A$DC: Stablecoins Go Mainstream in Crypto Evolution

One of the more intriguing examples of the crypto evolution has been the emergence of stablecoins. Stablecoins are crypto tokens that aim to maintain their price against a peg such as the US dollar and therefore act as a far less volatile store of value compared to cryptos such as Bitcoin or Ethereum.

Stablecoins emerged as early as 2014 and includes Tether which as of March 2022 ranks as the crypto with the third-highest market cap (over A$100B on https://coinmarketcap.com/), although it is dogged by ongoing speculation about the extent to which it is backed by real assets. At $A71 billion market cap, USD Coin (USDC) in fifth position further illustrates demand for crypto tokens whose price is stabilised by non-correlated assets (or baskets of assets).

Stablecoins come in four main flavours, being:

1. Fiat based: backed by USD or USD-denominated assets such as treasuries or commercial paper.
2. Commodity based: backed by gold or other real assets.
3. Crypto based: backed by another crypto asset.
4. Algorithmically based: price adjusted according to a formula usually enforced by a smart contract.

Fiat Based

The main advantage of fiat-backed stablecoins is their simplicity. An issuer underwrites their issuance with fiat currency or fiat-denominated stable assets such as government, institutional or corporate treasuries, and typically employs an independent auditor to verify the assets supporting the stablecoin.

In practice, it is not so straightforward, as demonstrated by Tether’s recent violation of US regulations and associated financial penalties for misrepresenting the amount of collateral. This hasn’t prevented Tether’s rise up the crypto market cap rankings or slowed the more recent ascent by USDC, another fiat-backed stablecoin.

Commodity Based

Commodity-based stablecoins are similar to fia- backed stablecoins in that they’re collateralised by a hard asset such as gold and managed by an issuer whose claims are also verified by an independent auditor. Tether Gold (XAUT) and Pax Gold (PAX) are two examples.

Crypto Based

Crypto-based stablecoins are typically collateralised by a basket of crypto assets and pegged to USD or other fiat currency.

A leading example is DAI, which is managed by the holders of Maker (MKR) governance tokens which comprise the MakerDAO, a Decentralised Autonomous Organisation (DAO) whose rules are enforced by smart contracts running on the Ethereum blockchain. DAI is pegged to USD and “minted” when users deposit other crypto assets into Maker Vaults, which operate according to the Maker protocol. The collateral requirements typically exceed the value of DAI minted to accommodate the volatility of the crypto collateral (ie. “over-collateralised”).

Algorithmically Based

Algorithmically-based stablecoins can also be pegged to a fiat currency such as USD but don’t rely on assets as collateral. Instead, their money supply is enforced via smart contracts which aims to result in a stable price.

TerraUST (UST) is a leading example of this kind of stablecoin and since its launch in late 2020 has already overtaken DAI with a market cap of around $A21 billion. UST operates on the Terra blockchain and employs an arbitrage mechanism to maintain price stability.

UST’s peg with USD is maintained due to its supply protocol which relies upon a minting mechanism using Terra’s native token, called LUNA. LUNA must be “burned” to “mint” UST, and vice versa which alters the supply/demand ratio. This creates price distortions in the market price of UST, encouraging arbitrageurs to trade it for LUNA, which in turn causes the UST market price to revert to the peg (ie. one UST = one USD). LUNA holders are also incentivised to hold LUNA to receive rewards derived from fees derived on the Terra blockchain.

Smart contract technology underpins the ability for algorithmic stablecoins to operate but also exposes an “attack surface” for malicious actors. Several blockchains provide “bug bounties” which are rewards for identifying holes in the underlying blockchain software code to incentivise independent auditors to plug holes in any security leaks.

Why stablecoins?

Stablecoins offer advantages over their fiat counterparts to those willing to accept the greater risks, such as:

• Faster transactions.
• Faster settlement.
• Transactions recorded on an immutable ledger.
• Lower costs.
• Access to crypto services such as DeFI, NFTs, decentralised exchanges etc.

As to risks, these include:

• Unscrupulous issuers and/or custodians operating in an unregulated environment.
• Poor liquidity due to insufficient collateralisation leading to investors running for the exit.
• Diversion from the peg due to algorithmic failure to maintain the supply schedule.
• Security breach of the underlying technology leading to loss or theft.

Stablecoins are now a significant feature of the crypto landscape, especially in support of DeFI products and services which as of writing, have some $A250 billion in total value locked.

Anchor protocol is a popular example that allows savers to deposit UST and earn interest of almost 20 per cent in annual percentage yield. The yield derives from rewards earned from a pool of collateralised proof-of-stake blockchains. Borrowers can also borrow UST which can then be used to generate yield, earn staking rewards, or buy other assets.

Anchor was developed by the developers of the Terra blockchain, initially to encourage demand for UST (which operates on the Terra blockchain), but now supports deposits of stablecoins based on Ethereum’s “ERC-20” protocol such as USDC, USDT and DAI. Whether its yields are sustainable are certainly open to challenge, but its popularity illustrates the potential for stablecoin use cases.

As for local initiatives, on 24 March, ANZ became the first of the four major banks to mint its own stablecoin pegged to the Aussie dollar, called A$DC. Based on Ethereum’s blockchain, ANZ used it to mint $A30 million of A$DC, transfer the stablecoins from a sender to a receiver (in minutes instead of the usual bank transfer wait times), and then converted A$DC back into AUD.

ANZ worked with digital asset providers including Fireblocks, Chainalysis and OpenZeppelin to create the in-house stablecoin smart contract. It seems likely that similar initiatives from the majors and other institutions will follow.

The growth of stablecoins and their presence in the crypto top-10 in positions #3 (USDT) and #5 (USDC) are a clear demonstration of investor demand for crypto versions of cash and cash equivalents. Investors looking to experiment with crypto might consider stablecoins as a “low volatility” form of exposure, albeit not without some risks.