Stablecoins have been hugely beneficial for the cryptocurrency markets since USDT launched in 2014. Having a stablecoin in an ongoing volatile market is convenient; that’s why it is easy to see the popularity of this kind of asset. Nonetheless, there’s a critical factor that stablecoins have to achieve, which is stability.
As tech stocks decline in value and inflation all-time high, cryptocurrency investors look for a safe haven. Various blockchain protocols offer attractive returns on dollar-pegged stablecoins. For this reason, multiple protocols have launched their stablecoin pegged to the US dollar offering staking incentives as high as 30% APY. As with every investment, these high returns are not risk-free.
What Are Stablecoins?
Cryptocurrencies are susceptible to extreme volatility regardless of marker conditions. Many projects have explored ways to minimize risk and incentivize investors to participate in their ecosystem. When stablecoins enter the picture, these kinds of assets are tokens pegged to different currencies and goods. The main goal of stablecoins is to maintain stability in their price. There are four kinds of stablecoins: fiat-backed, crypto-backed, commodity-backed, and algorithmic.
Fiat-backed stablecoins, as the name suggests, are tokens collateralized by fiat reserves off-chain. For example, USTD and USDC are fiat-backed stablecoins with fiat reserves that remain proportional to the issued stablecoin on-chain. Crypto collateral stablecoins are backed by another cryptocurrency using smart contracts.
The perfect example in this category is the stablecoin DAI. Algorithmic stablecoins use smart contracts and game theory concepts to obtain price stability. Finally, commodity-backed stablecoins are collateralized using physical goods such as gold, real estate, and oil.
Algorithmic Stablecoins’ Popularity in Q1’22
In theory, stablecoins do not pose as much risk as volatile cryptocurrencies. While this is not entirely true, investors still want exposure to the market, and stablecoins are the perfect tokens to invest in while maintaining a risk-averse strategy. Many blockchains created algorithmic stablecoins in their network because they are easier to deploy since they do not need fiat reserves.
Additionally, they truly represent a decentralized token, which is one of the main points of cryptocurrencies.
Different protocols have developed their stablecoins to obtain liquidity in their ecosystem. How these projects attract liquidity is by offering staking rewards on their stablecoins. It is the case of the popular stablecoins pegged to the US dollar, such as UST, USDN, USDD, and USN.
Utility from Stablecoins
These stablecoins, like any other asset, need utility and demand to defend their peg with the dollar. In the case of UST, Terra’s stablecoin, the utility comes from Anchor Protocol, and it’s 20% APY. USDD, Tron’s stablecoin, offers 30% APY in the Sun.io DeFi ecosystem. USDN, Waves’ stablecoin, offers 8-15% in the Vires defi protocol. Finally, Near’s new stablecoin, USN, provides at least a 10% annual yield in protocols such as Bastion, Burrow, and Aurigami.
Since algorithmic stablecoins are not backed by fiat reserves, it can be dangerous depending on their mechanism to keep the peg. For this reason, these stablecoins have proposed a cryptocurrency reserve to maintain the peg. In the case of USDD and UST, the protocols have acquired Bitcoin, creating a fund to support their peg. On the other hand, Near’s USN it’s backed by Near tokens and USDT.
Algorithmic Stablecoins and the Crypto Market
Algorithmic stablecoins pose a significant danger to the cryptocurrency market since their peg depends on smart contracts and specialized algorithms. These algorithms reduce the tokens in circulation when the price of the currency that it tracks falls conversely. If the cost of the token exceeds the price of the currency that it follows, new tokens enter the market, reestablishing the parity. The stablecoins use this model discussed previously.
There’s a lot of skepticism regarding algorithmic stablecoins since they risk falling into a downward spiral. It is what happened to Terra’s stablecoin UST, which lost its peg to the US dollar, collapsing to a price below $0.30. The deppeging of UST caused a massive sell-out of Luna tokens; in consequence, Terra’s algorithms to create UST brought the whole ecosystem down.
Luna token suffered a massive dump falling 99.99% in less than 48 hours, causing one of the worst events in cryptocurrency history.
The Necessity of Stablecoins despite Its Risk
Stablecoins are helpful in the cryptocurrency markets since they do not suffer volatility as other digital assets. A robust system is needed to create a stablecoin that maintains its peg to the asset it tracks. Fiat-backed stablecoins are the ones that have maintained parity for the longest time, such as USDT and USDC. However, these stablecoins are not entirely risk-free investments since USDT has deppeged a few times since its inception.
Although algorithmic stablecoins pose certain risks, some investors prefer this stablecoin over fiat-backed. Algorithmic stablecoin are attractive because they are decentralized, unlike their counterpart (fiat-backed). Since algorithmic stablecoins work with smart contracts and specialized algorithms, users can utilize them perpetually without government intervention. Algorithmic stablecoins sacrifice stability for decentralization which can create colossal risk as black swan events, as with UST.
Stablecoins are necessary for the crypto market since they attract institutional money; thus, it’s pretty unlikely that they will disappear. The regulation of these assets will protect investors from black swan events in the future. The perfect algorithmic stablecoin is still far away from being created. Many algorithmic stablecoins have failed, and many will die in the future.
UST was the predominant stablecoin in the cryptocurrency market, it was deemed too big to fail, but in the end, its model was not sustainable. UST is a grand experiment for algorithmic stablecoins, but it was not robust enough to withhold the immense pressure from the market. The collapse of Luna/UST will bring innovation to economical designs of protocols and stablecoins.