The Tie Research
DeFi 101: Stablecoins & CBDCs
The traditional banking system has shortcomings: lack of ability to self-custody, costly remittances & settlement processes, and narrow financial inclusion. Stablecoins and central bank digital currencies (CBDCs) address these shortcomings and serve as stable, dollar-denominated digital currencies suitable for store of value and daily transactions.
A stablecoin is a cryptocurrency that's price is tied with fiat (especially the US dollar) or commodity. There are many kinds of stablecoins, each with unique benefits and risk profiles. Because stablecoins derive their value from underlying fiat reserves, stablecoins reflect the monetary policies of central banks (no issuance of new value). No stablecoin or stablecoin issuer has managed to unilaterally dominate the market because market participants can choose which stablecoins they use. Users custody their funds (as opposed to storing them in a bank), and there is no registration required to use stablecoins. Users need only an internet connection to transact within or across borders in seconds, with all transactions viewable on a public ledger.
CBDCs are digital currencies that are liabilities of a central bank. CBDCs could offer some similar benefits as stablecoins, within a centralized, permissioned system. Because CBDCs follow the monetary policy of Central Banks, new value can be issued through CBDCs. Use of CBDCs is subject to a validation process that enforces government policies, like know-your-customer and anti-money laundering laws. Furthermore, CBDCs have varying permission levels, with central bank administrators possessing elevated rights above the standard user.
This article will describe the different categories of stablecoins, contextualize key risks of stablecoins, analyze stablecoin trends, and provide an overview of CBDCs.
The following table is a high-level overview of some of the information that will be covered.
There are three categories of stablecoins: fully collateralized, algorithmic, and fractional algorithmic stablecoins.
Fully Collateralized Stablecoins
Many fully collateralized stablecoins share a centralized token issuer business model. In this model, a user gives collateral (fiat, cryptocurrency, or commodity) to a centralized token issuer, who then mints and provides stablecoins of equivalent or lesser value to the user. The stablecoin is then available for secondary market trade.
A similar process happens when exchanging a stablecoin for collateral, often fiat money. A stablecoin user returns the stablecoin to the token issuer, who then takes the stablecoin out of circulation or "burns" it. The stablecoin user receives collateral equivalent to the stablecoin value.
Token issuers adopt this model because they can take advantage of low-risk off-chain yields, primarily through US Treasury bonds. When off-chain interest rates are high, token issuers, which can be any entity with sizable reserves, can arbitrage rates and provide on-chain liquidity.
In theory, this model guarantees that fully collateralized stablecoins can always be exchanged 1-to-1 with collateral of an equivalent value, avoiding bank run scenarios.
Fully collateralized stablecoins are the most popular type of stablecoin, and include the top three stablecoins by market capitalization: Tether, USD Coin, and Binance USD. These coins also adopt the centralized token issuer business model.
USDT - Tether
- Market Cap: $65b
- Stablecoin Market Cap Rank: 1
- Top 5 Blockchains by Supply: Tron, Ethereum, Solana, Omni, Avalanche
Tether Limited Inc. is the token issuer of USDT (Tether). Tether Limited Inc.’s parent company, iFinex Inc is based in Hong Kong. Tether is found on nearly all major exchanges and is a highly liquid asset. Tether Limited Inc. charges fees and has minimums for minting and redemption Tether.
Because Tether Limited Inc. is the sole token issuer, there are centralization risks when using Tether. For instance, Tether Limited Inc. maintains a global blacklist of addresses that cannot send or receive USDT.
Tether also incurs counterparty risk; some of Tether Limited Inc.'s reserves include digital tokens, commercial paper, and corporate bonds. Tether Limited Inc. can only exchange USDT for fiat currency, assuming it has enough liquidity. If there is insufficient liquidity during a bank run, USDT users will be left holding illiquid tokens. This counterparty risk applies to all centralized token issuer business models.
Although Tether has had a history around disclosure of reserve reports, they now publish monthly reserve attestation reports by BDO Italia, a major accounting firm. These attestations bring more confidence in Tether's reserve backing, but are not a full audit.
Tether Limited Inc. adheres to know-your-customer and anti-money laundering laws, but no US financial services department regulates Tether Limited Inc.
Because Tether is an ERC-20 token on the Ethereum blockchain, smart contract risks are also associated with using Tether. Smart contracts are only as secure as their underlying code. Because smart contracts are open source, potential hackers can look at every smart contract to identify potential security vulnerabilities.
