Deep Dive – Stablecoins

Stablecoins: A trend that keeps on giving

Stablecoins play a fundamental role in the crypto sector, allowing users to easily on-ramp from fiat to digital assets, conduct cheap payments, or lend and borrow on DeFi protocols. Unlike fiat money, stablecoin transactions allow for direct settlement and are peer-to-peer, meaning they don’t require intermediaries. Moreover, stablecoins provide people with more control over their money.

For these reasons, stablecoins are popular, recording a market capitalization of $128.3 billion as of June 20, 2023. Compared to the market cap in May 2020, which was around $11 billion, the market value of stablecoins has grown by over $100 billion in about three years – quite a phenomenal ride.

On the left are the 10 biggest stablecoins by market cap, mostly USD-based.

On the right, there are some gold- and euro-based ones.

Source: Coingecko

Important to note: Stablecoins aren’t built the same. Therefore, they could be fiat-backed, crypto-backed, algorithmic, or a combination of these categories. A stablecoin’s type depends on the mechanism used to maintain price stability.

Stablecoins: A global topic

While stablecoins are less volatile than regular crypto assets, they still pose a risk to investors if they depeg from the peg value. Stablecoins, whose reserves are held by traditional banks, are more centralized and as we have seen in the past, these centralized entities can pose a risk. Crypto-collateralized stablecoins instead can more easily be affected by the volatile prices of their underlying crypto assets.

As stablecoins (mostly the fiat-backed ones) have grown in importance, some consider them relevant for overall financial stability. Therefore, regulators across the globe are introducing regulations for stablecoins in the hopes of minimizing such risks. For example, the US House Finance Services Committee published a draft bill on stablecoins in April 2023. The bill highlights stablecoin issuers’ requirements, like providing monthly reports of their reserve assets. Also, it clarifies that stablecoins aren’t securities, meaning they won’t be under the SEC’s jurisdiction.

Most stablecoins are still issued on top of Ethereum. Smart contract blockchain Tron is second, mostly because of its low fees. 

Source: CoinGecko

In Europe, the Markets in Crypto Assets (MiCA) legislation tackles stablecoins by establishing requirements for stablecoin issuers, such as maintaining “appropriate minimum liquidity as a reserve” and creating recovery and redemption plans. Moreover, MiCA classifies stablecoins into two categories: e-money and asset-referenced tokens. MiCA will take effect in 2024. The European regulator also plans on banning algorithmic stablecoins, once its regulatory framework has passed.

Japan is ahead of Europe and the US in stablecoin regulations after its stablecoin legal framework took effect on June 1, 2023. The stablecoin law restricts stablecoin issuance to registered financial institutions. Moreover, it states that stablecoins must be pegged to the Yen or another fiat currency and redeemable at face value. Japan introduced the stablecoin bill in 2022.

As stablecoin regulations is taking shape, the introduction of new price-stable crypto assets is underway in Japan and Europe. For example, Mitsubishi UFJ Financial Group (MUFG), a bank in Japan, is set to deploy stablecoins on public blockchains. In Europe, Finland-based company Membrane Finance launched a (permissioned) Euro-backed stablecoin called EUROe on Ethereum in early 2023.

On-shore versus off-shore

In the future, some experts think that global stablecoin standards need to be established, especially since they could affect the monetary policies of emerging economies (crypto dollarization threatening local currencies). However, G7 and G20 aren’t on the same page on how to frame these global standards.

The stablecoin market is mainly dominated by a few prominent players, namely USDT, USDC, DAI, BUSD, and a few others. However, Tether (USDT) has gained over the rest by a large margin, scooping a 64.77% (depicted in purple in the image below) market share at the time of writing. USDC comes second (illustrated in blue in the graph below) with a market share of around 21%. That means the two stablecoins dominate more than 85% of the stablecoin market, making them the most significant players and highly competitive against each other. As a result, the on-shore vs. off-shore debate has emerged, where experts compare the on-shore (US-based) USDC to the off-shore USDT (outside the US).

Stablecoin total market cap as well as dominance.

Source: DeFiLlama

For instance, on-shore stablecoins are issued by regulated entities, while off-shore stablecoin issuers may not necessarily be regulated by jurisdictions like the US. As of now, the off-shore narrative is playing harder. This is illustrated by USDC’s performance that has been declined.

Some speculate that stablecoins, aka crypto dollars, will follow the path of eurodollars and thus mainly develop outside the US. The eurodollar market emerged due to a harsh tax environment in the US in the 1960s, forcing entities to create a source of dollars that US regulations couldn’t affect. Also, Russian banks were banned from having access to the US, while still needing to pay in USD. This is why they set up shop with European banks, providing them with US dollar derivatives.

