Concerns about Tether’s reserves are not a new problem, by any means. Investors have long worried about how Tether’s reserves are held- with Tether Limited originally claiming each tether was backed 1:1 with cash since 2014, until a report in May 2021 (the company’s first breakdown of its reserves in seven years) showed less than 3% of Tether’s reserves were cash (many debate whether Tether is essentially an unregulated, traditional fractional-reserve bank).

Tether was fined over $40M for lying about its reserves, alongside allegations that Tether funds were used to cover up $850M in Bitfinex losses (both companies have the same owner), and a full audit has never been conducted into Tether’s reserves.

Not ideal for the largest stablecoin by market cap.

Despite Tether FUD, however, Tether is probably ‘too big to fail’ (at least in the short term, other major market participants would jump in to support it if the peg collapsed). While the purpose of this piece is not to form a view on Tether, given how prominent stablecoins are and the cataclysmic ripple effects the collapse of a major stablecoin would have on the whole ecosystem, it’s important to step back and take a top-down view on the state of the current stablecoin market.

We’ll look at the core theory behind stablecoins, recent innovations (of which there are many), predictions for the future, as well as how we can view the stablecoin phenomena through a historical lens.

Let’s go.

Why do we need stablecoins?

Money has three core functions. As a:

• Medium of exchange

• Store of value

• And a unit of account.

Given the volatility most cryptocurrencies have displayed, something like Bitcoin doesn’t serve all three of these criteria particularly well- I could find I can afford a cup of coffee one day, and not the next- making it a relatively poor store of value and difficult to use for exchange. Stablecoins are therefore are a way to preserve fiat value while staying within the crypto ecosystem (and all the benefits the ecosystem brings, such as decentralisation and interoperability with DeFi).

For this reason, the market cap of stablecoins has exploded alongside the growth of the crypto ecosystem more broadly: from around $38B last year to almost $180B today.

For lovers of the free market, this is great news- why should the state have a monopoly on the issuance of money? Hayek argued this in The Denationalization of Money - competition in the currency market will reward the ‘best’ currency- which doesn’t have to be the domestic currency controlled by the central bank- indeed:

“There is no answer in the available literature to the question why a government monopoly of the provision of money is universally regarded as indispensable. ... It has the defects of all monopolies.” Friedrick Hayek

Going back to Tether, there does seem to be some serious dichotomy between Tether’s rise and the principles of the crypto ecosystem - instead of trusting a bank, I now have to trust another centralised company to own the assets they claim to own and to honour their promise to issue me $1 if I decide to withdraw. That’s some serious counterparty risk.

In fact, any team trying to build a stablecoin thus far has encountered the ‘Stablecoin Trilemma’ - similar to the ‘Impossible Trinity’ for traditional currencies )which essentially states it’s impossible for a country to have a fixed foreign exchange rate, free capital movement and independent monetary policy). Likewise, stablecoins face-off between stability, capital efficiency, and decentralisation.

Types of stablecoins: an overview

1. Centrally issued ‘digital IOUs’ backed by dollars

Examples: Tether (USDT), Circle (USDC), Paxos (USDP - formerly PAX), Binance USD (BUSD)

The most popular stablecoins today follow this model. The idea is users deposit a unit of fiat currency (usually a dollar), and receive a token in return. The company operating the stablecoin (ideally) stores the dollar in a bank account somewhere, and users can come back at any time to redeem their token for a dollar. Tokens are therefore backed 1:1 with dollars. While this approach does largely guarantee stability and is relatively capital efficient (i.e. not highly overcollateralized), the drawback is that this approach is still centralised - you have to trust the issuing party as described above (to store your dollar safely and to honour the IOU). Commodity-backed stablecoins, for example Digix Gold Tokens (DGX) follow a similar model, but use gold instead of dollars.

2. Multi-asset overcollateralized ‘on-chain’ stablecoins

Examples: Maker (DAI), Venus (VAI), Synthetix (sUSD)

These types of stablecoins are backed by other cryptoassets, with the benefit being users don’t have to trust any issuing party as with centrally issued stablecoins. For example, users can create $1 worth of DAI by depositing $1.50 worth of Ether - with the Ether stored in a smart contract that can be verified on-chain and programmed to return the deposited amount when the DAI is returned (or to sell the Ether if it falls below the required collateralization ratio). Smart contracts make this type of stablecoin far more decentralised and trustless than USDT, for example. The downside in this case, as you can probably tell from the example, is that we lose out on efficiency. Given the volatility of cryptoassets, stablecoins such as DAI are heavily overcollateralized, which also gives rise to issues when supplying large amounts of currency. It’s also worth noting that centralised stablecoins such as USDC can be used as collateral for DAI, reducing just how trustless the token really is.

