Stablecoins: Are they really Stable? | QuillAudits

Table of Content:

1. What is a Stablecoin?
2. Types of Stablecoins:
3. Risk in Stablecoins?
4. Stable Coin Depeg Case-Studies:
5. Regulations on Stablecoins?
6. Closing Thoughts
7. Reference

What is a Stablecoin?

Stablecoins are basically cryptocurrencies whose values are pegged to another currency like USD, EURO, etc. It may also be pegged to commodities like gold, silver, etc. A stablecoin is a non-volatile crypto asset.

Stablecoins aims to provide an alternative to the high volatility of the most popular cryptocurrencies like Bitcoin, Ethereum, Solana, etc. which has made crypto investments less suitable for everyday transactions.

The Need for Stablecoins:

1. Stablecoins have been developed with the objective of facilitating the broader adoption of cryptocurrencies.
2. Stablecoins are an incredibly important piece of making sure Web3 works. We need a token that people can transact in without the spikes and volatility of native blockchain assets.
3. Stablecoins are critical to decentralized finance because they allow investors to leverage the benefits of Defi without having to transact in highly volatile assets.

Types of Stable Coins

There are 4 types of stablecoins: fiat-based, crypto-collateralized, commodity-collateralized, and non-collateralized stablecoins.

1. Fiat-Backed Stablecoins

Fiat-backed stablecoins are truly backed by real-world currencies. In simple terms, “fiat-backed stablecoin” basically is a stablecoin backed by a reserve of fiat currencies in regulated institutions like banks. Stablecoins backed by fiat currencies have significantly transformed the cryptocurrency market. fiat-backed stablecoins are truly backed by real-world currencies.

Some common Fiat -Backed Stablecoins are:
- USD Coin (USDC)
- Tether (USDT, EURT, GBPT)
- Binance USD (BUSD)

2. Crypto-Backed Stablecoins:

Cryptocurrency-backed stablecoins are those backed by other cryptocurrencies like BTC or ETH rather than fiat currencies. A crypto-backed stablecoin can be issued to launch one asset on a different blockchain. For example, Wrapped Bitcoin (WBTC) is a stablecoin backed by Bitcoin issued on the Ethereum blockchain. Here the value of WBTC is pegged to Bitcoin in the 1:1 ratio.

Crypto-collateralized stablecoins are also over-collateralized to buffer against price fluctuations in the required cryptocurrency collateral asset.

Examples of some crypto-backed Stablecoins are:
- bitUSD
- Haven

3. Commodity-Backed Stablecoins

Commodity-backed stablecoins are essentially blockchain-based representations of commodities and are backed by reserves held by a central entity.

Physical assets such as precious metals, oil, and real estate are used to back commodity-backed stablecoins. Gold is the most commonly collateralized commodity.

Examples of such commodity-backed stablecoins backed by gold are:
- Tether Gold (XAUT)
- Paxos Gold (PAXG)

4. Algorithmic Stablecoins

Algorithmic stablecoins do not use fiat or cryptocurrency as collateral. Instead, their price stability results from the use of specialized algorithms and smart contracts that manage the supply of tokens in circulation.

An algorithmic stablecoin system will lower the number of tokens in circulation when the market price falls below the fiat currency’s price. Alternatively, if the token’s price exceeds that of the fiat currency it represents, new tokens are issued to bring the stablecoin’s value down.

Examples of Algorithmic Stable Coins are:
- Terra USTC
- RAI
- FEI

Risks of Stablecoins:

1. Counterparty risk and Lack of Transparency: By trusting the third party to print money and keep a cryptocurrency stable, the dollars could be fractionally reserved instead of fully backed. In this case, a bank run could cause the price of the coin to drop dramatically. These risks may be amplified by a lack of transparency with respect to the composition of reserve assets, as well as a lack of controls on.
2. Centralization risk: Centralization risks mean the same monetary issues fiat currencies face when a central authority has the power to print money without oversight. For example, the most widely traded stablecoin on the market USDT is controlled by a company called Tether. Being a centrally backed asset interferes with the nature of blockchain technology, albeit not technically.
3. Algorithm manipulations: Algorithmic stablecoins rely on an algorithm that buys up supply or produces it based on market fluctuations. These algorithms are often incredibly complex and difficult to execute which leaves scope for incorrect implementation and finally depeg of currency. We have seen what damage it can cause in the case of Terra UST depeg.
4. Economic Instability and Inflation Issues: If stablecoins were issued in a much worse-run economic fiat currency, no one would exchange their money for it, which means that the stablecoin would have no liquidity and therefore no value. However, this also puts your stablecoins at risk against global black swan events or sudden economic downturns which can lead to inflation.
5. Regulations: Stablecoins, like all digital currencies, possess inherent risks to the underworld. It makes it much easier to pay an arms dealer in cryptocurrency than it is with a bank check nowadays. Until proper regulations are put in place to safeguard your digital assets, it is probably not wise to fully commit to stablecoins.

