DeFi and the Rise of Stablecoins

The Bitcoin dominance has been unrivaled for the past decade. It continues to define the cryptocurrency market in a way that no other currency or token has done. It has reached as high as 86% dominance of the entire cryptocurrency market for the past decade. Beyond being the first to market, it remains the gateway crypto to own for most new crypto holders.

But in the last few years, Bitcoin has had an unexpected competitor - stablecoins. Unexpected because the cryptoverse has always been a battle of technology. While people were betting on alternative technologies that could best deliver the promises of Bitcoin, Tether (USDT) was quietly launched in late 2014 by a group called Tether Limited.

The Birth of Stablecoins

When Tether was introduced, it was a relatively simple concept for creating a crypto asset that maintained a stable price of 1:1 to the dollar. The idea is not new and has existed pre-Bitcoin. But Tether was the first to be successful at launching it on the crypto-verse. Stablecoins are designed to have low volatility and work because of their reserve mechanism. For every USDT issued, the Tether Foundation keeps $1 equivalent in reserve. Most stablecoins are pegged to relatively solid assets with low volatility, like the US dollar or other fiat or precious metals like gold. It's just like having a digital version of something that exists in the real world. It's technically a digital wrapper for a dollar-valued asset.

Tether (USDT) started to take off when Bitcoin's price began to rise in 2017, and Tether generated 1M for the first time in January 2016. By January 2017, it was a little under 10M. By January 2018, as Bitcoin's price peaked at close to $20K, the Tether supply had grown to over 1.4B.

The rise of Tether is surprising because the entire crypto market is fueled by speculative investment, and stablecoins are just the opposite of volatility. Tether functioned as a gateway for the bull run and allowed for a more effortless transfer of money between Bitcoin and the dollar.

While Tether was cementing its foothold on the blockchain (launching on Ethereum and Tron), other stablecoins followed. The USD Coin (USDC) (managed by a group called Centre, which includes Coinbase Exchange and Circle) was launched as well as the Gemini Dollar (GUSD) stable coin (operated by Gemini Exchange). Paxos Standard Token (PAX), managed by Paxos, which had previously launched Singapore-based itBit exchange, also opened its doors. Binance launched its stablecoin Binance USD (BUSD), which is used heavily on their exchange. Soon after, Huobi launched Huobi USD (HUSD). As most observers comment, stablecoins became the playground of exchanges and have been at the center of controversies since Tether began.

The Rise Of Stablecoins

Despite the controversies, stablecoins have rapidly risen following the March 2020 crypto crash as investors discovered another significant use of the stablecoins. It allowed them to seek shelter from Bitcoin's volatility and the host of altcoins that dropped along with Bitcoin at the time. Although the supply grew for many stablecoins, Tether supply grew more than all other stablecoins combined.

Tether's trading volume surpassed Bitcoin's for the first time in April 2020 and has remained on a high level ever since then. Today, Tether has a trading volume of about $120 billion per day, which is more than half of Bitcoin's trading volume, according to CoinMarketCap data. A 2021 Q1 report by Messari, a crypto research firm, said that the stablecoin monetary base had reached over $65 billion in Q1 of 2021. It continues to rise at an accelerating pace up to now. Stablecoins also generated a whopping $1 trillion in transaction volume, more than the previous four quarters combined.

The Birth of DeFi

While most stablecoins are backed by USD reserves, innovation caught up with the relatively simple stablecoin technology, and different stablecoin models emerged. Stablecoins allowed for the reimagining of traditional finance into decentralized finance.

In December 2017, MakerDAO turned the world of finance on its head when it launched its decentralized stablecoin called Dai, essentially giving birth to the decentralized finance (DeFi) we now know today. Like USDT, DAI is designed to be pegged to 1 USD. But unlike USDT, USDC, and PAX, DAI is not backed by a reserve of USD controlled by a single organization. Instead, DAI is collateralized by other crypto-assets like ETH.

Anyone can mint a new DAI, which they can later redeem to reclaim the original collateral. They achieve stability through the use of "smart contracts." These smart contracts became the heart of the decentralized finance system because they work based on code without an intermediary or third party and allow DeFi protocols to work independently. The marriage of stablecoins and smart contracts became so powerful that these became the backbone of the DeFi ecosystem.

What is DeFi?

Traditional finance has always been controlled by a few big hands, long criticized as closed and lacking transparency. DeFi stands for decentralized finance, and it aims to make existing financial products and services accessible on the blockchain by using decentralized applications.

Technically, Bitcoin started the age of decentralized finance in 2009 because it allowed people to transfer funds over the internet in a decentralized, peer-to-peer manner. But what we now know as DeFi today are decentralized applications (dapps) that replicate traditional financial services.

Dapps have no gatekeeper, and anyone with an internet connection can use and access basic financial services online— such as borrowing, lending, and investing — without needing a financial intermediary. Dapps allow users worldwide to gain access to a global financial marketplace that provides all the decentralized services that only traditional financial institutions offer.

In theory, a woman running a market stall in the Philippines can borrow funds at a competitive rate from a decentralized lending protocol using just her smartphone. Conversely, a merchant in Argentina who is worried and affected by inflation could ideally put their money into a yield-generating protocol that earns higher interest than Argentina's current inflation rate.

