Introduction

Stable coins are backed by different mechanisms that allow the token to maintain its set price “peg”, many mechanisms have been tried and many have failed during the crypto markets short and exciting history thus far. In this section of the research journal we are going to cover the three main types of stable coins, give a brief overview of the most used coins in each category, and to showcase the best stable coin use cases in Decentralized Finance (DeFi) for lending, borrowing, spending, and saving.

The Three Categories of Stable Coins

All stablecoins fall into three categories: “fiat backed, asset backed, or algorithmic”

Fiat Backed Stable Coins

Fiat backed stable coins are the easiest to understand category where one real world dollar is baking each token. Well known stable coins such as UDSC, Tether, and BUSD fall into this category of coins where each new token released on the block chain is backed by an actual dollar of real world currency in a company’s treasury. These companies such as “Centre” (in the case of USDC) are required to hold a real world dollar for each USDC token they mint on chain, redemptions work the same way where you can send your USDC back to Circle and they will credit your bank account with real world dollars.

Pros

Some of the pros of fiat backed stable coins are that the price will not fluctuate during periods of high volatility and during a market wide meltdown (a Black Swan event) the issuing company can allow redemptions at a stable price. Due to the fiat backed peg mechanism these types of stable coins are very scalable and allow growth across multiple chains. These coins are also much less vulnerable to hacks (smart contract risks) as the collateral for the tokens are held off-chain by the third party custodian.

Cons

Cons associated with a fiat backed stable coin model is “counterparty risk” where you are trusting a third party custodian to handle the dollars in the account responsibly and to remain operating to ensure the stable coins maintain their value. In the case of USDT (Tether) a lot of controversy has happened over the years due the management of the treasury; tether has shown through audits that it holds a lot of treasury bills (short term bonds) and other traditional assets on its books that make up the treasury (backing) of the coin. Due to these centralized companies holding the money you are also at risk of governments seizing funds, freezing wallets, or increased regulation that could endanger the operation of the issuing company.

Crypto Backed Stable Coins

Crypto backed stable coins (also known as over collateralized stable coins) are backed by a single token or a basket of tokens and are typically over collateralized. The most famous of these types of stable coins is “DAI” from “Maker Dao”. A user can borrow DAI by depositing twice the value of Ether in a vault and can withdraw DAI, meaning if you wanted to borrow $100 in DAI you would need to lock $200 in Ether into a vault. This overcollateralization allows the issuing entity to have reserves to defend the peg in time of market volatility. These coins are a decentralized version of the fiat backed stable coin model

Pros

These coins do not have the same counterparty risks as fiat backed stable coins do as the assets are on chain and visible to anyone using a block explorer. Since these coins are decentralized they are censorship resistant and immune to most governmental interventions like the freezing of wallets. Due to the treasury backing of these types of stable coins it is easy to liquidate your coins for crypto within the protocol. Crypto backed stable coins open up a new world of lending and borrowing that did not exist with fiat currencies and is changing the face of finance as we know it today.

Cons

With crypto backed stable coins underlying instability of collateral is an ever present danger; in the case above about DAI, if your $200 of ether suddenly dropped by 50% the protocol would liquidate your collateral, you would keep your DAI, but your eth would be sold and gone. During periods of high volatility the underlying crypto assets can fluctuate wildly in price and destabilize the peg. Scaling a crypto backed stable coin requires more and more assets to be locked into the protocol limiting its ability to grow as the market matures.

Algorithmic Stable Coins

Also referred to as “Hybrid Stablecoins” or “Seigniorage Style Stable Coins” are created and burned based on a complex set of algorithms in a smart contract to keep the price stable. Funds are used to defend the peg by buying the token if the price begins to fall below the $1 peg and selling the token when the price goes above the $1 peg. These algorithmic based stable coins are essentially small focused central banks fighting supply and demand economics to maintain a fixed price. Some protocols maintain a treasury of other crypto assets to help defend the peg, while others like LUNA with UST use a specific coin “LUNA” to create seigniorage in where LUNA is burned to mint UST and UST is burned to mint LUNA when the price peg fluctuates.

Pros

These on-chain smart, contract based stable coins are highly auditable with total transparency as you can look at block explorers and the protocol wallets to see how much of the supply has grown, shrunk, and what other assets are being used to defend the peg.

Do you Believe?

A pro and a con for these types of stablecoins is how strong the belief in them is by the community at large, also known as a “Schelling Point” . If everyone has faith in Terra/Luna and keeps buying then it will grow and become more successful, while if everyone thinks Terra/Luna Is a scam then it will have few buyers, more sell pressure, and a harder time to maintain its peg.

Cons

Understanding how these algorithms work can be daunting even for a trained mathematician and for most normal folks it would be close to impossible to understand the math behind what makes the protocol work; a large problem when assessing the risks of a stable coin. Another con is that the system works most effectively when the supply is growing , the road of progress in this field is littered with plenty of failed algo stable coins that lost their peg and crashed to become worthless. Even well known and trusted stable coins like UST and FEI have lost their peg for short periods of time creating havoc in the eco system.

Examples of Popular Stable Coin Projects

In this section we will take a quick overview of eight stable coin projects and how the models are similar and how they differ from each other. This list was selected based on popularity of the coins, how best they showcase their category, and the inventiveness of the system or tokenomics

USDC (Circle)

Tether (UST)

BUSD (Binance)

Dai (Maker DAO)

sUSD (Synthetix)

FRAX (Frax Finance)

UST (Terra/Luna)

FEI (Fei Labs / TRIBE DAO)

Introduction

Stable coins are backed by different mechanisms that allow the token to maintain its set price “peg”, many mechanisms have been tried and many have failed during the crypto markets short and exciting history thus far. In this section of the research journal we are going to cover the three main types of stable coins, give a brief overview of the most used coins in each category, and to showcase the best stable coin use cases in Decentralized Finance (DeFi) for lending, borrowing, spending, and saving.

