Stablecoins
Stablecoins are cryptocurrencies designed to maintain a stable value, typically by pegging to a fiat currency like the US dollar. In a crypto market notorious for volatility, stablecoins act as a safe harbor. With the rapid growth of DeFi, stablecoins are exploding in popularity because they allow investors to convert speculative assets to safe ones without leaving the network (going off-chain). The total market capitalization of these tokens surged from only a few billion dollars in early 2020 to tens of billions today (Tether alone reached $34.8 billion by February 2021). This growth underscores the enormous demand for stable-value assets in crypto. In this post, we'll explore the use cases of stablecoins in DeFi, the controversies surrounding them (from government scrutiny to questions about reserves), the rise of algorithmic stablecoins, and where the stablecoin sector might be headed.
Why Stablecoins Matter
Stablecoins have become the lifeblood of DeFi, serving multiple crucial roles in the crypto economy:
- Safe Haven from Volatility: Crypto traders and investors use stablecoins as a parking spot during wild market swings. Rather than cashing out to a bank (which is slow and incurs fees), one can quickly swap volatile tokens for a stablecoin (like USDT or USDC) to preserve value. This makes it easy to “de-risk” within the crypto ecosystem. Almost 75% of all trading on crypto exchanges involves a stablecoin as one side of the trade, highlighting how dominant these tokens are as a medium of exchange in crypto markets.
- Unit of Account in DeFi: Many DeFi protocols quote prices and balances in stablecoins (usually USD-pegged) because it’s easier for users to understand a stable value. For example, lending platforms like Compound or Aave often have deposits and loans denominated in USDC or DAI (a decentralized USD stablecoin). Using $1-pegged units lets users calculate yields and costs without worrying about constant price fluctuations.
- Liquidity for Trading and Yield Farming: Stablecoins provide deep liquidity on decentralized exchanges and automated market makers. Pools like USDC/ETH or DAI/ETH on Uniswap allow traders to swap into stable value easily. Yield farming strategies often involve supplying stablecoins as liquidity or lending them out. Because demand to borrow stablecoins is high (for leveraging trades or arbitrage), lenders can earn attractive interest. Even liquidity pools between two stablecoins (e.g. USDC/USDT on Curve) let people trade large amounts with minimal slippage while providers earn fees. Stablecoin liquidity pools and lending markets became a popular way to earn yield on essentially dollar-pegged assets during the “DeFi summer” of 2020. Providing liquidity in an ETH/USDT pool could net returns around 18%, thanks to trading fees.
- Collateral and Leverage: In DeFi, stablecoins are frequently used as collateral for loans and derivatives because their low volatility reduces risk. Borrowers can lock up stablecoins as collateral to take out a crypto loan, or conversely, deposit volatile crypto (like ETH) and borrow stablecoins against it to spend dollars without selling their crypto. Stability is key here – if you borrow $10,000 in a stablecoin, you know you have about $10k of purchasing power, unlike borrowing a volatile token that might crash. Stablecoins thus enable more predictable financial planning in crypto. They also bridge crypto with real-world spending, since one can convert USDC/USDT into actual USD relatively easily via exchanges.
Stablecoins function as the “crypto dollars” of DeFi – a medium of exchange and store of value that connects decentralized apps with the stability of fiat money. They allow the crypto ecosystem to mimic many functions of traditional finance (trading, lending, payments) in dollar terms, but without traditional banks. This pivotal role, however, has not come without controversy and scrutiny.
Controversies: Transparency and Regulation
The rapid growth of stablecoins has raised big questions from regulators and skeptics. Key concerns include how these coins are backed, and whether issuing stablecoins amounts to printing money outside government control. Let's unpack a few major issues:
- Reserve Backing and Transparency: Most popular stablecoins (like Tether’s USDT and Circle’s USDC) claim to be fully backed by fiat reserves, meaning each token is redeemable for $1 held in cash or safe assets. In practice, however, the exact composition of those reserves has been murky. Tether, currently the largest stablecoin, long claimed 1-to-1 backing by dollars in bank accounts. But investigations revealed this wasn’t always true. In 2019, Tether admitted it had loaned out some reserves to affiliated exchange Bitfinex, and in early 2021 Tether’s settlement with the New York Attorney General highlighted that for a period, hundreds of millions of dollars were missing from Tether’s reserves, breaking the promised 1:1 backing. Following regulatory pressure, Tether published a reserve breakdown in May 2021: shockingly, only 3.87% of its reserves were held in actual cash, with the majority in riskier assets like commercial paper (short-term corporate debt). In other words, billions of “stable” USDT tokens were backed not by dollars in a vault, but by IOUs and various investments ("cash equivalents" rather than actual cash). This revelation raised fear that Tether could be vulnerable to a bank-run scenario if too many holders redeemed at once, since not all reserves were guaranteed liquid or safe. Tether’s lawyers argued that holding reserves in other liquid assets is normal and that focusing only on cash was “misleading”, but the episode underscored the "trust-me" nature of centralized stablecoins. Even USDC, generally seen as more transparent, held a portion of reserves in corporate bonds and other investments (though by 2021 Circle began moving to all-cash or treasuries after public pressure). The controversies around Tether’s backing have made many in the crypto community wary. After all, if a stablecoin isn’t truly fully reserved or audited, its “stability” is only as good as the issuer’s solvency and honesty.