To get a better understanding, let’s take a deeper look into how DAI works. DAI is maintained by MakerDAO - and is considered to be one of the first stablecoins to achieve mainstream adoption.

DAI is created through Collateralized Debt Positions (CDPs)- users deposit Ether (or other accepted tokens), and receive DAI as a loan (for example, the collateralization for ETH is 150% as per the example above). When the loan is repaid (plus interest), the DAI returned is burned. If the collateral of a loan drops below a certain point, the loan is liquidated, i.e. the ETH is sold and used to repay the loan. If the value of collateral drops too much, MKR provides a backstop to the system: MKR is created and sold to re-collateralize the system. MKR is also the governance token for MakerDAO, and is used to pay fees on the platform (and is burned when fees are paid), thus increasing use of DAI should support the MKR price.

3. Algorithmic Stablecoins

Algorithmic stablecoins maintain their peg through a decentralised, self-sustaining protocol. This usually works through adjusting supply automatically in response to changes in demand- essentially acting like a quasi-Central Bank. However, most algorithmic stablecoins aren’t backed by any collateral- mirroring the shift from the gold standard to fiat money in the traditional world. This means that the success of algo stablecoins is highly dependent on sentiment and market psychology- as Haseeb Qureshi put it: “these schemes capitalize on a key insight: a stablecoin is, in the end, a Schelling point. If enough people believe that the system will survive, that belief can lead to a virtuous cycle that ensures its survival.”

Algorithmic stablecoins themselves are fascinating, and probably deserve a piece on their own, but there are a variety of different models, which primarily include Seigniorage Shares and Rebasing.

• Seigniorage Shares

Examples: Terra (UST), Basis Cash (BAC)

The seigniorage shares model was behind some of the earliest stablecoins, such as Basis (which notably shut down due to SEC pressure after raising $133M). The project (with essentially the same design) was revived by another team under the name Basis Cash, which spurred much of the algo stablecoin wave towards the end of 2020. The seigniorage shares model usually takes a multi-token approach to maintain the stable token’s price peg- typically the stablecoin, and ‘bonds and shares’.

For example, in the case of Basis Cash (BAC), when BAC falls below $1, users are incentivised to burn BAC to receive a Basis Bond, reducing BAC in circulation. Users do this in order to profit when the price returns to $1 and the Bond can be redeemed. When the price peg rises above $1, the protocol creates new BAC which is distributed first to Bond holders, and then to holders of Basis Shares.

Although Basis Cash has since failed too, UST uses a similar model. UST is the dollar-pegged stablecoin on Terra’s blockchain, created by Terraform Labs.

The Terra ecosystem is fascinating, and has garnered significant attention in recent months (check out Mario Gabriele’s brilliant overview for the in-depth background). Terra actually has a number of stablecoins, pegged to different fiat currencies, which all operate in a similar way. UST’s peg is maintained through LUNA, which users can arbitrage as one dollar of UST can be swapped for one UST at any time (and vice versa). Hence, when UST rises above $1, arbitrageurs swap $1 of LUNA for one UST, and when UST falls below $1 users swap one UST for $1 of LUNA, making a profit from the spread in either case and maintaining UST’s peg at $1.

Terra has seen a lot of success recently, and the UST price peg has held up pretty well, especially given most seigniorage shares algo stablecoins have failed- likely due to the extensive ecosystem Terraform have built, as CoinBureau put it:

“While most seigniorage stablecoins have failed, Terra stablecoins seemed to have perfected the model by focusing on the one thing that most other projects failed to develop – a functioning value-driven ecosystem. The Terra stablecoins form an integral part of the Terra blockchain as they are used for most trading pairs on the Terra blockchain. The blockchain aims to achieve mass adoption by becoming the easiest and most stable global payment system on the blockchain. They can act as a decentralized bank, giving higher rates and reduced fees, thanks to their Anchor Protocol and Mirror Protocol. While Mirror Protocol brings in participants through its function of being able to create tokenized representations of real-world assets, Anchor Protocol helps keep the money flowing into the ecosystem within the ecosystem by offering attractive staking rewards for their stablecoins.”

Interestingly, recently Terra has also decided to make a switch to have Bitcoin as collateral, as The Pomp put it in his recent newsletter:

“There is approximately $3 billion in bitcoin, Tether, and LUNA sitting in the Luna Foundation reserves today. They are slowly converting the majority of this into bitcoin. As for new issuance, the Terra team will refrain from having market participants burn 100% of their LUNA when they seek UST.