USDC - USD Coin
- Market Cap: $44b
- Stablecoin Market Cap Rank: 2
- Blockchains Supported: Ethereum, Solana, Tron, Avalanche, Polygon
The CENTRE consortium, the issuer of USDC, is a partnership between Circle, a US fintech company, and Coinbase, one of the largest US exchanges. BlackRock, BNY Mellon, and other regulated US financial institutions manage USDC reserves. Grant Thorton LLP audits and provides publically available third-party assurances to USDC reserves each month. USDC is another highly liquid asset found on most large exchanges.
Because the US regulates the CENTRE consortium and the CENTRE consortium is the sole USDC token issuer, there are centralization risks. Like Tether, the CENTRE consortium can freeze USDC use and blacklist individual addresses.
USDC also incurs counterparty risk as regulated third parties manage funds.
Because USDC is an ERC-20 token on the Ethereum blockchain, smart contract risks are also associated with using USDC.
BUSD - Binance USD
- Market Cap: $23b
- Stablecoin Market Cap Rank: 3
- Top 5 Blockchains by Supply: (BUSD) Ethereum, (Binance-Peg BUSD) BNB Beacon Chain, Binance Smart Chain, Avalanche, Polygon
Paxos Trust Company is the sole token issuer of BUSD. The New York State Department of Financial Services (NYSDFS) regulates Paxos and BUSD. Paxos also self-reports its monthly reserve holdings, and WithumSmith+Brown, PC issues attestation reports.
Paxos issues BUSD on the Ethereum blockchain. Additionally, Binance wraps BUSD to create separate tokens called Binance-Peg BUSD. Wrapped tokens are tokens that represent locked collateral and can be redeemed for the locked collateral. These tokens are usable on the BNB Smart Chain, Polygon, and Avalanche blockchains. The NYSDFS does not regulate Binance-Peg BUSD.
Because Paxos is the sole token issuer and has funds managed by third parties, BUSD incurs centralization risks. Like the previous stablecoins discussed, Paxos can blacklist addresses from sending or receiving BUSD.
Using BUSD also incurs counterparty risk through regulated reserve custodians.
Because BUSD is an ERC-20 token on the Ethereum blockchain, smart contract risks are also associated with using BUSD. Furthermore, wrapped BUSD tokens incur additional smart contract risk as the wrapping contract adds another potential attack vector for hackers.
DAI - Dai
- Market Cap: $6b
- Stablecoin Market Cap Rank: 4
- Top 5 Blockchains by Supply: Ethereum, Polygon, Binance Smart Chain, Fantom, Avalanche
Cryptocurrency assets, like Bitcoin and Ethereum, can back fully collateralized stablecoins. Cryptocurrency as collateral enables decentralized governance. Dai is the largest of this kind of stablecoin.
MakerDAO, a decentralized autonomous organization or DAO, is the token issuer of Dai. A community of MKR token holders, a distinct token from Dai, governs the Maker protocol. MKR token holders can vote on new collateral types and adjusting policies for the Dai stablecoin.
MakerDAO issues Dai as a part of a lending and borrowing process. Borrowers can lock their funds in a smart contract called a collateralized debt position (CDP) or Maker Vault. In return for locking up their collateral, borrowers can borrow a percentage against their collateral in the form of newly issued Dai. Borrowers can then exchange this Dai on the secondary market.
Through Maker Vaults, borrowers maintain exposure to their collateralized assets while having stablecoin liquidity ready for deployment.
Dai maintains its stable value through open market arbitrage. If the value of Dai is over $1 on the open market, arbitrageurs can lock up more collateral, mint more Dai, and sell on the open market for profit. If the value of Dai is less than $1, arbitrageurs can buy open market Dai and close their vaults by repaying their loans.
To control the system’s long-term stability, MakerDAO can also adjust a Dai savings rate to encourage the lock up of collateral in the system, and a stability fee, charged during borrowing.
If the ratio of USD value to the value of deposited collateral reaches a minimum amount (varies per collateral type), the collateral gets locked and set for public sale at the price of the outstanding debt and a penalty fee. After the sale, the remaining collateral gets returned to the borrower and minted Dai gets burned.
There is a liquidation risk associated with minting Dai through the borrowing process. Periods of extreme volatility or market crashes heighten liquidation risks. When the value of the collateral loses value relative to the borrowed amount in USD, borrowers must either add more collateral to maintain their Dai position or face liquidation.
Because MakerDAO is a DAO that governs the protocol via governance token, there is a risk that voting power gets centralized by those that own the most tokens. Anyone can view the ownership distribution through block explorers like Etherscan.
Finally, because Dai is an ERC-20 token, a smart contract risk is associated with owning the token.
Algorithmic stablecoins are tokens pegged to the value of a fiat currency or commodity using financial incentives without collateral. There are two kinds of algorithmic stablecoins: rebasing and seigniorage algorithmic stablecoins.
