Stablecoins in DeFi (Decentralized Finance)

What are Stablecoins?

Stablecoins are cryptocurrencies that are designed to have a stable value, often pegged to a fiat currency like the US dollar or the euro. Stablecoins try to tackle price fluctuations by tying the value of cryptocurrencies to other more stable assets, more commonly used is fiat currencies. Fiat currencies on the other hand are a types of money that are issued by a government and declared to be legal tender for transactions within that country, such as USD, EURO, REAL etc.

The objective of stablecoins is to maintain a stable value relative to a specified peg. As such, stablecoins intend to offer a solution to the price volatility that afflicts other cryptoassets, potentially making them more attractive as a means of payment or store of value. This peg can be one specific asset or a basket of assets. As such, their issuers claim that stablecoins can be redeemed at par with the value of the relevant peg

How Stablecoins Work

Stablecoins work by maintaining their value relative to a stable asset, such as a fiat currency or a commodity. They do this by tracking another assets price through a pegging mechanism.

Types of Stablecoins

Fiat-backed stablecoins: These are the most common types of stable coins. As the name dictates they are backed by a Fiat currency such as Euro, US Dollar, Yen, etc. This implies that for every stablecoin in circulation there is an equivalent amount of Fiat currency in reserve, thus helping to keep the value of the stablecoin stable. Examples include, USDC (USD Coin), BUSD (Binance USD), USDT(Tether). Example of how Stablecoins are backed to Fiat currencies: Tether is pegged to the US dollar at a 1:1 ratio, meaning that one unit of tether should be backed by one unit of US dollar, and the total market cap of tether should be backed 1:1 with assets.
Crypto-backed stablecoins: Just like fiat backed stablecoins, Crypto-backed stablecoins are backed by Cryptocurrencies such as Ethereum, Celo, Bitcoin etc. This means that for every stablecoin in circulation, there is an equivalent amount of cryptocurrency held in reserve, It's good to note that as the crypto market is highly volatile, crypto-backed stablecoins usually over-collateralize the reserves as a measure against price swings. Examples include, LUSD, DAI, MIM, RAI, TerraUSD (UST)
Algorithmic stablecoins: Unlike Fiatbacked stablecoins and crypto backed stable coins, Algorithmic stablecoins do not use any collateral to maintain their value, they instead use algorithms and smart contracts to manage and control the supply of the stable coins or tokens issued. This is usually done by burning or minting stablecoins, depending on the market conditions. Examples include, AMPL (Ampleforth), FRAX (Frax).
Commodity-backed stablecoins: stablecoins that claim to be backed by commodities. Examples are PAX Gold and Tether Gold.

Note: that fiat-backed, commodity-backed and crypto-backed stablecoins are sometimes also defined as collateralised stablecoins, with the first two referred to as

off-chain collateralised and the latter on-chain collateralised stablecoins.

According to CCData, Crypto stablecoin market shift: Tether reigns supreme, new players emerge

January 2024 saw a major shakeup in the stablecoin market, with the established giant Tether (USDT) extending its dominance while new contenders like First Digital USD (FDUSD) and PayPalUSD (PYUSD) made significant strides.

Tether reaches new heights:

USDT market cap soared 3.61% to a record 95.1 billion dollars, solidifying its position as the undisputed leader with a 70.8% market share its highest since December 2020.

Rising challengers:

FDUSD, a newcomer launched in July 2023, witnessed a remarkable 16.6% jump in market cap, reaching 2.1 billion dollars and even dethroning TrueUSD (TUSD) as the fourth-largest stablecoin.
TUSD, unfortunately, saw a 18.5% decline in market cap, dropping to 2.1 billion dollars.
BinanceUSD (BUSD) also faced a steeper 48.7% drop, landing at 625 million dollars.

Newcomer enters the top 10:

PYUSD, launched in August 2023 by the payment giant PayPal, enjoyed a 11.2% market cap increase, securing a coveted spot among the top 10 stablecoins with a valuation of 260 million dollars.

Stablecoin Usecases

Stablecoins offer various usecases to revolutionize how we handle our money. Below are just but a few Stablecoin usecases.