Some of the features that we dreamt of seeing in the future are actually already possible thanks to market-leading applications in Defi such as Aave, Compound, Yearn Finance, and more.

The Role of Stablecoins in DeFi

While Bitcoin still dreams of an open financial system, decentralized finance has already been delivered. And it did so by curbing the volatility that has so far plagued cryptocurrencies and yet allows investors to earn at a much higher rate than traditional savings accounts.

Stablecoins are often used for decentralized finance activities like lending and borrowing and providing liquidity and farming, investing in baskets of digital assets, trading digital assets on margin, hedging digital asset exposure, taking out an insurance policy, or betting on trustless prediction markets. The stablecoins have expanded so rapidly in the blockchain that as of Friday, the market cap of stablecoins stood at roughly US$125 billion, according to industry data site CoinMarketCap.

The creation of yield-generation savings protocols with Compound Protocol as the frontrunner gave way to numerous new lending and borrowing applications and new types of decentralized financial applications that primarily use stablecoins.

For example, a risk-averse individual can avoid speculative crypto trading by depositing stablecoins on decentralized liquidity pools. While crypto, such as BTC or ETH, presents a possibility of a higher gain, it also can offset all gains, leaving the investor with a loss. By providing stablecoin liquidity in liquidity pools, they earn interest or generate yield safely.

This is called Yield Farming. Yield farming generally is defined as putting your capital to work, providing utility elsewhere in the DeFi ecosystem, and earning fees for doing so. Yield farming can have various forms, depositing funds in high-yielding lending protocols being the most common.

What's even more exciting is the concept of composability. For example, when you provide liquidity in a market, you are granted liquidity provider (LP) tokens. These act as a receipt or proof that you have provided liquidity and are necessary to reclaim your original deposit. Some protocols add incentives for you to provide liquidity in certain markets. For example, you can now deposit your LP tokens in another protocol’s smart contracts, and they can provide you with additional rewards (generally in their own tokens) as an incentive to continue to provide liquidity.

The newly launched Ubiquity DAO, for example, incentivizes users to deposit dollars into their stablecoin’s market, deepening its liquidity by minting new tokens. It also incentives users to leave their liquidity in for a long period of time by also including lockup time with a rewards multiplier for the longer a user locks up their LP tokens.

Another interesting offshoot of using stablecoins in Defi projects is Yield Aggregators. Through yield aggregators, people can continuously find the highest yield lending and borrowing markets, and these aggregators move their investments accordingly. Thus, always returning the best yield available.

Ubiquity has created a “Proxy” Yield Aggregator, which deploys a user’s capital across the highest yield across multiple yield aggregators, with the added benefit of doubling yield on top in Ubiquity’s own dollar’s “debt” tokens. This allows users to redeem for more Ubiquity Dollars when the protocol needs to print more.

A New Generation of Stablecoins

As the DeFi market grows, more protocols are created to answer new market needs and build new innovative models for financial agreements. In 2021, digital dollar stablecoins are becoming increasingly relevant assets, and there's no sign that innovation in stablecoins is stopping yet.

The past year saw the birth of a new genre of stablecoins dubbed “algorithmic.” Unlike the earlier permutations of stablecoins, algorithmic stablecoins rely on increasing capital efficiency and being undercollateralized. They use algorithms in their smart contracts to calculate what the supply should be to peg to any price. AMPL, FRAX, UST, ESD, and uAD are examples of algorithmic stablecoins.

For algorithmic tokens, for example, if a token's price increases to $1.20, new tokens will be minted to bring the price down to $1. Although, there's a risk associated with relying on an algorithm. For example, YAM Finance rebased their token, but the project failed when a bug caused the currency to inflate the supply.

Already, iterations are being made to correct this mistake. By design, Ubiquity's uAD is the world's first polymorphic stablecoin. In simple terms, polymorphic means adaptable. Earlier attempts at algorithmic stablecoins like YAM set their stabilization strategies in stone. As a result, when the dynamics of the economy change or when exploitative actors attack the system, their re-stabilization mechanics can no longer achieve the original design objectives. Or in the particular case of YAMS, once the bug was discovered, they could not fix the issue. Ubiquity designed the uAD stablecoin with a highly flexible architecture to maximize the options of enhancing stabilization mechanisms.

According to the semi-anon founder Alex, "We originally intended to design uAD to have no collateral but realized that the algorithmic stablecoins that remained on-peg all had some form of collateralization. We are adding in a 1:20 collateralization to the protocol in Q4 2021." Its Proxy Yield Farming is used to fund the reserves. The fractional reserve fund collects a 10% fee on any deposit and all yield in stablecoins generated by the deployment of the funds. To offset this, the protocol compensates the users with debt tokens to an amount greater than the collected yield and upfront fee.

The key takeaway of the Proxy Yield Aggregator is that it can potentially offer double the yield to your stablecoins compared to its underlying yield aggregator in a sustainable way. Once a fringe tool for cryptocurrency traders, stablecoins have the potential to become the answer to supporting critical infrastructure for payments, banking, and credit cards.

Disclosure:

I write occasional articles in my industry to build my portfolio and often mention work that I'm proud of. Currently, I'm affiliated with @ubq.fi, Decentralized Autonomous Organization. This content is part of / inspired by one of our online resources at the UBQ Blog,