Stablecoins: Game-Changers or Dangerous Speculative Bubbles?

Stablecoins have rapidly gained prominence, serving as vital pillars of liquidity within decentralized finance (DeFi) applications, including decentralized exchanges (DEXes) and lending protocols. These digital assets provide stability, acting as bridges between the crypto and traditional financial realms, offering stability, transparency, and utility to users. In addition to being a medium of exchange, stablecoins are also intrinsically valuable as a store of value. 

The use of stablecoins as a medium of exchange is evident on over 80 percent of major centralized crypto exchanges. Further, stablecoins accounted for 45% of liquidity on DEXes in May 2022, highlighting their significance to the growth of the DeFi market.

However, not all stablecoins are created equal. This article explores the contrasting dynamics between collateralized stablecoins like Tether and USD Coin and algorithmic stablecoins like DAI and TerraUSD. Despite contributing to the stability of the crypto-asset ecosystem, different variants provide different levels of liquidity for decentralized trading.

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Types of Stablecoins

Stablecoins currently have three types competing for market share. These are:

Centrally Issued

First, you have fiat-collateralized stablecoins, they are the easiest to understand; every stablecoin issue is pegged to one unit of a fiat asset. Some examples include Tether, TrueUSD, Dai, Paxos, and USD Coin. The fiat-collateralized stablecoins are, however, centralized. 

The main benefit of a centrally issued currency is that it is backed (usually by the issuer) and, therefore, is stable. However, a lack of decentralization can pose a problem regarding transparency. Additionally, centralized entities have a history of legal problems.

For example, former BUSD stablecoin issuer Paxos recently fell into legal trouble as the SEC wanted to sue it for selling BUSD as an unregistered security. 

Crypto Collateralized

Crypto collateralized stablecoins are secured by reserves of other selected cryptocurrencies (usually a diversified basket) at a higher than 1:1 ratio (to offset the volatility of the underlying collateral). Examples include MakerDAO DAI stablecoin. However, it is also "soft-pegged" to the US Dollar, which means it aims to match its value at any time. Even though DAI is a stablecoin and does not require fiat collateral, collateral can be volatile depending on other forms of crypto. DAI has sometimes surged above $1 or fall well below it.

In addition, DAI provides fewer trading pairs than other cryptos, and it isn't listed on as many exchanges as other cryptocurrencies. Because of this, it may have lower liquidity than other types of crypto.

Non-Collaterized (Algorithmic)

Ideally, algorithmic stablecoins should not be collateralized or at least be collateralized. Instead, they maintain stability by enforcing contract codes that manipulate circulating coin supplies to stabilize asset prices around a peg.

For instance, TerraUSD. At the time, the model was criticized as "a way to create something out of nothing." Still, investors were soothed by mega-yields of up to 20% APY +0.4% (annual percentage yield), "true decentralization." However, in the wake of last year's dramatic collapse of stablecoin TerraUSD and its sister token Terra LUNA, the crypto community pondered the future of algorithmic or programmable stablecoins. 

For collateralized stablecoins like Tether and USD Coin, liquidity provision for decentralized trading or lending is relatively low compared to their total market capitalization (less than 8%). As a result, stablecoins serve multiple purposes beyond DeFi, emphasizing their broader adoption within crypto-asset ecosystems.

A different trend is observed with algorithmic stablecoins like DAI and TerraUSD, which rely heavily on DeFi liquidity. In contrast, DAI's liquidity provision represents more than 30% of its market capitalization, while TerraUSD's represents more than 75% before its crash.

Thus, in the end, all the stablecoins still fail to meet the trinity below:

Having a stablecoin does not necessarily mean its price is fixed at one specific fiat-denominated value. However, it is less susceptible to speculative fluctuations.

Looking ahead, stablecoins hold significant promise for reshaping traditional financial systems and fostering greater financial inclusion. Moreover, their stability, utility, and potential for broader adoption make them attractive alternatives to volatile fiat currencies, particularly in regions where currency stability is a pressing concern. 

However, it is important to tread cautiously in the stablecoin realm. Regulatory oversight, transparency, and ongoing evaluation of stabilization mechanisms are crucial to ensure the trust and confidence of users. In addition, collaboration among market participants, policymakers, and industry stakeholders is essential in establishing robust frameworks that address potential risks and maintain the stability of stablecoins.