Rebasing algorithmic stablecoins utilize dynamic adjustments to their circulating supply. When the price of the stablecoin becomes too high, the protocol will automatically mint more supply. When the price of the stablecoin becomes too low, the protocol will remove supply from circulation. Each rebasing protocol implements distinct mechanics for minting, burning, and distributing its stablecoins.
Seigniorage algorithmic stablecoins often use a two-token system. One token is the stablecoin, pegged to the value of fiat or commodity. The other token is a value accrual token whose price follows a trajectory tied to protocol use demand.
Seigniorage algorithmic stablecoins have a mechanism that allows the minting or burning of one token in exchange for value in the other. Several protocol-specific implementations exist for minting, burning, and distribution.
While algorithmic stablecoins may be a valid approach to implementing stable currencies, the most well-known algorithmic stablecoin, US Terra (UST), failed and caused a significant crash in the cryptocurrency markets.
USTC - US Terra Classic
- Market Cap: $200m
- Stablecoin Market Cap Rank: 11
- Top 5 Blockchains by Supply: Terra, Binance Smart Chain, Avalanche, Solana, Polygon
The most infamous instance of a widely adopted algorithmic stablecoin was UST, a seigniorage algorithmic stablecoin. UST’s value accrual token was Luna. After the crash, the tokens were rebranded to US Terra Classic (USTC) and Luna Classic (LUNAC). Prior to the crash, UST had a peak market cap of $18.7b, making it the most widely adopted algorithmic stablecoin. Currently, USTC has a market capitalization of $200m.
Anchor Protocol, a popular yield farming protocol on the Terra blockchain, offered ~20% APR rates for locking UST in their contract. Terraform Labs supplied ~$450m worth of subsidies to fund the high APR and boost the demand for Luna.
Open market arbitrageurs stabilized the value of UST and Luna through the protocol's minting and burning mechanism. For instance, if the open market value of UST was at $0.99, users could burn one UST and mint $1 worth of Luna, netting $0.01 in profit. This mechanism would reduce the supply of UST, causing the open market price to increase. If the open market value of UST was at $1.01, arbitrageurs could burn Luna for an equal value of UST and sell on the open market at a $0.01 profit.
In May 2022, UST's price diverged from the US dollar. The divergence, or "depegging," caused a significant crash in cryptocurrency markets. As token holders lost confidence in UST, token holders sold off both UST and Luna in mass, causing the sudden collapse of the TerraLuna. USTC now trades at ~$0.02.
There are design risks associated with TerraLuna. The design of UST assumed that Luna would always be valuable enough to redeem for 1 UST. When the market cap for Luna was lower than the market cap for UST, this assured failure for both tokens. Furthermore, the stability mechanisms were not agnostic to market conditions. As UST and the US dollar divergence increased, the cost for the ecosystem became greater with every exchange through the stability mechanism.
Anchor protocol hampered the TerraLuna’s ability to respond to a depegging event. The high yields that drew users into the ecosystem proved to be a financial liability, limiting the protocol’s ability to maintain the peg.
Fractional Algorithmic Stablecoins
Fractional algorithmic stablecoins offer a hybrid approach that combines collateralized backing and algorithmically stabilizing support. Frax is the most popular stablecoin in this category.
FRAX - Frax
- Market Cap: $1.1b
- Stablecoin Market Cap Rank: 13
- Top 5 Blockchains by Supply: Ethereum, Arbitrum, Moonriver, Fantom, Avalanche
Frax (FRAX) is a stablecoin pegged to the US dollar, with Frax Shares (FXS) as the value accrual and governance token.
FXS builds value through algorithmic market operations (AMO) and fee revenues. AMOs are a set of contracts that conduct arbitrary monetary policy without burning or minting new Frax. FXS is also needed to mint new Frax. The FXS market cap is equal to the non-collateralized value of Frax’s market cap.
A dynamic collateralization ratio (c-ratio) of USDC-to-FXS dictates inputs and outputs for minting and redeeming Frax. This c-ratio adjusts the balance of collateral backing and algorithmic stability; the more USDC in the c-ratio, the more the value of Frax is backed by collateral. Through this dynamic c-ratio, Frax can maintain its stability, while being market agnostic.
The c-ratio changes based on market conditions. When the Frax token trades under $1 on the open market (as provided by the Chainlink oracle), the c-ratio increases. When the Frax token trades above $1 on the open market, the c-ratio decreases. Regardless of market conditions, Frax is minted and redeemed 1-to-1 in accordance with the c-ratio.
Open market arbitrageurs stabilize the price of Frax. If the market price is above the price target of $1, arbitrageurs can profit by minting Frax and selling the minted Frax for above $1 on the open market. If the market price of Frax is below the price target, arbitrageurs can purchase tokens on the open market and redeem Frax for $1 of value from the Frax protocol.
