What are Stablecoins? - Perpetual Protocol 🥨

‍As the world of cryptocurrencies continues to grow and evolve, one type of digital currency has emerged as a popular choice for investors and traders alike: stablecoins. This guide will introduce you to stablecoins, how they function and their importance in Decentralized Finance (DeFi).

Introduction to Stablecoins

Stablecoins are one of the most successful applications of cryptocurrencies that offer a wide range of use cases, such as:

Offering a sanctuary from the volatility of crypto-assets like Bitcoin and Ethereum,
Earning yield in DeFi, and
Protecting people’s wealth in countries that experience hyperinflation.

As a distinct category of cryptocurrencies, stablecoins differ from other cryptocurrencies because they are pegged to a specific fiat currency or commodity (such as the US Dollar, the Euro or gold), meaning that they do not fluctuate wildly in value.

However, similar to Bitcoin and other crypto-assets, stablecoins are also based on blockchain technology. That means these digital assets are available 24/7, with greater accessibility for the unbanked and much easier to transfer than physical currency.

Stablecoins are not all the same, though. Different methods are used to ensure they keep to their peg, along with a variety of minting and redemption mechanisms. When talking about stablecoins, it’s important to keep in mind there are three main types:

Fiat-collateralized stablecoins which are backed by currencies like the US dollar or the euro. The advantage of this model is that they are more suited to maintaining price stability. However, the drawback is that they are more centralized since they’re usually operated by a single or a handful of corporate entities. They also require audits to verify the value of the assets held off-chain. These types of stablecoins have gotten the most traction so far, with some examples being Tether’s USDT, Circle’s USDC and Binance’s BUSD.
Crypto-collateralized stablecoins that utilize a reserve of crypto-assets such as Ethereum to guarantee their value. The advantage of this model is that it tends to be more decentralized. However, capital efficiency is a disadvantage which affects the scalability of these stablecoins, since their users are required to be overcollateralized. For example, $100 worth of a crypto-collateralized stablecoin may only be minted by putting up at least $150 worth of ETH. Some examples are MakerDAO’s DAI, Liquity’s LUSD and Synthetix’s sUSD.
Algorithmic stablecoins aim to maintain a stable value without any collateral backing. This model is the least proven and least successful to date. One example of an algorithmic stablecoin is Terra’s UST, which collapsed back in May 2022.

Each model makes different trade-offs, which gives rise to the term of the ‘stablecoin trilemma’. The trilemma states that such an asset cannot have all three properties of capital efficiency, decentralization, and price stability. There are also hybrid models which combine aspects of the different models highlighted above, such as FRAX, which is a cross between an algorithmic and a crypto-collateralized stablecoin.

Source: stablecoins.wtf

A Brief History of Stablecoins

The need for stablecoin emerged due to the friction between traditional finance and the crypto world. Prior to the beginning of the ascent of stablecoins in 2015, cryptocurrencies were mostly traded against BTC.

However, as the demand for cryptocurrency grew, the need to exit positions in these volatile assets without having to go through the traditional finance system (which is often costly, hostile to crypto, and slow) became greater.

The rising popularity of stablecoins over the years can be attributed to the fact that they can be sent and received instantly. They do not need intermediaries like banks and do not carry the burden of regulations or restrictions that apply to fiat currencies.

The list below details some (but not all) of the main events in the history of stablecoins:

BitUSD, a crypto-collateralized stablecoin backed by BTS, was introduced in July 2014 on the BitShares blockchain. However, it lost parity with the US Dollar at the end of 2018.
NuBits was another early stablecoin experiment which saw two failures in maintaining price stability: once in 2016 and another at the beginning of 2018, where the price crashed from $1 to $0.30 in less than 2 weeks.
Tether USD (initially called RealCoin) was introduced to the crypto market by Bitfinex and Tether Inc. in 2015 and took a different approach to BitUSD and NuBits by collateralizing the stablecoin with off-chain assets.
MakerDAO's decentralized stablecoin DAI launched in December 2017 on Ethereum’s mainnet as one of the earliest DeFi projects. The blueprint for DAI was outlined by MakerDAO founder Rune Christensen in 2015 in this Reddit post.
BUSD was introduced in 2019 and one of the first stablecoins to receive backing from New York regulators.
FRAX was announced in May 2019 and launched in the following year in 2020, becoming the first stablecoin to utilize crypto collateralization and algorithmic stabilization to maintain its peg to the US Dollar.
RAI launches as an alternative to DAI in February 2020. It’s backed by ETH, but not pegged to any stable asset. Instead, the price adjusts algorithmically over time.
Liquity’s LUSD launched in April 2021 as an ETH-backed stablecoin that’s completely immutable, with no governance.
The UST collapse during early May 2022 drew criticism, as well as increased scrutiny, of cryptocurrencies and stablecoins.
Aave released the technical whitepaper for its GHO stablecoin in October 2022.
Curve Finance deployed its crvUSD stablecoin in May 2023.
In April 2023, a multi-collateral version of the RAI stablecoin was proposed and is due to launch on Optimism in July 2023.

