How Stable Are Stablecoins?

By Aniruddh Vadlamani

Digital currency has been touted as the future of finance. As of March 2022, over 18000 cryptocurrencies have surfaced with the intrinsic goal of providing a decentralised and distributive way of financing. However, the saying ‘all that glitters is not gold’ comes to mind because of the multiple fundamental failures in the enforcement and execution of these digital currencies. This article introduces the concept of “Stablecoins”. It analyses the different types of stablecoins and how they are less volatile than a traditional cryptocurrency. However, the paper posits that the term ‘unstable stablecoin’ though an oxymoron might actually be factually correct. Through the case studies of Terra, DAI and USDT, it is argued that stablecoins can sometimes be deceptive in nature. The paper concludes by providing a way forward for cryptocurrency regulations and governance.

With the advent of disruptive technologies like Blockchain, it is apparent that a paradigm shift from the existing centralized financial structure to an inchoate decentralized one is in the making. The buzz around the term blockchain is more so because of the burgeoning space of digital assets. Lately, people have been enthralled with investing in Cryptocurrencies, Decentralized Finance Protocols and Fintech etc. ‘Bitcoin’ (BTC), a decentralized digital asset, is a leading cryptocurrency which ushered in the new era of blockchain technology and digital currencies. The total value of Bitcoin as of November 2021 was around 1.03 trillion USD which is five times larger than Elon Musk’s fortune. The craze behind investing and financing transactions through Bitcoin and cryptocurrencies, in general, is because of its decentralized and distributive characteristics. Bitcoin, a decentralized digital currency based on blockchain technology, does not have any governing or centralized regulating body. All the transactions done through cryptos are anonymous and trustless. However, the major drawback of cryptocurrencies is that they are just fundamental computer codes and therefore are highly volatile compared to their fiat counterparts. The BTC volatility is roughly ten times when compared to that of the US Dollar.

Therefore, this article introduces the concept of “Stablecoins” and how they are still less volatile being a cryptocurrency. Further, through various case studies, the paper posits that the term stablecoin may be a deception.

WHAT ARE STABLECOINS?

Stablecoins are a type of digital asset designed to maintain a stable value by linking its value to another asset or a basket of assets. They are touted by investors and financial consultants as a bridge between the cryptographic currency and the traditional fiat currency. Termed as Altcoins, stablecoins are generally private-asset linked tokens which are collateral backed. These collaterals include fiat currencies, treasury bonds, other cryptos and traditional financial assets. Stablecoins are of four types: fiat-backed, crypto-backed, algorithmic and commodity-backed. The concept of stablecoins originated because of the high volatility of the crypto tokens such as Bitcoin, Ether and Terra. The idea of a stablecoin allowed the investors to invest in digital currency, which holds a steady value and provides the same value as traditional cryptos in return. Some of the most popular stablecoins by market capitalization are the Tether (USDT), Binance USD (BUSD) and USD Coin (USDC). First seen in 2014, stablecoins now have a total of $130bn worth of coins in circulation. As traditional cryptos cannot be used to finance transactions or for financial statements or tax returns because of the volatility risk, stablecoins have been publicized as an excellent medium of exchange and store of value.

TYPES OF STABLECOINS

As discussed above, stablecoins are of four types. These four types can be categorically divided into two, namely, i) Asset-backed and ii) Algorithmic. Asset-backed stablecoins are either fiat-backed, crypto-backed or Commodity backed. The fiat-backed stablecoins are the most popular and are backed 1:1 by a fiat currency. This is also known as an off-chain stablecoin because the underlying asset which the stablecoin is pegged with is not a cryptocurrency. For example, if an issuer has a $20 million worth of fiat currency, he can only mint $20 million worth of stablecoins, thereby maintaining that 1:1 peg with the traditional currency. USDC and USDT are the most prominent examples of fiat-backed stablecoin. 

On the other hand, crypto-backed stablecoins are on-chain tokens backed by another cryptocurrency. Crypto-backed stablecoins are on-chain because they employ a smart contract instead of relying on a central issuer. For example, when purchasing this stablecoin, a user locks the pegged cryptocurrency into a smart contract, and the smart contract deployed issues the equivalent amount of stablecoins against the pegged crypto tokens to the user. The user can also return the stablecoin to the smart contract and withdraw the original crypto. Further, as we know that traditional cryptocurrencies are highly volatile, so the crypto-collateralized stablecoins are over-collateralized so that if there is any massive fluctuation in the original crypto, then the collateral that was paid over and above the actual price can be paid back into the smart contract to liquidate a user’s Collateralized Debt Position (CDP). 