Instead, Terra may burn 60% of the LUNA and use 40% to purchase bitcoin. Here is an example — I want $10 of UST. Instead of burning $10 of LUNA, I may have $6 of LUNA burned and $4 would be used to purchase bitcoin. This dual strategy begins to slowly add a bitcoin-backing to the UST stablecoin that is in circulation.”

Basically:

https://twitter.com/0xfoobar/status/1506113180099096583?s=20&t=k-63_Y49AhbEhGHS8i4Ihw

• Rebasing

Examples: Ampleforth (AMPL), Base Protocol (BASE)

These are rules-based, supply-elastic currencies where the total supply of the token is increased/decreased in proportion to the change from the peg price. For example, if the price of the token rises by 10%, your supply of tokens will also rise by 10%, i.e. you own a fixed fraction of the total AMPL circulating supply, as opposed to a fixed number of tokens. For AMPL, for example:

This automatic supply adjustment process is known as a “rebase” and occurs once each day, with a positive rebase if the price goes above $1.06, and a negative rebase if it is below $0.96. The overall goal of the system is to create incentives that drive the market price of AMPL back to ~$1.

The (significant downside) to this is, if the market cap of the stablecoin drops dramatically, the value of your holdings will also fall by the same proportion, although each individual token will ideally remain close to the pegged price. Personally, it’s unclear how useful this function is, if at all- even though AMPL is still worth around $1, your purchasing power can drop dramatically. And even on that front, AMPL hasn’t really been able to maintain it’s peg very well over its history.

Algo Death Spiral

Although algo stablecoins can scale much more quickly than collateralised stablecoins that have to build up huge reserves to issue currency, and are hugely efficient, the downside is the far higher risk of collapse this type of stablecoins have - they are very reflexive and a collapse in confidence can lead to a death spiral seen by many stablecoins- in the seigniorage shares model, investors face a risk the peg won’t rise back above $1 (hence they won’t be paid), which causes a negative spiral of falling price which reduces the likelihood of people buying bonds further.

Many argue algo stablecoins are fundamentally impossible to sustain. According to Ryan Clements:

“Algorithmic stablecoins are inherently fragile. These uncollateralized digital assets, which attempt to peg the price of a reference asset using financial engineering, algorithms, and market incentives, are not stable at all but exist in a state of perpetual vulnerability. Iterations to date have struggled to maintain a stable peg, and some have failed catastrophically. This Article argues that algorithmic stablecoins are fundamentally flawed because they rely on three factors which history has shown to be impossible to control.

First, they require a support level of demand for operational stability. Second, they rely on independent actors with market incentives to perform price-stabilizing arbitrage. Finally, they require reliable price information at all times. None of these factors are certain, and all of them have proven to be historically tenuous in the context of financial crises or periods of extreme volatility.”

Algo stablecoins essentially look to recreate central banking, but with little of the legitimacy, reputation and access to money markets something like The Fed has.

In crypto, one can’t solely analyse fundamentals. In reflexive environments, you have to analyse the memes.

Concluding Thoughts

While fiat stablecoins remain dominant, others are growing more quickly, vying to outpace the path dependency and deep liquidity in assets like USDT or USDC.

The stablecoin market is still nascent, and there are plenty of unanswered questions, alongside opportunities to build. For example, I reckon we’ll see more non-USD pegged stablecoins. Further, pegging a stablecoin to any currency exposes holders to inflation that is determined exogenously: the value of USDC erodes with inflation of the dollar and you’re exposed to the same geopolitical risks- which is another problem of its own. Some new projects such as UXD claim to have solved the stablecoin trilemma, while solutions such as Frax (see Jack Chong’s great analysis) combine a variety of the previous approaches, which may prove to be successful (although UXD and Frax still have a long way to prove themselves). We’ll probably see a variety of stablecoins gain prominence reflecting different preferences for different user groups- institutions who require deep markets might choose USDT while decentralisation maxis might prefer DAI or UST, although this is weighed against network effects and information costs which tend towards ‘one stablecoin to rule them all’.

Solving stablecoins is one of huge importance, as Kyle Samani from Multicoin Capital put it:

“Stablecoins are one of the highest convexity opportunities in crypto. They aim to become global, fiat-free, digital cash, so the total addressable market (TAM) is simply that of all the money in the world: ~$90T. The opportunity for stablecoins is, intrinsically, the largest possible TAM.” Kyle Samani

If you’re building something in the stablecoin space, I’d love to chat.