- Regulatory Crackdowns and Government Stance: It didn’t take long for regulators to wake up to stablecoins. Governments see private stablecoins as potentially undermining financial control. If people start using digital dollar tokens en masse, how will that affect the banking system and monetary policy? In late 2020, U.S. lawmakers introduced the STABLE Act, a bill that would impose bank-like regulations on stablecoin issuers. The proposal would require issuers to obtain a banking charter, follow banking regulations, notify the Federal Reserve and FDIC 6 months before issuing a coin, and hold FDIC insurance or reserves at the Fed (coingeek.com). In essence, regulators want to ensure stablecoins are as safe as bank deposits if they’re going to be “money”. Politicians like Congresswoman Rashida Tlaib, who sponsored the act, argued it was about protecting consumers and preventing unregulated “Wild West” digital money from proliferating. They even singled out Facebook’s proposed Libra (a stablecoin project by Facebook, later renamed Diem) as a major concern, fearing a tech giant could launch a global private currency outside government control. Libra’s announcement in 2019 indeed rang alarm bells worldwide and faced fierce regulatory pushback, causing the project to stall.
- Shadow Banking and Systemic Risk: Stablecoin issuers hold massive pools of assets to back their coins, effectively acting like unregulated money market funds or banks. For example, if Tether holds $30+ billion in commercial paper, it’s one of the world’s top commercial paper investors, meaning a sudden redemption run on Tether could shock short-term credit markets. Agencies like the U.S. Federal Reserve and SEC started examining whether stablecoins should be treated as securities or funds. International bodies (e.g. the Financial Stability Board) warned that large stablecoins could pose systemic risks if not properly overseen. In early 2021 this was still an evolving discussion, but the likely direction was tighter regulation: requiring regular audits of reserves, capital requirements, and possibly limiting stablecoin issuance to banks or licensed entities. Some governments considered developing their own digital currencies in response (more on that shortly).
- Decentralization vs. Censorship: Another point of contention is that fiat-backed stablecoins are issued by centralized companies, making them subject to censorship or asset freezes. In fact, issuers like Circle (USDC) have blacklisted certain addresses when required by law enforcement. This is at odds with the original goals of Bitcoin. The idea that a “crypto dollar” can be frozen or invalidated by the issuer feels contrary to cryptocurrency’s open, permissionless ethos. It’s a reminder that centrally managed stablecoins carry counterparty risk: you’re trusting the issuer not just to be solvent but also not to arbitrarily lock your funds. This controversy has driven interest in more decentralized or algorithmic models of stablecoins that don’t depend on any single authority (though those come with their own risks, as we’ll see).
Algorithmic Stablecoins
Given the concerns with fiat-backed stablecoins, the crypto community is actively experimenting with alternative designs that remove the need for traditional dollar reserves. Enter algorithmic stablecoins - an ambitious idea to keep a token’s price stable purely through smart contract algorithms and game-theory, without fiat collateral.
How do they work? In simple terms, an algorithmic stablecoin system expands or contracts the supply of the coin to push its market price back towards the peg. This is somewhat analogous to a central bank adjusting money supply, but it’s all automated on-chain. There are a few models:
- Rebasing Models (Elastic Supply): A coin like Ampleforth (AMPL) pioneered the rebasing approach. Instead of each token always being $1, AMPL targets a $1 price by changing the quantity of tokens in every holder’s wallet. If AMPL trades above $1, the protocol “rebases” by minting extra tokens and distributing them proportionally to all holders, increasing supply until price per token falls back toward $1. If it trades below $1, it destroys a portion of tokens from everyone’s holdings (a negative rebase) to reduce supply and push the price up. So your balance of AMPL fluctuates daily, but ideally the value of your holdings stays relatively stable. It’s a mind-bending concept (having 20% more tokens one day than the last, but each worth slightly less). While clever, rebasing can feel disconcerting and relies on traders expecting future rebases to trade it back to the peg. AMPL did achieve periods of $1 stability, but it’s not exact and can swing around the target.