Further Reads:
https://coinrivet.com/guides/altcoins/stablecoins-what-are-the-risks-and-benefits/
https://medium.com/stably-blog/the-risks-of-stablecoins

Stablecoin Depeg Case Study:

1. Terra UST:

TerraUSD ($UST) was an algorithmic stablecoin that relied on a complex mathematical algorithm to maintain its dollar value. Unlike other stablecoins, $UST was backed by LUNA tokens to keep the dollar peg in check.
On 9 May 2022, the value of TerraUSD fell from $1 to $0.68 which led investors to liquidate their UST and go for other stablecoins as TerraUSD was trading at a price below its USD value. Furthermore, LUNA plummeted as a result of large-scale short-selling. The incident led the value of LUNA to plummet from US$80.3 to US$0.0001702 and the UST price fell from US$1 to US$0.10.

Check out this blog for more details on it.

2. aUSD:

On the 14th of August, 2022, Acala Network suffered an exploit that resulted in its native stablecoin aUSD falling to almost zero. The exploit was due to a “misconfiguration” in the newly launched iBTC/aUSD liquidity pool that allowed users to mint unlimited aUSD instead of LP tokens. According to Acala Trace Results, more than 3 Billion aUSD were minted by attackers, which led to depeg of aUSD. Currently, the price of aUSD is $0.73 at coinmarketcap.

Check out this blog for more details on it.

3. USDD:

USDD is a native algorithmic stablecoin of Tron Blockchain. USDD is backed by the over-collateralization of various cryptocurrencies, namely TRX, BTC, USDT, etc. On June 13, the stability of USDD staggered when the price started dropping. USDD reached the minimum of $0.967 on June 15.

Again on November 8, when a whale exchanged 4.49 million USDD for 4.46 million USDT on November 8 at a ratio of 0.9935. At this point, the stablecoin started to devalue. Currently, the price of USDD is $0.98.

4. HUSD:

HUSD is a fiat-collateralized stablecoin and it is issued by Stable Universal. On August 18th, popular crypto exchange Huobi’s stablecoin temporarily lost its USD depeg. HUSD traded at $0.82 for a few hours, before recovering its dollar value.

Although the depeg only lasted for about 24 hours, the HUSD community went into a frenzy fearing a complete breakdown of the stablecoin mechanism. It again depegged this month and fell down below $0.20. Currently, the price of HUSD is $0.16.

Check out this blog for further details.

5. DUSD:

DUSD is a hybrid stablecoin on the DeFiChain blockchain that is created from a mix of crypto-backed loans and burning the blockchain’s native coin DFI. As everything else crashed in Crypto Market, DUSD, the stable counterpart to all the other cryptocurrencies, became less and less needed. Moreover, after so many DeFi projects failed, people became frightened and left the sector to move their purchase power somewhere else. Currently, the price of DUSD is $0.67 at coinmarketcap.

DeFiChain announced “the wider DeFiChain community should not be worried about any similar occurrences that happened in the Luna ecosystem. The DeFiChain system by design is resilient enough to withstand similar events.”

Regulations on Stablecoins:

Most stablecoins offer limited financial and monetary stability risk, but the advent of global stablecoins raises much larger issues and concerns.

To address these gaps, a consistent and comprehensive regulatory framework is needed both to increase transparency into key aspects of stablecoin arrangements and to ensure that stablecoins function in both normal times and in stressed market conditions. At the international level, discussions around crypto-asset and stablecoin approaches are taking place through the G20, G7, FSB, IOSCO, BCBS, FATF, and others.

“We’ve allowed “experiments” like TerraUSD to dominate and grow significantly beyond where they naturally should sit given their inherent risk,” says Alex McDougall, CEO of Stablecorp, who agrees that aggressive regulation is a net positive for digital assets.

Reference:
https://www.forbes.com/advisor/investing/cryptocurrency/stablecoin-regulations/
https://www.investopedia.com/cryptocurrency-regulations-around-the-world-5202122

Final Verdict:

In recent times the crypto market experienced a disorderly collapse of stablecoins that has raised questions about the stability of these coins.

We have seen a lot of downfall of these stablecoins so the big question is which is the best and safest Stable Coin? There isn’t one. Each stablecoin makes design choices that make them widely different from each other but accomplish similar things. There isn’t a “best” system, and the industry constantly changes. Looking at the recent collapse of these stablecoins, there is a need for a regulatory framework to increase transparency and trust among investors and users.

References:

https://www.bis.org/publ/work905.pdf
https://www.ecb.europa.eu/pub/financial-stability

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