Cryptocurrencies were envisioned as a new form of digital money and democratized finance. But extreme volatility has severely hampered their use as currency or payments. Consider Bitcoin – its value plunged from nearly $69,000 in November 2021 to below $17,600 just a year later, only to bounce back above $23,000 at the time of this writing. These gut-wrenching swings make crypto untenable as a medium of exchange.
Enter stablecoins – the cryptocurrencies engineered for price stability. Let‘s demystify stablecoins and evaluate whether they can reliably maintain pegs and drive adoption.
The Promise and Peril of Stablecoins
Unlike fiat money issued by governments, cryptos derive value solely from market demand. Their speculative nature leaves prices vulnerable to large boom-bust cycles.
Stablecoins offer refuge by pegging value to external assets like fiat currency. The peg incentivizes arbitrage to eliminate major deviations – if a stablecoin drops enough below its peg, traders can profit by buying it and redeeming for the underlying asset.
The stability opens doors for blockchain-based innovation. Payments using volatile coins means assuming exchange rate risk. Who wants to pay 1 ETH for a TV today, if that equals $500, only to see ETH plunge 40% tomorrow? Stability allows smart contracts, decentralized finance and other applications to flourish.
However, as algorithmic stablecoin TerraUSD discovered in its spectacular collapse, maintaining pegs can prove harder than designing them. Do stablecoin models match this lofty vision with rock-solid stability? Let‘s breakdown their inner workings.
Stablecoin Models: Backing Assets Provide Stability
Stablecoins use various mechanisms to stabilize value, which we can classify into 4 key models:
Fiat-Collateralized Stablecoins
The most straightforward design backs coin issuance 1:1 with fiat currency reserves, like the dollar or euro. Reserves act as a cushion against supply-demand imbalances. If coin demand rises, more units can be issued against reserves. If it falls, coins can be withdrawn to prop up value.
Examples: Tether (USDT), USD Coin (USDC), Paxos Standard (PAX)
Benefits: Simple model, easier to implement. Fiat reserves provide tangible backing.
Risks: Requires trusting issuers to hold sufficient reserves and allow redemption. History like Tether’s highlights why transparency over reserves is crucial.
| Coin | Launch Date | Peg Asset | Collateralization |
|---|---|---|---|
| Tether | Oct-2014 | USD | Fiat + Other |
| USD Coin | Oct-2018 | USD | Cash + Securities |
| Paxos Standard | Sep-2018 | USD | Cash + Securities |
Crypto-Collateralized Stablecoins
Rather than fiat, these maintain value using overcollateralized crypto assets as reserves. The large cushion handles volatility in the backing assets. If prices fluctuate beyond a threshold however, reserves may need active management like selling coins to maintain the peg.
Examples: DAI, Frax
Benefits: Backed by crypto assets with values verifiable on-chain through smart contracts.
Risks: Still indirectly relies on crypto collateral, although the overcollateralization provides a buffer.
| Coin | Launch Date | Peg Asset | Collateralization |
|---|---|---|---|
| Dai | Nov-2019 | USD | >100% crypto |
| Frax | Dec-2020 | USD | >100% crypto |
Commodity-Collateralized Stablecoins
Some stablecoins peg value to real-world commodities, like precious metals. The idea of currency backed by gold or silver dates back centuries in finance. Holding the commodity in reserves provides solid backing for redemption.
Examples: PAX Gold (PAXG) – backed by gold reserves
Benefits: Stability tied to globally valued commodity as old as human civilization itself.
Risks: Peg depends on the value of just that single commodity.
| Coin | Launch Date | Peg Asset | Collateralization |
|---|---|---|---|
| PAX Gold | Sept-2019 | 1 oz gold | Gold bars |
Algorithmic Stablecoins
The most radical design, algorithmic stablecoins aim for full decentralization without any currency or commodity reserves. Supply and incentive mechanisms coded directly into the token are supposed to maintain the peg.
Examples: TerraUSD (UST)
Benefits: No need for real-world collateral if the algorithm works.
Risks: Relies completely on unproven algorithmic tokenomics. Failure can be catastrophic with no external stabilization.
Now that we‘ve broken down the models, let‘s overview some popular stablecoins and whether stability held up.
Top Stablecoins: Scrutinizing the Peg Performance
Ranking the top stablecoins by market cap, these 4 lead the pack:
1. Tether (USDT)
Launched in 2014 by Tether Holdings Limited, Tether pioneered stablecoins pegged 1:1 to the US dollar. It runs on numerous blockchains like Bitcoin‘s Omni protocol, Ethereum, Tron and others to power frictionless transfers between platforms.
USDT aims to eliminate price volatility by maintaining fiat currency reserves equal to the number of tether tokens issued. But reserves have shifted over time from pure fiat holdings to include other assets like corporate bonds. Tether faced accusations around transparency of its reserves in its early history.
It has weathered past controversy to become the most widely used stablecoin with over $65 billion in circulation. Tether‘s stability helped cement stablecoins‘ value:
Tether (USDT) price chart over 5 years shows it maintained long-term US dollar peg through crypto bear/bull cycles
2. USD Coin (USDC)
Launched collaboratively between Coinbase and Circle Internet Financial in 2018, USD Coin aimed to raise the standard for transparency. USDC reserves are attested to monthly and published online. Reserves must match the USDC 1:1, held in cash and ultra-short duration US Treasuries.
USDC has focused on aggressive regulation compliance, getting approval to operate in jurisdictions globally. It has rapidly grown to over $43 billion in circulation, making it the #2 largest stablecoin.