How do Stablecoins Work?

The three different categories of stablecoins mentioned have implications for price stability and whether there’s a need for trust.

Fiat collateralized stablecoins work by holding a reserve of the underlying fiat currency equal to the number of stablecoins in circulation. For example, if there are 1 million stablecoins in circulation, the issuer should hold $1 million in reserve. This ensures that the stablecoin's value remains stable and is not affected by market volatility. However, the user has to place some trust in the company that issues and redeems them so that they are not ‘cooking the books’ or engaging in accounting fraud.

On the other hand, crypto-collateralized stablecoins that utilize a reserve of other cryptocurrencies get around the issue of trust by decentralizing issuance and redemptions. But the trade-off is that these types have to use a trusted oracle since there’s no way for blockchains to track the price of any collateral used to mint these types of stablecoins.

In the following sections will examine the most popular stablecoins, explain how they work and their pros and cons.

USDT

USDT is currently the leading stablecoin with a dominance of 63.33% according to DeFiLlama and the company behind Tether works closely with cryptocurrency exchange Bitfinex.The minting and redemption of these tokens for USD is only available to Tether customers who have undergone a verification process.

Tether can be described as a fiat-backed stablecoin, but it has been the subject of much controversy over the years. Critics claim there are no adequate audits or a lack of collateral assets to back up the USDT supply. Nevertheless, it is dominant when it comes to trading volumes, likely due to its first-mover advantage.

As well as USDT, Tether also offers many other stablecoins. For example, the EURt which is pegged to the Euro and XAUt, which is pegged to Gold.

USDC

USDC, launched by Coinbase and Circle, is the most widely used stablecoin in DeFi applications since it is perceived as the safest stablecoin since it is fully regulated in the US (unlike USDT). But as with USDT, the mechanism for keeping the peg is similar: users are incentivized to mint (or redeem) new tokens when the price is too low (or high) to maintain price stability. Therefore, arbitrageurs can earn a profit by helping to maintain the peg.

USDC is fully backed by cash and short-dated U.S. government obligations, so it is always redeemable 1:1 for U.S. dollars. The minting and redemption for USD is only available to eligible businesses with a Circle Account. What’s notable about USDC is that it is available across many more chains than USDT (which is predominantly based on Tron and Ethereum).

BUSD

BUSD, created by Binance, is backed by fiat to maintain a 1:1 value with the US Dollar. This stablecoin is approved by the New York State Department of Financial Services (NYDFS) and issued in partnership with Paxos. The minting and redemption of BUSD can be done through Paxos, but only for customers who have undergone a verification process.

However, Paxos has been in talks with the SEC since February 2023 after the American regulatory agency said that it should have registered BUSD as a security. The total supply of BUSD dropped sharply following the news, currently standing around $5.76 billion (the lowest value since April 2021).

Source: CoinMetrics

While USDT, USDC and BUSD are the most popular centralized stables, there are alternatives that are more decentralized and have gained a lot of traction amongst crypto users. In the following sections, we’ll provide a brief overview of the three most popular decentralized stablecoins.

DAI

DAI was introduced in 2017 by MakerDAO that maintains a ‘soft peg’ to the US Dollar. The MKR governance token plays a role in governing the system, such as adding new collateral types or adjusting the protocol’s parameters.

Source: MakerDAO

To maintain this peg, a system of collateralization and stability fees are used. Users can deposit any Ethereum-based asset as collateral into Maker’s vaults and mint up to 66% of the collateral’s value in DAI. If the value of the collateral falls below a certain threshold, the collateral is liquidated to ensure that the DAI remains fully backed. When the loan is repaid to retrieve the collateral, the DAI that’s paid back is burned.

While DAI is the first decentralized stablecoin that comes to mind for most people involved in crypto, there are some drawbacks to be aware of. Most of its balance sheet consists of USDC, so it essentially relies on another stablecoin that is centralized and backed by fiat.

This has led to debate about whether DAI should be fixed to the US Dollar and allowed to float freely in order to prioritize the decentralization property from the stablecoin trilemma mentioned earlier in this post. Nevertheless, MakerDAO plans to improve decentralization and improve innovation in DeFi with their long-term plan, known as the ‘Endgame’.

Another project that has pursued the floating peg idea proposed for DAI is RAI, created by Reflexer Finance. RAI sacrifices the price stability aspect of the stablecoin trilemma and instead focuses on decentralization and capital efficiency. However, RAI is only backed by ETH but more recently, a multi-collateral version of this stablecoin was proposed to be launchd on Optimism (known as HAI).

FRAX

Frax Finance’s FRAX is an interesting and unique design that uses a FRAX-USDC base pool on Curve as a swap facility and Algorithmic Market Operations to maintain its peg.

To mint FRAX tokens, users need to supply two collateral tokens: USDC and the project’s governance token, known as Frax Shares (FXS). When the demand for FRAX stablecoin increases, the system can expand the money supply beyond the total collateral in the system, ensuring stability.