Alternatively, Commodity backed stablecoins are collateralized using physical assets like gold, oil, real estate, etc. Commodity collateralized essentially means tokenization of an asset as it derives its value from a particular external tradeable asset like gold or oil. These types of stablecoins are helpful when people want to facilitate investment in a specific physical asset but do not have the means, or that particular asset is out of their reach. 

Lastly, algorithmic stablecoins are very different from the ones mentioned above. They do not use fiat currency, Commodity, or cryptocurrency as collateral. Instead, as the name suggests, the price stability of these types of tokens results from using a specialized algorithm and smart contracts. Algorithmic stablecoins are based on the supply and demand algorithm wherein the system automatically burns the tokens when the token’s market price falls below its collateral. Alternatively, it mints the tokens when the cost of the stablecoin is above the price of the collateral so as to adjust the value of the stablecoin. For example, TerraUSD (UST) is an algorithmic stablecoin issued and backed by the Terra (LUNA) cryptocurrency. This means that instead of tracking the fiat currency (USD), UST maintains its peg to the US Dollar via an algorithm that changes with the supply and demand for another cryptocurrency. 

ARE STABLECOINS STABLE?

The so-called stablecoins have been touted as unstable over the recent months. It is a known fact that stablecoins are only stable as their underlying asset, and if there is a high fluctuation in the price of the collateral, it will affect the coin similarly. Further, due to the changing trading volume of a stablecoin, it frequently deviates from its underlying peg. The term unstable stablecoin might only be an oxymoron, but in reality, is it evident that stablecoins can sometimes be deceptive. This is not only because of the coin’s volatility but also because of the general lack of governance and regulation of cryptocurrencies. 

History has shown that stablecoins have their limitations. In 2018, the USDT stablecoin, one of the top 10 cryptocurrencies in the market, published that it was pausing its fiat deposits because of processing complications. However, the actual reason for stopping the fiat deposits was that only 74% of the USD reserves were backing the token during the auditing of reserves. This made the investors consider their position in the stablecoin, ultimately leading to a plunge in USDT’s value. 

Another case study that can be cited is of the DAI stablecoin. DAI, an on-chain crypto-backed stablecoin, was created by MakerDAO (an Ethereum-based protocol). On 12th March 2020, the MakerDAO protocol experienced a black swan attack, a rare and acute surprise attack on the system. As discussed in the above part of the paper, over-collateralization is necessary in the case of crypto-backed stablecoins. The black swan attack decreased the price of the collaterals, and most of the CDPs of the investors were liquidated because the price oracle, which the protocols rely on to showcase the fluctuations off-chain, had lagged behind the trading activity. As most investors were trying to avoid the liquidations, the Ethereum network got congested and spiked gas prices (network fees). 

The recent Terra (UST) debacle should also be relied upon wherein UST, an algorithmic stablecoin, was issued and backed by the Terra (LUNA) cryptocurrency. The UST stablecoin relied on the supply and demand algorithm wherein the system automatically minted or burned existing LUNA to maintain the peg of UST to the Dollar. In April 2020, with the UST price continuing to fall, LUNA was minted to maintain the peg. However, as more and more LUNA was minted to protect the value of the stablecoin, the price of LUNA headed towards zero. This stablecoin crash had a negative impact on the cryptocurrency market in general. As more than $3 billion worth of BTC were deployed to protect the value of LUNA, the price of BTC slumped 35%. 

These case studies showcase that even stable cryptocurrencies have limitations and can be sometimes deceptive because of the lack of governance and regulation.

THE WAY FORWARD

The cryptocurrency’s governance and regulations have been a topic of interest for the past couple of years. Regulators believe that the risks to investors are high due to the volatile nature of these tokens, and the debacle of UST and DAI has confirmed this. The UST case shows that this decentralized finance space needs to be roped under government control. With the shift in the financial system and the rapid growth of stablecoins, urgent actions must be taken to assess the future risks of stablecoins. Many countries around the world have started to regulate this space. India has introduced a 30% tax on income from the transfer of crypto and a surcharge of 1% at source on all transactions. This regulation has deterred high trading volumes of cryptos, thereby considerably maintaining a stable value for the token. A draft legislation requiring stablecoins to be federally audited in the USA is in the process. With the introduction of this legislation, it is hoped that stablecoins are placed under the purview of the comptroller of the currency. Placing the tokens under a federal bureau’s purview will ensure that issuers of stablecoins provide insurance to the customers and simultaneously provide proof that  they have 90 days of liquid reserves for any future crisis.

Therefore, to conclude, it is apposite to say that the uncontrolled and unregulated period of cryptocurrency is on the end, and all the crypto protocols need to work together with the regulators to provide a sustainable decentralized finance system for the future.

Aniruddh Vadlamani is an undergraduate student at Jindal Global Law School.

Image credits – CNBC

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