Trust in its reserves and regulatory oversight helped USDC hold the peg through turbulent times:
Price stability allows USDC‘s use for blockchain payments, lending and digital dollar transactions
3. Binance USD (BUSD)
BINANCE developed BUSD jointly with the Paxos Trust Company, merging Paxos‘ regulatory framework with the exchange‘s massive crypto user base. Like USDC, BUSD maintains 1:1 USD reserves certified monthly by top auditors.
Its extensive regulation compliance, including approval from the New York State Department of Financial Services (NYDFS), helped drive rapid adoption since its 2019 launch. Developed by leading crypto entities, BUSD held its peg reliably:
Jointly created by Binance and Paxos, BUSD maintained perfect 1:1 USD peg
4. DAI
Unlike the other top stablecoins backed by fiat or assets held centrally, DAI aimed for pure decentralization since its launch in 2017. It operates based on Ethereum smart contracts, without reliance on any external entity or fiat currency.
DAI maintains its soft peg to USD through an overcollateralized model backed by crypto assets. It uses dynamic monetary policies coded into its protocol to algorithmically adjust supply based on demand shifts. This automated stability helped DAI hold overall peg through volatile periods:
DAI relied its decentralized crypto-backed model to maintain long-term stability
Now that we‘ve seen the top players and models, it‘s time we confront the elephant in the room. The spectacular failure of TerraUSD stablecoin in May 2022 shattered assumptions of guaranteed stability.
Case Study: How TerraUSD Stablecoin Imploded, Draining $60 Billion in Value
TerraUSD (UST) was launched in 2020 as an algorithmic stablecoin protocol developed by Terraform Labs. Let‘s analyze what happened step-by-step during its implosion:
Overview
- UST targeted a $1 peg without any collateral, using an algorithmic central bank coded in smart contracts.
- It maintained stability via arbitrage and convertibility with LUNA, a sister token in its ecosystem.
- On May 7th, $10B in UST was suddenly unstaked from Anchor protocol causing panic.
- Massive UST selling pressure overwhelmed its algorithmic levers attempting to defend the $1 peg.
- With UST rapidly losing its peg, LUNA holders panicked and rushed to exit, creating a "death spiral".
- Billions drained from the ecosystem, with UST and LUNA losing nearly 100% of value.
| Date | Event Summary |
|---|---|
| May 7-8 2022 | $10B UST unstaked from Anchor protocol, UST selling pressure builds |
| May 8th | UST loses $1 peg falling to $0.98, then crashes below $0.70 over next 4 days |
| May 10th | LUNA down 80%+ in a week as UST depegging shakes confidence |
| May 11th | UST falls under $0.30, LUNA drops from $60+ to $5 in one day |
| May 12th – Now | UST, LUNA hit near $0 valuations, efforts underway to revive LUNA network |
Key Factors in the Crash
Dependence on Unproven Algorithm – Unlike collateral-backed stablecoins, TerraUSD relied solely on algorithmic mechanisms coded into smart contracts to maintain the peg. Worked in theory, proved fatally flawed in practice.
Mass Bank Run – Rapid $10 billion withdrawal of UST reserve assets from Anchor protocol shattered stability, triggering a "bank run". Huge selling pressure was more than the algorithm could handle.
Structural Weaknesses – System depended heavily on new LUNA token issuances, and converting LUNA <=> UST arbs to manage supply. Design flaws got exposed under panic events.
Contagious Fear – UST broke from $1, shaking confidence. With death spiral underway, LUNA collapsed from $60+ to near $0 in days as terrified holders rushed to exit.
Financial Ruin – By May 13th, UST and LUNA lost nearly all value in one of history‘s most stunning crypto implosions. Over $60 billion value erased, devastating holders.
The fallout showed the risks underlying algorithmic stablecoins. Unlike fiat or collateral-based models, algorithmic designs remain largely unproven in handling Black Swan financial events. When panic struck and redemptions flooded in, the whole system came crashing down in a stablecoin bank run.
Stablecoin Viability: Evaluating True Stability
So where does this turbulence leave stablecoins? Can any design fully stabilize volatility as imagined? Let‘s weigh their pros and cons:
Fiat-Collateralized
Pros: Tangible backing by assets most recognize as valuable
Cons: Requires trusting central third-party custodians
Crypto-Collateralized
Pros: Publicly verifiable on-chain backing through code
Cons: Still depends on crypto assets with inherent volatility
Commodity-Collateralized
Pros: Familiar stability of commodities like gold
Cons: Peg relies on single asset‘s value
Algorithmic
Pros: No external backing required if executed perfectly
Cons: Full faith in unproven software, failure can be catastrophic
There exists an inescapable irony around decentralization versus stability. The more decentralized through math alone without real-world collateral, the less battle-tested the stability mechanism is.
Perhaps there is a middle ground, where prudent design blending central guardrails with code-driven automation calms volatility. Just like planes leverage autopilot for routine tasks but human pilots steer us safely through storms.
Conclusion: Caution Warranted But Stablecoins Poised for Growth
The Terra implosion rightfully shook faith and sparked calls for regulation. However, stablecoins address a vital problem and central bank digital currencies integrating blockchain technology are on the horizon.
With prudent governance, transparency and collateralization backing, stablecoins still hold potential to enable real-world use cases. Payments, tokenized assets and smart contracts fundamentally require less volatility.
Mass adoption won‘t materialize overnight. But blockchain-powered innovation waits for stability mechanisms that users trust day-to-day. In sensitive areas like finance, reliability proves itself slowly but surely.