Source: Eugene Ang

The project’s FXS token gives governance rights to holders and the ability to vote on adjustments to collateral pools, add new pools, and change the collateral ratio. FXS holders can also lock FXS into veFXS to earn a portion of the protocol’s revenues. As more FRAX tokens are minted and used, it is expected that more FXS tokens will be burned and removed from circulation.

To dive deeper into FRAX, check out the guide linked below:

https://flywheeldefi.com/p/frax-101-what-is-frax-a-complete

As well as the USD-pegged FRAX, the project also offers two other stablecoin products:

an inflation-resistant stablecoin FPI that uses the US Consumer Price Index to adjust its price and maintain purchasing power with on-chain stability mechanisms.
frxETH is pegged to ETH and can be staked to earn validator/MEV rewards, providing an alternative to solo staking and other liquid staking derivatives.

LUSD

Liquity’s LUSD has seen more adoption and attention in recent times given the concerns around stablecoin centralization. While it works in a similar manner to DAI, there’s a more attractive collaterization ratio where up to 90% of the collateral value can be used to mint LUSD.

However, only ETH can be used as collateral since it is more decentralized and cannot be censored (unlike USDC). Liquity also differs from MakerDAO in that it takes a ‘governance minimization’ approach and is completely immutable.

Through Liquity’s troves, users can mint LUSD using ETH with 0% interest and pay a one-time fee of 0.50%. The system allows LUSD holders to redeem their tokens for the underlying ETH collateral at face value at any time. When a trove falls below the 110% collateralization ratio, the liquidated ETH is distributed to those that provide LUSD to the Stability Pool, effectively allowing these users to automatically dollar cost average into ETH.

Source: DeFiLlama wiki

LUSD has a price floor at $1, and if the peg is lost to the downside, holders of LUSD can always redeem it for $1 worth of ETH. However, there’s a soft peg between $1.00 and $1.10, so the LUSD value can fluctuate within this range.

But the stability mechanism ensures it is pulled back down close to $1 when needed, as explained in this blog post. Because of this mechanism, LUSD has performed well even in extreme market conditions and has even consistently displayed a slight premium against the US Dollar.

Uncovering Insights into Stablecoins

The supply growth of a stablecoin is a good metric to track the adoption of these different options presented above. Tracking stablecoins flows can also help with investing decisions and help you to assess the risk appetite of traders.

The following list provides a non-exhaustive list of resources to uncover insights into stablecoins and the wider crypto ecosystem:

CoinMetrics: monitor on-chain indicators such as active addresses, supply growth and more.
CryptoQuant: track supply, exchange flows and number of transactions.
Dune Analytics: discover a variety of stablecoin-related dashboards built by Dune Wizards (useful if you want to dive deeper into a particular project).
DeFiLlama: provides a ranking of different stablecoins, as well as detailed information on their TVL, peg deviation and much more.
Nansen: offers detailed stats on stablecoins, such as exchange flows and smart money percentage holdings in stablecoins indicator to gauge whether “smart money” addresses are holding stables or deploying them to non-stable crypto-assets.
Stablecoins.wtf: A Bloomberg terminal styled website educating degens about stablecoins.

Earning Yield with Stablecoins in DeFi

DeFi is a new type of financial system that is built on blockchain technology. It aims to provide an alternative to traditional financial systems by allowing users to access financial services without the involvement of intermediaries like banks.

Stablecoins play a crucial role in the DeFi ecosystem. They are used as a medium of exchange, a store of value, and a unit of account. They enable users to access DeFi services without the need for traditional fiat currencies.

For example, you can borrow or lend stablecoins with automated lending protocols such as Aave, use them as collateral to trade or market make in a decentralized way on Uniswap or Perp, or earn a return using automated investment strategies provided by projects like Reaper Farm or Yearn Finance. Perp also has a vault product, known as Hot Tub, that allows you to earn yield in USDC. Sign up for updates about the Hot Tub and get whitelisted.

Risks Associated with Stablecoins

While stablecoins offer several advantages over traditional cryptocurrencies, they are not without risks. One of the major risks associated with stablecoins is the risk of collateral failure. If the collateral backing the stablecoin fails, the stablecoin's value can become unstable, leading to significant losses for investors.

Another risk associated with stablecoins is the risk of regulatory intervention. Regulators may impose harsh restrictions on stablecoins, which could impact their value and popularity. In such a scenario, only the most decentralized stablecoins will survive.

The Future of Stablecoins

The future of stablecoins looks bright. As more investors and traders seek stability in their investments, the demand for stablecoins is likely to increase. Expect to see more innovation in the stablecoin space, with some recent newcomers being Aave’s GHO, Curve’s crvUSD, Reflexer’s HAI and Rico. While stablecoins are not without risks, their future looks bright given that as more investors get involved in DeFi, the demand for these popular crypto-assets is likely to increase.