, or financial instrument, making them less susceptible to market volatility. In addition, because stablecoins maintain near-constant value, they’re often seen as a safer entry point to the digital asset class. And while this is mainly true, there are always risks that investors must consider.
The high-profile Terra stablecoin (UST) collapse in May 2022 highlights these risks, contributing to a 7.7% reduction in stablecoin market capitalization as of June of the same year. However, it’s important to note that not all stablecoins are the same, and each has a unique risk profile. For example, while UST was algorithmic, there are also fiat-backed, crypto-backed, and commodity-backed stablecoins. This article will discuss how each stablecoin type maintains its peg and its associated risks.
Fiat-backed stablecoins are pegged to the value of fiat currency, usually the USD. In this case, fiat collateral is kept on reserve by a central issuer who is responsible for maintaining the stablecoin supply. So, for example, if the issuer holds $1,000 on reserve, there can only be 1,000 stablecoins worth $1 in circulation. These stablecoins are “centralized” because the fiat collateral is held physically, not in on-chain smart contracts.
Although fiat-backed stablecoins garner the most attention and trust, there are still potential risks associated with their use. Specifically, because collateral isn't on-chain, a third party must audit reserves regularly to ensure they reflect the circulating token supply. For example, if there are 1,000 stablecoins in circulation (each worth $1) but only $900 held in reserve, the real value of each stablecoin is $0.90, not $1. This reality is problematic because it undermines credibility and de-pegs the stablecoin, causing further sell-offs and price depreciation.
Asset-backed stablecoins are generally over-collateralized to maintain a constant peg. This dynamic helps buffer against price fluctuations in the underlying collateral. For example, if an investor wants to mint 1,000 DAI stablecoins on Maker (each worth $1), they would need to deposit crypto collateral worth $1,500—representing a collateralization ratio of 150%. This excess collateral helps protect the protocol and investors during extreme market volatility.
Because investors need to lock their collateral in smart contracts on-chain, these stablecoins are considered decentralized. As a result, users can retrieve their collateral later by paying stablecoins back into the contract and liquidating the position or trading them on secondary markets for other digital assets.
For many, the biggest downside to crypto-backed stablecoins is the need to provide excess collateral, a less capital-efficient practice. Because of this dynamic, investors have fewer funds to allocate elsewhere, effectively reducing yields and overall ecosystem growth. Beyond this concern, there are also risks associated with the dependence on smart contracts, especially when bad actors exploit vulnerabilities. For this reason, investors must ensure they interact with audited smart contracts built and deployed by reputable projects.
Commodity-backed stablecoins are collateralized using real-world assets, most notably gold. For example, each Paxos Gold (PAXG) stablecoin is backed by on fine troy ounce (t oz) of a 400 oz London Good Delivery gold bar stored in Brink's vaults. As the price of gold rises, traders benefit from their fractional ownership of the underlying asset held in custody by the Paxos Trust Company. Although similar to gold exchange-traded funds (ETFs), PAXG stablecoins represent actual ownership of the physical commodity, not just its price.
Because commodity-backed stablecoins are not securities, they are not subject to the same regulatory requirements. As such, it's essential to ensure that collateral reserves are audited regularly to maintain credibility and stabilize the stablecoin price. Beyond this risk, investors should be aware that commodity-back stablecoins are generally less liquid than other cryptocurrencies and fiat. However, despite being less liquid, commodity-backed stablecoins are typically considered relatively safe compared to other stablecoin types, especially those that utilize algorithms.
Algorithmic stablecoins don’t utilize fiat, crypto, or commodities as collateral. Instead, they employ algorithms executed by smart contracts to maintain price stability. In general, there are three different algorithmic stablecoin mechanisms:
A rebasing algorithmic stablecoin adaptively adjusts the stablecoin's total supply to maintain a fixed peg, such as $1. For example, if the price of a stablecoin falls below the peg, the protocol will reduce the number of stablecoins in circulation. Conversely, if the price rises above the peg, more stablecoins are released into circulation. The Ampleforth protocol is one example of this mechanism, changing the number of tokens in user wallets daily based on a weighted average of the token price every 24 hours.
The seigniorage algorithmic stablecoin model usually consists of two cryptocurrencies: stablecoins (coins) and seigniorage ownership (shares). If the stablecoin price exceeds the fixed peg, shares are utilized to increase the supply of coins, bringing the price back down. Conversely, if the stablecoin price falls below the peg, most seigniorage-style stablecoin protocols issue a redeemable bond to incentivize investors to buy, raising the price.
Simply put, fractional algorithmic stablecoins combine the features of algorithmic and collateralized stablecoins. However, these stablecoins don't require over-collateralization and have fewer custodial risks. Furthermore, unlike solely algorithmic protocols, this model aims to enforce a tight peg and high stability. At this time, Frax is the first protocol to offer a partially-collateralized protocol, with FRAX serving as a $1-pegged stablecoin and FXS acting as a governance token.
Algorithmic stablecoins come with the most risk because they are usually uncollateralized and rely on algorithms, financial engineering, and market incentives to peg the price of a particular asset. In addition, because algorithmic stablecoins rely on an intricate balance of supply and demand, self-motivated, independent investors are more likely to impact the price negatively. For example, if demand drops dramatically, the entire system will collapse—the same would happen if investors sell simultaneously.
As the DeFi ecosystem evolves, stablecoins are poised to play a significant role in user adoption. As less volatile digital assets, these cryptocurrencies are meant to function as an effective store of value and medium of exchange, aligning them more closely with traditional fiat currencies. However, not all stablecoins are created equal, and understanding the interdependencies between components is critical.
At the core, the degree of collateralization defines the strength of any crypto, fiat, or commodity-backed stablecoin. For this reason, projects must work to remain trustworthy and transparent about reserve holdings. If credibility is damaged, collateral devaluation can negatively impact the stablecoin price, triggering a more significant selloff reminiscent of a class bank run.
And while algorithmic stablecoins are entirely decentralized and on-chain, they also come with inherent risks. For example, like crypto-backed stablecoins, these digital assets are susceptible to smart contract vulnerabilities. In addition, algorithmic stablecoins are largely uncollateralized, meaning there's no safety net if the protocol fails.
No matter which stablecoin is selected, investors must conduct their research and understand the technical signals of the token under consideration. Despite the stablecoin moniker, there is much more to consider when deciding whether or not to invest in these unique digital assets.