- Seigniorage Shares (Multi-Token Systems): Another design uses multiple tokens to absorb volatility. A notable early example was Basis Cash (BAC) (launched late 2020, inspired by an earlier project Basis). Basis Cash introduced a three-token system: a stablecoin (BAC) intended to be $1, plus a bond token and a governance/share token. When BAC > $1, new BAC are minted and distributed to the share token holders (or sold to expand supply), bringing price down. When BAC < $1, the system issues bond tokens at e.g. $0.95, promising to redeem them for 1 BAC in the future when the price is >$1 (thus incentivizing speculators to buy BAC out of circulation and reduce supply). This design tries to mimic central bank-like open market operations with incentives for arbitragers. In practice, Basis Cash failed. It lost its peg early (trading well below $1) and never recovered, because confidence evaporated and new buyers for the bonds didn’t materialize. This highlighted a core challenge: algorithmic coins are fragile. They work while people believe they will hold $1 and are willing to buy dips or sell rallies, but if that faith falters, there’s nothing concrete backing the value. As of 2021, no purely algorithmic stablecoin had proven truly stable long-term. Most had either drifted off peg or collapsed under extreme market conditions.
- Hybrid and Fractional Models: Newer projects introduced partial collateral to bolster confidence. Frax (FRAX), launched around the end of 2020, is a fractional-algorithmic stablecoin. Frax is partially backed by collateral (e.g. USDC or other assets) and partially stabilized by an algorithmic token called FXS. The protocol might start, say, 80% collateralized and 20% algorithmic – meaning for each Frax issued, $0.80 of real assets are held and $0.20 of value comes from algorithmic market operations. If demand for FRAX grows, it can lower the collateral ratio and rely more on the algorithmic side; if FRAX is under pressure, it can increase collateralization. The idea is to find a sweet spot of efficiency while retaining some trust from collateral. The fractional nature of these stablecoins creates a floor that purely algorithmic tokens do not have (since for the asset to collapse to zero, the underlying value of the cash reserves needs to go to zero as well).
Pros of algorithmic stablecoins
Algorithmic stablecoins aim to be fully decentralized: no bank accounts, no central issuer that could be shut down. If successful, they would be a censorship-resistant, purely crypto-native dollar alternative. They’re also more capital efficient in theory (not needing to park $1 for every token). The promise is alluring: a stablecoin that lives entirely on blockchain magic and game theory.
Cons and risks
History so far has shown they are incredibly hard to get right. Maintaining a peg is a delicate balance that depends on continuous market confidence. If people doubt the peg, a run can occur, driving the price far off target and breaking the system. Unlike fiat-backed stablecoins, there’s no big reserve pool to draw on. The algorithmic design has no intrinsic value floor, it’s only as good as market participants’ willingness to support it. Early 2021 saw multiple algo stablecoins break down: besides Basis Cash, there was Empty Set Dollar (ESD) and others which temporarily hit $1 but then plunged to mere cents once growth stalled. The death spiral scenario is a real threat: if the stablecoin breaks its peg downward, investors may rush for the exits, and the mechanism (often involving printing more of a secondary token to compensate) can lead to hyperinflation of supply and total collapse. In essence, algorithmic stablecoins trade off the issuer/centralization risk for model risk (the risk that the design or assumptions fail in practice).
These projects are experiments. As of 2021, many in DeFi are excited by the idea of a truly decentralized stablecoin (even MakerDAO’s DAI, while crypto-backed and decentralized in governance, ultimately relies on collateral like Ether and centralized USDC to hold its $1 peg). Algorithmic stables are the holy grail of sorts, but their checkered track record means most users still flock to the larger fiat-backed coins for now. Nonetheless, innovation is ongoing. New mechanisms and hybrid approaches could eventually yield a stablecoin that is both stable and resistant to censorship. It’s a challenging balancing act, and only time will tell if a sustainable algorithmic dollar can exist.