As I write this, crypto assets across the board are experiencing a significant dip in valuation. For believers in the technology and its future impact (myself included), this is a great buying opportunity, and represents a chance for the system to periodically purge some excess speculation and leveraging. With the recent advancements in lightning-fast payment rails for Bitcoin, and Ethereum Smart Contract deployments on the rise, the causes of the current bearish trend are likely related to general volatility currently being experienced by the broader financial markets.
However, there have been some observations that the collapse of TerraUSD, an algorithmic stablecoin with an objective of being pegged in value to the US dollar, could be to blame for some of the current downward price movement in crypto assets in general. At the time of this writing, the value of a Terra is closer to a goose egg than a buck, at pennies on the dollar. Let’s take this opportunity to explore a bit about stablecoins in general, as a springboard for your own research, so you can decide for yourself if they represent a good investment for your objectives.
A Stablecoin sounds like something you need to pay to ride a horse at the county fair. What does it mean in the crypto sphere?
While continuing the trend for lackluster blockchain-based asset names, the objective for a stablecoin is to maintain its peg to the dollar (or another currency, but here we’ll refer to USD for simplicity), meaning that one coin will always have this value. If this works, it removes the price volatility from the asset, as compared to unpegged crypto asset counterparts (Bitcoin, Ethereum and many more). Depending on how you think about the crypto space, you might be wondering what kind of utility an asset that doesn’t change its price can have. It’s interesting that the greatest use cases seem to be split at the two extremes of the risk spectrum. Stablecoins have garnered attention with more conservative investors looking for moderate yield on their price-stable investments like cash, as through both centralized and decentralized vehicles it has been possible to earn significantly greater APYs as compared to traditional USD-based deposits like savings accounts. On the other end of the spectrum, folks who like to trade and speculate on crypto currency often need a place to park some cash as they move in and out of positions. Stablecoins provide a way to move money between cryptocurrencies without backing all the way out into cash, which can cause delays, transaction fees and additional KYC requirements (KYC refers to Know Your Customer and relates to requirements to provide personal identification and information to financial institutions dealing with dollars).
Ironically, perhaps, at least some of these coins could represent the weakest links in the crypto ecosystem, despite their lack of price volatility, or perhaps because of it. These concerns have generally centered about the collateralization, or financial backing of these assets and the forms it can take. Stablecoin collateral is generally composed of either fiat (e.g. dollars), other crypto (e.g. Ethereum), or commodities (e.g. gold). Another significant type of stablecoin, of which TerraUSD is an example, are the algorithmic stablecoins. An algorithmic coin can attempt to peg to the dollar by creating an equilibrium within a system of coins that it creates and destroys to maintain supply and demand and by encouraging arbitrage that would theoretically prevent the price differences from becoming too out of balance. Terraform Labs, the creator of TerraUSD (or UST) was attempting to maintain such a system between UST and its governance token LUNA.
Getting to the bottom of the issue of collateralization has been like pulling teeth for some cryptocurrencies, while others have been more transparent. There is currently no standard way that stablecoins are required to report these assets. In general, collateralizing currencies has often not been a successful endeavor, especially long term. Since the US left the gold standard completely in August of 1971, it has not been possible to redeem dollars for gold at a fixed value. That’s why the US dollar is referred to as ‘fiat’ currency, in the sense that it’s backed by the ‘full faith and credit’ of the United States government. And that’s all that it’s backed by.
Let’s look at a few more example of stablecoins, including the most popular ones, with different collateralization structures.
USDC is a stablecoin that has purportedly been fully backed by fiat currency. For each USDC in circulation, the group behind the currency (called Center, of which the well-known exchange platform Coinbase and the financial platform Circle are prominent members) had originally indicated that for each USDC in circulation, there was one USD on deposit somewhere. Last summer this was clarified to indicate that the stable coin’s collateral, in addition to USD, was also back by assets including commercial paper, corporate bonds and other assets considered to be less liquid than cash. Liquidity is important in case there is a run on the currency, i.e. many people all at once wanting to exchange it for dollars.