The Three Categories of Stable Coins

All stablecoins fall into three categories: “fiat backed, asset backed, or algorithmic”

Fiat Backed Stable Coins

Fiat backed stable coins are the easiest to understand category where one real world dollar is baking each token. Well known stable coins such as UDSC, Tether, and BUSD fall into this category of coins where each new token released on the block chain is backed by an actual dollar of real world currency in a company’s treasury. These companies such as “Centre” (in the case of USDC) are required to hold a real world dollar for each USDC token they mint on chain, redemptions work the same way where you can send your USDC back to Circle and they will credit your bank account with real world dollars.

Pros

Some of the pros of fiat backed stable coins are that the price will not fluctuate during periods of high volatility and during a market wide meltdown (a Black Swan event) the issuing company can allow redemptions at a stable price. Due to the fiat backed peg mechanism these types of stable coins are very scalable and allow growth across multiple chains. These coins are also much less vulnerable to hacks (smart contract risks) as the collateral for the tokens are held off-chain by the third party custodian.

Cons

Cons associated with a fiat backed stable coin model is “counterparty risk” where you are trusting a third party custodian to handle the dollars in the account responsibly and to remain operating to ensure the stable coins maintain their value. In the case of USDT (Tether) a lot of controversy has happened over the years due the management of the treasury; tether has shown through audits that it holds a lot of treasury bills (short term bonds) and other traditional assets on its books that make up the treasury (backing) of the coin. Due to these centralized companies holding the money you are also at risk of governments seizing funds, freezing wallets, or increased regulation that could endanger the operation of the issuing company.

Crypto Backed Stable Coins

Crypto backed stable coins (also known as over collateralized stable coins) are backed by a single token or a basket of tokens and are typically over collateralized. The most famous of these types of stable coins is “DAI” from “Maker Dao”. A user can borrow DAI by depositing twice the value of Ether in a vault and can withdraw DAI, meaning if you wanted to borrow $100 in DAI you would need to lock $200 in Ether into a vault. This overcollateralization allows the issuing entity to have reserves to defend the peg in time of market volatility. These coins are a decentralized version of the fiat backed stable coin model

Pros

These coins do not have the same counterparty risks as fiat backed stable coins do as the assets are on chain and visible to anyone using a block explorer. Since these coins are decentralized they are censorship resistant and immune to most governmental interventions like the freezing of wallets. Due to the treasury backing of these types of stable coins it is easy to liquidate your coins for crypto within the protocol. Crypto backed stable coins open up a new world of lending and borrowing that did not exist with fiat currencies and is changing the face of finance as we know it today.

Cons

With crypto backed stable coins underlying instability of collateral is an ever present danger; in the case above about DAI, if your $200 of ether suddenly dropped by 50% the protocol would liquidate your collateral, you would keep your DAI, but your eth would be sold and gone. During periods of high volatility the underlying crypto assets can fluctuate wildly in price and destabilize the peg. Scaling a crypto backed stable coin requires more and more assets to be locked into the protocol limiting its ability to grow as the market matures.

Algorithmic Stable Coins

Also referred to as “Hybrid Stablecoins” or “Seigniorage Style Stable Coins” are created and burned based on a complex set of algorithms in a smart contract to keep the price stable. Funds are used to defend the peg by buying the token if the price begins to fall below the $1 peg and selling the token when the price goes above the $1 peg. These algorithmic based stable coins are essentially small focused central banks fighting supply and demand economics to maintain a fixed price. Some protocols maintain a treasury of other crypto assets to help defend the peg, while others like LUNA with UST use a specific coin “LUNA” to create seigniorage in where LUNA is burned to mint UST and UST is burned to mint LUNA when the price peg fluctuates.

Pros

These on-chain smart, contract based stable coins are highly auditable with total transparency as you can look at block explorers and the protocol wallets to see how much of the supply has grown, shrunk, and what other assets are being used to defend the peg.

Do you Believe?

A pro and a con for these types of stablecoins is how strong the belief in them is by the community at large, also known as a “Schelling Point” . If everyone has faith in Terra/Luna and keeps buying then it will grow and become more successful, while if everyone thinks Terra/Luna Is a scam then it will have few buyers, more sell pressure, and a harder time to maintain its peg.

Cons

Understanding how these algorithms work can be daunting even for a trained mathematician and for most normal folks it would be close to impossible to understand the math behind what makes the protocol work; a large problem when assessing the risks of a stable coin. Another con is that the system works most effectively when the supply is growing , the road of progress in this field is littered with plenty of failed algo stable coins that lost their peg and crashed to become worthless. Even well known and trusted stable coins like UST and FEI have lost their peg for short periods of time creating havoc in the eco system.

Examples of Popular Stable Coin Projects

In this section we will take a quick overview of eight stable coin projects and how the models are similar and how they differ from each other. This list was selected based on popularity of the coins, how best they showcase their category, and the inventiveness of the system or tokenomics

USDC (Circle)

Tether (UST)

BUSD (Binance)

Dai (Maker DAO)

sUSD (Synthetix)

FRAX (Frax Finance)

UST (Terra/Luna)

FEI (Fei Labs / TRIBE DAO)