The combination of collateral and algorithmic stabilization allows Frax to avoid the custodial risk and capital inefficiencies (e.g., over-collateralization) of fully collateralized stablecoins. Additionally, Frax avoids the downsides of purely algorithmic stablecoins, including slow growth and periods of extreme volatility.
Centralization risks are associated with using USDC as collateral. As a derivative of USDC, Frax inherits USDC’s risk profile.
Through a variety of AMOs, Frax can perform centralized banking operations on floating Frax. These operations earn revenue for the protocol, but also increase Frax’s potential counterparty risk through integration with protocols like Aragon, Yearn, and Curve.
While Frax is guaranteed to be redeemable for $1 worth of value, FXS is subject to market conditions and could lose all of its value.
According to CBDC Tracker, two countries launched CBDCs, 13 countries launched a CBDC pilot, and 20 countries launched a CBDC proof-of-concept. 86 countries, including the United States, are researching CBDCs.
As the country with the world’s dominant reserve currency and largest financial market, a United States CBDC would dramatically affect domestic and international financial markets.
US CBDC Potential Benefits
Through a CBDC, the US could issue low-risk credit to the general public. This CBDC would eliminate liquidity risk associated with commercial money and non-bank money (like Venmo or other financial service providers). This would likely reduce the demand for commercial money and non-bank money over time.
Similarly, if US central banks assume the role of centralized token issuer, cryptocurrency markets would, for the first time, have a ‘risk-free’ rate for dollars from a trusted counterparty. This would reduce demand for other centralized token issuers without the full faith and credit of the US government, like Tether, BUSD, and Circle.
A US CBDC could allow the US to compete internationally against other CBDCs and stablecoins and preserve the US dollar as the world reserve currency. This could give easier global access to US-denominated credit and rates.
A US CBDC could bring new use cases to mass adoption. For instance, users could program the CBDC for scheduled payments, and payments could be divided into micropayments for streamed payments. A US CBDC could also drastically reduce settlement times and costs of remittances.
Several other potential benefits include providing for new financial services and product, giving bank accounts to ~5% of unbanked Americans, and combating illicit activity by limiting access to funds for known criminals.
US CBDC Potential Drawbacks
A move to a US CBDC would necessitate significant reform of the US financial sector. CBDCs would be a near-perfect substitute for commercial money. Because commercial money poses more liquidity risk than a CBDC, commercial banks may receive fewer deposits. Commercial banks rely on bank deposits to fund their loans, and limited deposits could make it more difficult for households and businesses to acquire credit from commercial banks.
Moreover, CBDC design affects the level of reform required for adoption. For instance, an interest-bearing CBDC could result in a shift away from other low-risk assets like US treasury bills, which would have dramatic downstream effects on bond owners and borrowers.
Assuming US CBDC-cryptocurrency network integration, there would be adoption obstacles for decentralized financial (DeFi) services. CBDCs only function within a permissioned system, so anonymous CBDC liquidity provision, for example, may not be possible. New services would need to be built to accommodate the permissioning process, potentially resulting in a blend of traditional financial and decentralized finance services.
A CBDC could make US Central banks the administrators of all forms of sovereign digital US dollars, centralizing the supply and control of money. Centralizing money supply and control introduces efficiency but also runs the risk of corruption and privacy invasion if implemented without checks and balances.
The Federal Reserve of Boston has partnered with the Digital Currency Initiative at Massachusetts Institute of Technology in CBDC design exploratory research called Project Hamilton. The project is not intended for a pilot of public launch. All of the software from the first phase of the research is open source.
In November 2022, The New York Fed announced it is exploring a proof-of-concept around regulated liability networks. Current distributed ledger technologies are not interoperable for transfer and settlement among regulated financial institutions. Regulated liability networks are a concept to help regulated financial institutions interoperate.
In this article, we have identified problems in traditional finance and two implementations for alternative dollar-denominated currencies: stablecoins and CBDCs. We've defined the three categories of stablecoins (fully collateralized stablecoins, algorithmic stablecoins, and fractional algorithmic stablecoins). For each category, we've explained relevant business models and analyzed the performance and distribution of prominent coins. Finally, we've outlined potential benefits, drawbacks, and current state of a US CBDC.
This report is for informational purposes only and is not investment or trading advice. The views and opinions expressed in this report are exclusively those of the author, and do not necessarily reflect the views or positions of The TIE Inc. The Author may be holding the cryptocurrencies or using the strategies mentioned in this report. You are fully responsible for any decisions you make; the TIE Inc. is not liable for any loss or damage caused by reliance on information provided. For investment advice, please consult a registered investment advisor
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