Something interesting about USDC that certainly impacts its use in certain circles is that to transact, you must provide KYC information such as in a traditional banking relationship. This process has also not been standardized across financial service platforms. On a personal note, here in Miami there are many people with, well, let’s describe it as a complicated citizenship situation. For some platforms, these folks have provided their ex-US passports and been able to transact without further issue. On other platforms, once their foreign passport has been accepted (let’s use Slovenia for example) the system automatically changes their address to Miami, Slovenia, and then asks them for a Slovenia bank account. So much for the ability to use cryptocurrency seamlessly across borders.
DAI is the stablecoin of the decentralized autonomous organization (DAO) called Maker, and it’s an example of a crypto-backed currency that aims to peg to the USD. The major cryptocurrencies backing DAI have traditionally been Ethereum and USDC, although the relative proportion of these held in reserves can and has fluctuated. To account for the relative volatility of using crypto as a backer, DAI is ‘over-collateralized,’ i.e. the collateralization threshold is greater than 100%, reportedly at 150%. Regarding KYC, Maker DAO does not require KYC information to transact in DAI. There’s an opportunity to participate in DAI oversight by owning its MKR governance token.
Based on market capitalization Tether is one of the most important stablecoins, at a value that has reached $60 billion. However, it has been notoriously difficult to obtain information on its collateralization. The story began similarly to that for USDC, where an initial claim of a 1-to-1 dollar match was later relaxed to ‘currency and cash equivalents,’ as well as loans made by Tether and other assets. In 2019, an investigation by the New York State Attorney determined that Tether was, at least at certain times, not only not fully backed but sometimes had no reserves, while continuing to claim (like on Twitter) that they were fully collateralized. As part of the settlement with NY State, Tether was ordered to provide reports on its reserves, which have revealed large amounts of unspecified commercial paper.
So how stable are these coins?
We began by citing a couple of the reasons that people have traditionally utilized stablecoins. But are there reasons to avoid them? What is the prognosis long term?
We discussed the difficulties of determining adequate collateralization for certain coins. But it may not be sufficient to simply avoid any single coins that you feel uncomfortable with, as a bad actor may be able to take down, or at least wreck the ‘stability,’ of the entire system. This is due to the relationships among the coins through liquidity pools that exist, both among stablecoins themselves and between stablecoins and volatile crypto assets (e.g. USDT and Bitcoin).
Additionally, doubts concerning the future regulatory environment are frequently cited as a reason for the hesitancy of some to enter the crypto space in general. Stablecoins may be especially impacted by any of these regulations if and when they do roll out. Personally, late last year I moved my stablecoin assets to a financial institution that was doing an excellent job at maintaining transparency as they navigated queries from the government. However, since this process began the APYs offered on these deposits have dropped and these accounts are no longer open to new investment. Lastly, it’s important to note that among crypto-world assets, stablecoins would be the most significantly impacted by the introduction of central bank digital currencies, which would have significantly reduced counterparty risk as compared to any other stablecoin offerings.
And finally, for those concerned by recent US monetary policy, pegging to UDS fiat is not really a viable objective. Stablecoins don’t have the capacity to provide the inflation hedge and store of value that is one of the greatest features of an unpegged cryptocurrency investment.
I hope that this has given you a little more insight into the world of stable coins. I’ve intentionally not mentioned the names of any financial institutions because my purpose in writing is to encourage you to DYOR (do your own research). So, nothing included here is intended to serve as financial advice for you to follow. But I will disclose this. While my stablecoin assets have served me well until now, they will likely be the first thing I cash in when I buy my apartment later this year. In contrast I’m HODLing* (or adding to) my other crypto assets.
*HODL = Hold On for Dear Life (used a lot in the crypto space) 😊