DeFi 101: Not All Stablecoins Were Created Equal (A Cautionary Tale)

Stablecoins give cryptocurrency investors the best of all worlds: a low-volatility asset with high transactional speed, low transactional cost, and the ability to access decentralised finance (DeFi) services in a few clicks.

— —

Decentralisation has changed everything we thought we knew about finance. 

Where you used to have to deposit money with a bank to earn interest, you can now trust software to provide exactly the same service.

Where you used to have to fill out mounds of paperwork and wait weeks for a loan, you can now get one almost instantly and in a few clicks. This is all thanks to a basket of decentralised finance (DeFi) applications on the blockchain.

Today, anyone in the world can earn interest, borrow money, or take out insurance with nothing more than an internet connection.

But to do this, you’ll have to get comfortable using stablecoins.

What is a stablecoin?

A stablecoin is a digital token that pegs its value to a stable reserve asset. 

There are dollar-backed stablecoins like USD Coin (USDC) and Tether (USDT). There are gold-backed stablecoins like Paxos Gold (PAXG).

There are even stablecoins backed by cryptocurrency itself. DAI, for example, uses Ethereum in its reserve. The caveat with DAI is that it is over-collateralised: it has 150% of the value of its circulating supply in its treasury.

You see, most stablecoins deposit reserve assets into a vault every time someone mints the token, which preserves their peg. And the process allows users to access DeFi services, all while avoiding the volatility of cryptocurrency.

After all, many investors question the point of earning 8% APY on an asset like Bitcoin if the price of Bitcoin could drop by 50% while you hold it.

Stablecoins avoid outcomes like these, but some do it better than others.

Allow us to explain.

Three categories of stablecoin

Broadly speaking, there are three categories of stablecoin.

Tokens like USDC and USDT are fiat-backed stablecoins. They’re 100%-backed by fiat currency reserves, which some say makes them easier to trust.

• USD Coin (USDC) owns U.S. Dollar cash and cash equivalents equal to 100% of its circulating supply, so users know they can redeem 1 USDC for $1;
• Tether (USDT) has a similar reserve, but it includes a mix of U.S. Dollar cash, cash equivalents, and notes on loans made to third parties.

Both USDC and USDT have proven themselves trustworthy over the years, which is why their combined circulating supply is well over $100 billion. 

What’s more, neither one has suffered a prolonged depeg. A token like DAI is a crypto-backed stablecoin (while DAI also pegs its value to the U.S. Dollar, it uses a basket of cryptocurrencies to maintain its peg). 

At the other end of the spectrum, you have algorithmic stablecoins, which is where you see how some stablecoins are more stable than others.

Algorithmic stablecoins: a cautionary tale

Algorithmic stablecoins are the opposite of collateral-backed stablecoins. 

That is — they have no treasury. Instead, they rely on a predefined set of rules (enforced by computer code) to manage supply and maintain their peg. 

The concept may sound somewhat crazy until you realise that central banks work on much the same model. They have no currency reserves. They print money when needed in a cat-and-mouse game, balancing interest rates and inflation.

The crucial difference is that central banks have decades of experience. In contrast, the algorithmic stablecoin concept is barely twelve months old, and if you’ve read the news this year, you’ll know the experiment hasn’t gone well.

In early 2021, a new layer-one blockchain broke onto the scene. 

Its name was Terra, and supporters were excited about an innovative mint-and-burn mechanism used to hold the peg of its native stablecoin TerraUSD (UST).

Here’s how the algorithm worked:

• Anyone could swap $1 worth of a token called Luna for 1 UST
• Anyone could burn 1 UST for $1 worth of Luna

The Terra blockchain attracted developers looking for an alternative to Ethereum.

And as its popularity grew, so did the supply of UST. Terra also launched an application called Anchor, offering a yield of around 20% on UST.  The issue was that Anchor was printing money from thin air, which didn’t matter much during the bull market.

But then sentiment turned.

The start of 2022 saw rising inflation coupled with Russia’s invasion of Ukraine, and long story short: nervous investors started to withdraw their UST.

At this point, shortcomings with Terra’s algorithm started to become apparent. Which is why, on May 7th, 2021, UST lost its dollar peg for the first time. After that, an effective bank run ensued, and Terra had to print billions of Luna in the face in UST redemptions.

Luna’s price then collapsed, UST followed suit, and that was it — $60 billion of value up in smoke, and it’ll take a long time before investors trust another algorithmic stablecoin.

Which leaves us with one final question.

What is the safest stablecoin?

History is the greatest teacher.

Look back across a decade of blockchain technology, and you’ll see just a handful of assets have survived the test of time.

We trust Tether (USDT) and USD Coin (USDC) because they’re some of the most battle-hardened stablecoins; they’ve endured bull and bear markets without so much as a wobble (and that’s why they power our stablecoin savings plans).

On the other hand, tokens like UST hold hidden risks, so despite the offer of lucrative yields, we make it a policy to steer clear.

That’s why we didn’t lose a cent of client funds during the 2021 market rout.