Feel free to connect with me on Twitter or LinkedIn - would be great to hear your thoughts/feedback if you’ve made it this far! I’m currently an investor at HodlCo, backing founders in crypto and web3.

The purpose of this recurring piece is to provide a summary of all the major crypto deals in the previous week. Even as a crypto VC, it’s impossible to keep track of everything, so hopefully this acts as a useful summary for investors and builders both inside the space and those peering in. I’ll also provide brief commentary on three of the most interesting/significant deals (IMO). The full sheet with links to articles can be found here.

Notes/disclaimer: The ‘Investors’ column includes the round’s lead investors. Where there are no lead investors given, other well-known investors are listed. The reliability of this information also cannot be guaranteed and is for informational purposes only. Always DYOR.

Last week was a great week for private crypto investments, with large funding rounds into MetaMask parent company Consensys, Aptos- which is trying to bring Meta’s Diem blockchain back to life, and Optimism- a layer 2 scaling solution for Ethereum.

1. ConsenSys

ConsenSys raised a $450M Series D led by ParaFi Capital, more than doubling the company’s valuation since November 2021.

ConsenSys is one of the most significant companies in web3 as the creator of both MetaMask and Infura. MetaMask is one of the most widely used crypto wallets, with over 30 million monthly active users, while Infura is a suite of tools for blockchain developers with over 430,000 users.

Other investors in the round included Third Point, Marshall Wace, Temasek, Microsoft, and SoftBank Vision Fund 2.

ConsenSys Software Inc (which raised the round) spun out of ConsenSys Mesh (a crypto venture builder) in 2020 after a transfer of a number of assets. The deal caused controversy, however, after a group representing over half of the company’s known shareholders claimed that founder Joe Lubin (also a co-founder of Ethereum) illegally transferred a number of assets to the detriment of the shareholders while benefitting Lubin personally.

The company plans to introduce a major MetaMask redesign in the coming months, including plug-in extensibility to allow for greater integration with other protocols, as well as expanding the ConsenSys team significantly. Part of the round proceeds will be converted into ETH, and Lubin said:

“This round takes in digital assets as well as fiat and converts immediately to ETH. Next round will be our ‘Series ETH’ where we will assist investors in getting fully crypto native to contribute ETH as a symbol of and commitment to the ongoing paradigm shift.”

2. Aptos

Aptos raised $200M in a ‘strategic’ investment led by a16z, with participation from the likes of Tiger Global, MultiCoin Capital, 3 Arrows Capital, and FTX Ventures.

Although the valuation wasn’t disclosed, the founders said it was “well off into the unicorn territory”, with the company only being formally founded in December 2021.

Aptos was founded by a number of ex-members of Meta’s Diem team. The Diem Association was developed by Meta, with the goal of becoming a highly accessible crypto payments network, but the project was disbanded with Silvergate Capital acquiring the technology assets for $182M last year.

Aptos is building ‘the safest and most scalable Layer 1’, according to their website, and the Devnet is live, with Mainnet launch expected to occur in Q3. The blockchain will be based on Move, an open-source language initially developed for Diem. The company and its investors believe a highly scalable Layer 1 is a better approach compared to something like Ethereum- with Layer 2 scaling solutions built on top of it, reducing latency, complexity and improving composability. On the security front, founder Mo Shaikh said:

“Feedback that we’ve heard from Solidity and Ethereum developers is that they are running up against limitations, they are running up against challenges where you have to spend hours on auditing your smart contracts. There’s only so much capacity that smart contract auditors have today. Those things continue to become pain points. They are looking for other L1s to build on top of natively rather than just porting over assets or going through bridges because that often compromises security.”

3. Optimism

Optimism announced a $150M Series B at a $1.65B valuation, co-led by a16z and Paradigm.

As the name suggests, Optimism uses optimistic rollups to improve throughput and lower fees for interacting on Ethereum, while maintaining the security of the underlying chain. Optimistic rollups and zero-knowledge rollups are the two primary scaling solutions for Ethereum as of now. They work by conducting many transactions off-chain, before posting the result to the main chain. Optimism has around $370M in TVL, and comes amidst the growth of competitors such as Arbitrum and Polygon, although unlike Polygon, Arbitrum and Optimism do not have a token yet… wen token??

Connect with me on Twitter or LinkedIn- feel free to send any feedback or things you would like to see! I’m currently at HodlCo, investing across crypto and web3.