Why Stablecoins are the Backbone of the Crypto Markets

stablecoins

In previous articles we have already covered decentralized forms of stablecoins such as DAI and Terra UST. To reiterate, decentralized stablecoins were created as an alternative to centralized stablecoins. As we will discuss further in this article, decentralized stablecoins are truly censorship resistant and are impossible to fully regulate. However, there are always some trade offs. 

Decentralized stablecoins are often more volatile than their centralized counterparts. This is because they are designed to be redeemable for 1 USD or equivalent in crypto collateral. For this article, we will focus on centralized stablecoins. Centralized stablecoins are widely used, and dominate most markets compared to decentralized alternatives. 

A few numbers

Firstly, centralized stablecoins are cryptocurrencies that derive their underlying value from government issued currencies such as USD, EUR, GBP etc. Issuers such as Circle, iFinex, and Paxos issue USDC, USDT, and BUSD/USDP respectively. 

These issuers meet compliance and license requirements to operate and issue stablecoins. There is no clear regulatory framework for stablecoins. However, the 3 biggest issuers of stablecoins have frequent audits. They are regulated to a very high standard similar to how Apple cash, PayPal, Venmo, and Cash App are regulated.

The most popular stablecoins are Tether (USDT), USD Coin (USDC), and Binance USD (BUSD). According to DeFi Llama, there are a total of $158 B in both centralized and decentralized stablecoins. Centralized stablecoins make up over 90%. The rest of the 10% include decentralized stablecoins such as DAI, MIM, FRAX, RAI, and others. USDT alone makes up 45% of all stablecoins in circulation. Following Tether, USDC makes up about 33% and BUSD makes up 12%. For reference, before the Terra collapse, Terra UST peaked at an astonishing $18 B in circulation. It would have surpassed BUSD, the third largest centralized stablecoin. 

Lack of trust

The early days of stablecoins started in 2015 with USDT. The creation of USDT vastly improved efficiency and liquidity of crypto assets. Before USDT, investors relied on the traditional banking infrastructure to wire funds to exchanges to buy crypto. Due to lack of regulatory oversight, operating an exchange had many barriers. 

First, banks would not trust crypto related companies and their activities. It was common that exchanges relied on many banks outside of their typical jurisdiction which had more relaxed compliance procedures. 

For example, many years ago, Kraken was a popular exchange for Canadians. Although Kraken was based in the USA, Canadians were required to wire CAD to Kraken’s bank in Japan. This seemed odd at the time but for possibly a compliance issue at the time, Canadian banks would not work with Kraken to accept Canadian funds. Since it was common to submit wire transfers to banks overseas, deposits could take anywhere from 4-7 business days. This made it incredibly inconvenient to Buy the Dip as the price of crypto is often very volatile. 

Contradictory trades

Another issue was that crypto would trade at different prices on multiple exchanges. Due to crypto being a global market that allows anyone in the world to participate, some exchanges were only allowed to offer services within certain regions or countries. 

Due to South Korea’s strict cross border payment restrictions, companies like Coinbase, FTX, and Binance are not allowed to offer their services to South Korean residents. This has caused the price of Bitcoin to trade at a premium many times during bull markets. 

With centralized stablecoins, investors can easily transfer USD equivalent crypto to any crypto exchange in the world. They can take advantage of crypto premiums and discounts. Often called arbitrageurs, traders could buy BTC on exchange A and transfer it to exchange B. Then sell it for a profit. After selling it for a stablecoin such as USDC, they could transfer it back to exchange A within minutes. Then repeat the process. 

Stablecoins, the backbone to the crypto market

Since stablecoins are cryptocurrencies, they inherit the borderless and quick settlement properties of any other cryptocurrency. USDC has officially launched on Ethereum, Algorand, Solana, Stellar, Avalanche, and has been bridged on to many other EVM chains such as Binance Smart Chain, Near, Oasis etc. With traditional banking infrastructures, it would not be possible to arbitrage cryptocurrencies. This is because wiring money back and forth between crypto exchanges is inefficient and cumbersome. 

This is why the stablecoin market serves as a backbone to the crypto market. Indeed, it greatly it improves liquidity and efficiency. If the circulation of stablecoins were to decrease greatly, crypto prices would become more volatile and less liquid which is a sizeable issue. 

Since the Terra collapse resulted in over $40 B in wealth being lost, there has been many worries regarding stablecoin regulations. To prevent a similar event from happening, regulators might tighten them. Such worries trickled into billion in redemptions (investors redeeming USDT for USD). This caused USDT to trade less than $1 USD for many days. 

This was caused in part by speculation that Tether did not hold enough currency reserves to back USDT. However, it only fell to a low of $0.97 unlike the many decentralized stablecoins that fell by much more during this time. For many years, there was speculation that Tether’s issuer, iFinex, did not hold 1 USD in a bank account for every USDT that was issued. For transparency sake, the three largest issuers have monthly attestation reports with a third party to provide transparency on their currency reserves. 

Improvements on regulation

Circle Internet Financial LLC, USDC issuer, has partnered with nationally ranked auditing firm Grant Thornton LLP to conduct monthly attestation reports and weekly currency reserve audits. The latest attestation report in April 2022 shows that as of April 30th, there were 49 billion USDC in circulation. The attestation claims that Circle has an equivalent amount of assets held in multiple accounts. 

Circle also reports on USDC issuance and redemptions, and what the USDC reserves are made up of on a weekly basis. Since May 27th 2022, 5.1 billion USDC was issued, 4.5 billion USDC was redeemed for USD. As of May 27th, the Circle reserves consist of $12.5 billion in cash, and $41.2 billion in short duration US treasuries (cash equivalents). Similar to Circle, Tether and Paxos have similar monthly attestation reports and currency reserve audits that can be found on their respective websites.

Understanding trade-offs

Lastly, to decide if centralized or decentralized stablecoins are right for you, you must understand the trade-offs between the two. Centralized stablecoins are the safer alternative in terms of keeping their price pegged to 1 USD. However, since they are regulated, they must comply with law enforcement and suspicious behavior. 

Although centralized stablecoins live on decentralized networks that are supposedly censorship resistant, issuers of such stablecoins can blacklist addresses linked to exchange hacks, DeFi exploits, and scams or terrorist financing related activities. 

Having your wallet address blacklisted means that you cannot receive, transfer, or send stablecoins. This could be a problem if you live in an authoritative state like China or Russia, even if you are using stablecoins for legitimate and legally acceptable reasons. 

Furthermore, stablecoin regulations could lead to a stablecoins downfall. If a regulatory framework were to ban the use of stablecoins on certain blockchains like Ethereum, the price of the said stablecoin could fall below 1 USD. Although this is unlikely, the fear of regulation itself can create volatility within stablecoins. 

On the other hand, decentralized counterparts like DAI do not have reason to comply with regulations or law enforcement, and are designed not to be controlled by any entity. Therefore, in theory addresses cannot be blacklisted, and DAI cannot be censored. However, DAI is collateralized by crypto assets such as ETH, USDC, and USDT. 

This means if ETH falls rapidly, DAI could trade under 1 USD because the ETH that collateralized it has lost value. In March of 2020 when ETH crashed 50% in one day to $95, DAI only fell to $0.95. The price decline is less worse than other decentralized stablecoins making DAI the most robust decentralized stablecoin out there. Still, many criticize its inner workings.