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Stablecoins are a fundamental invention that unlocked a new means of trading and storing value in the often erratic crypto market. Numerous crypto fans, investors, and experts saw their development as a significant step in connecting DeFi with the TradFi sector, potentially drawing a more cautious audience to the crypto space. Despite their brief existence, stablecoins have evolved significantly, and new models have emerged, reflecting the complex challenges and aspirations of the crypto community.
Stablecoins are cryptocurrencies whose value entirely depends on other assets. Generally, the crypto community discerns four models: fiat-backed, crypto-backed, commodity-backed, and algorithmic. While the underlying models may differ, stablecoins always pursue one objective: fighting price volatility.
The stablecoin market experienced significant growth during the pandemic, with its market cap nearly tripling. On one hand, it was powered by the overall interest in the crypto market. On the other hand, a large audience, including institutional investors, was enticed by the notion of stablecoins' stability, which is very useful when entering or exiting the crypto market.
The initial batch of stablecoins was mainly linked to widespread fiat currencies (fiat-backed) and struggled with centralization. With time, the crypto community started to look into creating more decentralized solutions, searching for ways to make stablecoins more efficient, scalable, and secure.
Fiat-backed stablecoins were the first model of such assets created. These stablecoins maintained stability by supporting each coin with the chosen fiat currency 1:1. Such an approach demanded the creation of reserves, which should continuously be monitored and adjusted following the demand. Therefore, the fiat-backed stablecoins required entities that created them to manage such reserves, raising questions about the degree of centralization and its effect on the long-term sustainability of this model.
Tether (USDT), released in 2014, is an example of a centralized and fiat-backed stablecoin. USDT aimed to deliver stability by reserving an equivalent amount of USD for every issued token. This way, users could trade and hold assets without much concern for market fluctuations, which contributed to increasing user trust and confidence in the crypto products. Unfortunately, it later became known that claims of fully fiat-backed collateral were only partially accurate, with the company changing the model to encompass other assets and receivables from loans provided by Tether to third parties.
As the example above demonstrates, trust issues pose significant challenges for fiat-based (usually centralized) stablecoins. Users ought to trust the issuing entity to uphold an adequate reserve and handle redemptions and other processes, thus rightfully prompting legal and regulatory concerns. Additionally, this compromises the core principle of decentralization in the crypto space, which might be problematic for many crypto users.
Acknowledging the limitations of centralized stablecoins, the DeFi community began developing decentralized alternatives to uphold the fundamental principles of cryptocurrency while providing stability. This quest has resulted in the rise of crypto-backed stablecoins. This model fosters openness and eliminates the necessity for a central entity. Firstly, such an approach implies that the creation and redemption of stablecoins are handled by smart contracts rather than a single organization or authority, ensuring decentralization. Moreover, all transactions and reserves are openly accessible on the blockchain, enabling complete visibility and verifiability of the stablecoin's activities.
MakerDAO's DAI, introduced in 2017, is one example of a crypto-backed stablecoin. DAI is an Ethereum-based stablecoin backed by collateralized debt positions (CDP). Users can lock up their Ether (ETH) in smart contracts in order to generate DAI, which maintains its value pegged to the USD through a system of incentives and penalties. (Note that some believe that DAI is instead an algorithmic or hybrid stablecoin because of its CDP approach and link to USD prices.)
Some drawbacks of this model include excessive collateralization and overall intricacy. Users encounter the hurdle of over-collateralization, which necessitates locking up more value in collateral than the stablecoins they receive. This may restrict the capital efficiency of the system. Furthermore, the complexity of the mechanisms used to sustain the price peg can be very complicated for users to comprehend and navigate effectively.
Algorithmic stablecoins operate in a unique manner by forgoing collateral backing and instead utilizing algorithms to regulate supply based on demand. If the price moves away from the target peg, the algorithm adjusts the supply to stabilize the price.
Algorithmic stablecoins offer their users capital efficiency by not requiring over-collateralization. They also have the potential for scalability as they are not limited by collateral reserves, which may be tricky for fiat-backed stablecoins. However, algorithmic stablecoins encounter challenges in maintaining price stability, historically struggling to hold their pegs and eliminate volatility. The most infamous example is TerraUSD. In only two weeks, its price decreased sharply and never rebounded, causing the Terra community to consider renaming the asset and starting afresh.
Commodity-backed stablecoins are pegged to the value of physical assets such as precious metals, oil, real estate, etc. Such stablecoins make it possible to invest in real-world assets, much like purchasing stocks on the stock market. For instance, acquiring a gold bar and finding a secure place to store it can be complicated and pricey; commodity-backed stablecoins give people another option for investing in this metal. Gold is the most commonly used asset to back stablecoins, with Tether Gold (XAUt) and Paxos Gold (PAXG) being some of the most popular choices.
One of the evident drawbacks of this model is the limited access to all goods. While some holders of gold-backed stablecoins can swap their tokens for actual gold, not all holders of other commodity-backed stablecoins are as fortunate. For instance, Venezuela's failed Petro stablecoin could not be exchanged for a barrel of oil. Nevertheless, this stablecoin model continues to attract interest from cryptocurrency holders and even individuals outside the cryptocurrency industry.
The rapid advancement of stablecoins demonstrates the innovative spirit and creativity within the DeFi community. Recently, the cryptocurrency market has witnessed the development of innovative hybrid stablecoins that integrate elements of collateralized and algorithmic models. One key advantage of such an approach is the great potential for improved stability and scalability thanks to leveraging the strengths of both mechanisms. Frax (FRAX) is a prime example of such a hybrid, incorporating partial algorithmic and collateralized features.
However, despite their benefits, hybrid stablecoins present specific challenges, the most prominent of which is the complexity associated with managing and understanding these hybrid models. The integration of multiple mechanisms may result in a more intricate system, requiring a deeper level of understanding from users and developers alike.
Stablecoins have progressed significantly from their centralized beginnings, transforming into sophisticated tools that support the DeFi ecosystem and the adoption of the crypto industry as a whole. Regardless of the model or approach employed, the objective of establishing a stable yet decentralized currency remains at the forefront of driving progress within a landscape full of volatility and uncertainty. Consequently, stablecoins are anticipated to significantly impact shaping the financial environment, both online and offline.
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