A changing landscape

As the US regulatory crackdown intensifies, we could see US-based stablecoin issuers moving off-shore. However, moving off-shore may not be an immediate option for companies already under regulators’ scrutiny. For example, BUSD’s performance was affected when the New York State Department of Financial Services (NYDFS) asked Paxos, the issuer, to stop minting new Binance USD (BUSD) tokens in February 2023. About three months later, the SEC filed charges against Binance, further impacting BUSD. Consequently, BUSD has dropped to fourth place in the market cap ranking, and DAI has taken its place.

Still, off-shore jurisdictions are not the only place to go. Issuers may also move fully on-chain, joining other on-chain stablecoins like DAI. Ultimately, blockchains represent a new type of “digital high sea”, where regulation has a harder time of taking full effect.

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Did you know?

The Maker protocol is the issuer of DAI, a stablecoin backed by a basket of different assets. 38% of its reserve assets consist of real-world asset vaults. Over 20% is still held in USDC. Some of its other reserved assets include ETH, staked ETH vaults, WBTC, and RETH. Even though DAI is currently the third-largest stablecoin by market cap, it has been experiencing reduced user interest, which it seeks to tackle by increasing the DAI savings rate (DSR) to 3.49% from 1%. This change could encourage investors to hold and lend DAI. Also, it might help DAI compete better with USDT and USDC. The savings rate increase was voted for on June 15, 2023.

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Stablecoin trends worth watching

Yield-paying stablecoins

Now that interest rates have increased across the board, yield-paying stablecoins will increasingly become the preferred choice for investors when compared to non-yielding stables. USDT and USDC are examples of non-paying stablecoins, since they don’t natively pay any yields.

The rise of LSDFi, a blend of liquid staking derivatives (LSDs) and DeFi, is allowing investors to mint interest-bearing stablecoins. Using LSDs for overcollateralized stablecoins makes them interest-bearing, since LSDs generate staking income while being backed by ether. According to data on Dune Analytics, eUSD is the top LSD stablecoin by market share. LSDfi stablecoin protocol Lybra Finance issues it. In second place is R, followed by GRAI. R is issued by Raft, while Gravita issues GRAI. While LSD-backed stablecoins are relatively new, they could experience rapid growth in the future.

An overview on the LSD backed stablecoins.

Source: Dune Analytics

Bitcoin-based stablecoins

Recent upgrades to the Bitcoin protocol — Taproot and SegWit — are making Bitcoin-native stablecoins possible. There are BRC-20 stablecoins like Stably USD, which are minted directly on the Bitcoin blockchain. Stably USD was introduced in May 2023, but it is only the innovative avant-garde. Going forward, Bitcoin-based stablecoins will most likely use Taproot Assets, a better protocol that permits users to issue assets like stablecoins on the Bitcoin blockchain. The stablecoins can then be transferred over the Lightning Network (LN) for low-fee and instant transactions. Taproot Assets, previously Taro, is currently on the test network. It will only help make Bitcoin-based stablecoins more popular.

Decentralizing stablecoins

Ethereum DeFi is presently also experiencing increased interest in decentralized stablecoin models where different protocols are using various mechanisms to achieve full decentralization. For a stablecoin to be considered decentralized, it should have uncensorable collateral and fallback plans for (decentralized) oracles. However, creating a fully decentralized stablecoin is a long-term goal. Naturally, investors are more interested in LSDfi yields than decentralized stablecoins. Still, the demand for decentralized stablecoins is inevitable. Liquidity protocol’s LUSD and Reflexer Finance’s RAI are examples of decentralized stablecoins.

Three Stablecoins to Watch Out for

crvUSD

crvUSD is a collateralized debt position (CDP) stablecoin. This means that users deposit collateral in digital assets to mint and borrow crvUSD. The issuer, Curve Finance, uses an innovative AMM model called Lending-Liquidating AMM Algorithm (LLAMMA) to provide timely liquidation against the collateral that is below the liquidation threshold.

GHO

GHO will be a stablecoin issued on the Aave protocol. Just like crvUSD, users must deposit collateral to mint and borrow GHO. In this case, ETH collateral is needed to mint GHO. Aave is set to launch GHO on Ethereum soon. Its goal is to make stablecoins more useful in real-world payments.

FRAX

FRAX is a formerly algorithmic stablecoin issued on the Frax Finance protocol. It is 80% backed by a crypto asset and partially backed algorithmically. However, the algorithmic backing will be phased out following a community vote in February 2023. This will make FRAX fully collateralized. Additionally, Frax Finance plans to launch a layer-2 network, Fraxchain, by the end of 2023.

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Looking for alpha? Curious about some current stablecoin yield opportunities? It’s time to do your own research, and this Twitter thread might help: https://twitter.com/yieldinator/status/1669739659344379906

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