Crypto’s Stablecoin Throne is Vacant

Solving the stablecoin dilemma is paramount to crypto’s survival and success as our industry matures. Without a secure, capitally efficient, and decentralized stablecoin, it will be extremely difficult to onboard institutional and retail capital.

What are stablecoins?

Stablecoins are cryptocurrencies designed to maintain a peg with another currency, asset, or financial instrument. They are most commonly used as decentralized analogs to FIAT currencies, such as USD, EUR, and GBP. This provides traders a more “stable” alternative to historically volatile assets like ETH and BTC.

What is the history of stablecoins?

The first stablecoins were introduced in 2014 by BitUSD (BITUSD) and NuBits (USNBT) and they were collateralized using different baskets of cryptocurrencies. While both of these tokens were revolutionary during their time, neither have managed to succeed at the one key task they were created to carry out, to maintain a “stable” peg with the US dollar. Both stablecoins have since lost their pegs and all but faded into oblivion, but their hurdles and trajectories would foreshadow one of crypto’s biggest unsolved problems, “The Stablecoin Trilemma”.

The Stablecoin Trilemma dictates that no one stablecoin can satisfy all 3 conditions:

1. Price/Peg Stability - ie. The ability to constantly be traded at 1 USD.

2. Capital Efficiency - ie. Having to lock up ≤ 1 USD to mint 1 USD stablecoin.

3. Decentralization - Not relying on centralized custodians to manage collateral.

   
   

What are the different types of stablecoin implementations?

This stablecoin implementation problem has been tackled by crypto’s best and brightest to widely varying degrees of success, however, a perfect solution has yet to be found. As such, there are multiple different implementation strategies, each with its own unique tradeoffs. Broadly, these strategies can be split into two main categories, collateralized stablecoins and algorithmic (aka. uncollateralized) stablecoins.

Collateralized Stablecoins

A collateralized stablecoin is any cryptocurrency that is either partially or completely backed by collateral held in a treasury or reserve. This backing helps to ensure that the value of a collateralized stablecoin does not fall below its peg. Using USDC as an example, if 1 USDC was traded below 1 USD in value, traders would arbitrage the difference by purchasing USDC and redeeming it for 1 USD each. The inherent issue with FIAT collateralized stablecoins is the centralized nature of the collateral reserves. This opens up token holders to institutional risks like bankruptcy or mismanagement of funds.

Collateralized backings are not limited to FIAT currencies alone. As it stands, there are stablecoins such as DAI and sUSD which are collateralized with other cryptocurrencies (namely, ETH and SNX respectively). These stablecoins can mitigate the centralized risk factors associated with FIAT-backed stables, however, due to the inherent volatility of most crypto assets, they require over-collateralized positions (ie 4:1 for USD) in order to maintain their pegs. This system is significantly safer but also much more capitally inefficient for end users.

Algorithmic Stablecoins

Algorithmic stablecoins are assets that do not rely on collateral reserves to maintain their peg. Instead, they utilize smart contracts to buy, sell, or burn tokens to respond to market supply and demand. In essence, algorithmic stablecoins maintain their pegs by mechanistically controlling their circulating supplies. Examples of algorithmic stablecoins include $FRAX and $UXD. Algorithmic stablecoins are inherently decentralized and fairly capitally efficient, however, their pegging mechanisms have greater sensitivity to extreme market conditions and attacks.

$FRAX operates under a fractionally collateralized system, where each $FRAX is partially collateralized by fiat-backed stablecoins and partially backed by its own token, $FXS. The Frax collateralization ratio determines the ratio between collateral (ie. USDC) and algorithm ($FXS) that makes up the $1 FRAX value. An important requirement for $FRAX to function smoothly is to have deep liquidity with other stablecoins (ie. USDC and USDT). The FRAX+3Crv Pool on Curve Finance has nearly 1.1b USD of liquidity to help ensure as little slippage as possible when making trades.

$UXD is a “delta-neutral” stablecoin that works by taking deposits, such as $ETH, and using those deposits as collateral to short an equivalent amount of perpetual swap contracts or dated futures. This balanced pair of the $ETH long and 1x ETH-USD short creates a delta neutral position with a value of $1 for each $UXD. If the price of $UXD < $1, arbitrageurs can redeem their $UXD for $1 of collateral assets (currently limited to ETH, BTC, and SOL) to make a profit. Conversely, if the price of $UXD > $1, arbitrageurs can mint $UXD at a cost of $1 per $UXD to make a profit. This mechanism allows UXD to consistently maintain its peg.

Currently, $UXD and $FRAX seem to be the front-runners for solutions to the stablecoin dilemma as they are fully decentralized and capital-efficient. What remains is for them to continue to prove their stability over time.

Why are stablecoins important/necessary?

The vision is simple: Decentralized finance requires decentralized currencies. As crypto is still an emerging market, volatility is to be expected and perhaps even welcomed. However, there must exist an on-chain alternative to “stable” FIAT currencies to act as trading pairs on DEXs and as a means to store capital long-term.

About Dan Edlebeck

Dan is a co-founder of Sei Network. Active in the Cosmos ecosystem, Dan led Sentinel for the past 2 years. Over the past five years, Dan has held several roles within crypto organizations including leading marketing for Blockparty and operating a PR agency, deedle connects. He is a strong advocate for the power of an inclusive financial system built on web3 infrastructure.

About Sei Network

Sei Network is the first orderbook-specific L1 blockchain. It is built using the Cosmos SDK and Tendermint core and features a built-in central limit orderbook (CLOB) module. Decentralized applications building on Sei can build on top of the CLOB, and other Cosmos-based blockchains can leverage Sei's CLOB as a shared liquidity hub and create markets for any asset. Designed with developers and users in mind, Sei serves as the infrastructure and shared liquidity hub for the next generation of DeFi. Apps can easily plug-and-play to trade on Sei orderbook infrastructure and access pooled liquidity from other apps. To prioritize developer experience, Sei Network has integrated the wasmd module to support CosmWasm.

By Sei Network’s Dan Edlebeck