On-ramps/Off-ramps: On and Off ramps are platforms used to enter in to the Crypto ecosystem. On-ramps are ways to buy cryptocurrencies with fiat currency, while Off-ramps are ways to sell cryptocurrencies for fiat currency, all this can also be done through exchanges, brokers and P2P platforms such as Binance. Stablecoins bridge traditional finance (TradFi) and decentralized finance (DeFi), and help ease the transition into this new monetary system. Stablecoins are preferred by many DeFi platforms because of their stable nature compared to other Cryptocurrencies.
Digital Payments: Due to their highly liquid nature and ease of being swapped with fiat stablecoins can be used to facilitate speedy peer-to-peer transactions and payments. Users can send and receive payments without worrying about the price volatility associated with traditional cryptocurrencies like Bitcoin or Ethereum.
Remittances: Cross-border remittances can be costly and time-consuming when using TradFi Platforms. Stablecoins offer a faster and cheaper way to send money internationally, cutting down on fees and processing times. Since the Verification processes are done on-chain, this reduces transaction times from days to minutes.
Hedging Against Volatility: Users can also use stablecoins to hedge against the volatility of cryptocurrencies. By converting their assets into stablecoins, they can preserve the value of their holdings. They can also take advantage of stablecoins to reduce the risk of price volatility in remittances.
Savings and Staking: Stablecoins can also be an alternative to a high-yield savings account, by offering interest-bearing accounts or staking opportunities, users can earn passive income on their holdings.

Why is USDT the most dorminant Stablecoins

Tether is the world's most popular fiat-backed stablecoin with a market capitalization of around $83 billion. It was also the first stablecoin on the crypto market and has the highest number of global transactions, making it the most liquid stablecoin.

Liquidity: As stated above USDT was the first stablecoin on the crypto market and has the highest global transactions, making it the most liquid, hence this makes it a good chice for traders who want to enter or exit the cryptocurrency market quickly and easily
Availability on Multiple Blockchains: Tether is available on various blockchain networks, including Ethereum (as an ERC-20 token), Tron, and more. This allows users to choose the blockchain that suits their preferences and transaction fees.
Pairs and Trading: USDT pairs with a wide range of cryptocurrencies, making it a popular trading pair. Traders often use USDT as a stable store of value when they want to exit volatile markets quickly.
Used in DeFi: Tether is widely used in the decentralized finance (DeFi) ecosystem, where it serves as collateral for loans, a stable asset for liquidity provision, and a unit of account in various DeFi protocols.

Why do stablecoins depeg & repeg

Stablecoins are designed to maintain a stable value relative to a fiat currency or other asset. However, there are a number of factors that can cause stablecoins to depeg, or lose their peg.

Reasons for Depegging

Market volatility: If the market is volatile, it can be difficult for stablecoins to maintain their peg. This is because investors may be more likely to sell stablecoins if they believe that the value of the underlying asset is going to fall.
Market Demand and Supply: The most common reason for a stablecoin to depeg is fluctuations in supply and demand within the cryptocurrency market. If the demand for the stablecoin surpasses the supply, its price may trade above the peg. Conversely, if there's an oversupply of the stablecoin, its price may drop below the peg.
Lack of Reserves: Some stablecoins are backed by reserves (e.g., fiat currencies, cryptocurrencies, or other assets). If there are doubts or concerns about the adequacy of these reserves, it can erode trust in the stablecoin, causing it to depeg.
Technical Challenges: Smart contract vulnerabilities or technical issues on the blockchain platform hosting the stablecoin can lead to depegging. These issues can result in unexpected behaviors that affect the coin's value.

Reasons for Repegging

Algorithmic Mechanisms: Some stablecoins use algorithmic mechanisms to maintain their peg. These mechanisms adjust the coin's supply based on market conditions to influence its price and bring it back to the desired peg.
Market Stabilization: Stablecoin issuers and stakeholders may intervene to stabilize the market by buying or selling the coin in large quantities to maintain the peg.
Market Arbitrage: Traders and arbitrageurs can play a significant role in repegging stablecoins. When a stablecoin deviates from its peg, arbitrageurs may buy or sell the coin to profit from the price difference, helping to restore its value to the peg.

How do Stablecoin protocols make money

Stablecoin protocols can generate revenue in several ways, depending on their design, underlying mechanisms, and business models.

Transaction Fees:Protocols may charge transaction fees from various operations they conduct within their ecosystems, this may range from minting, transferring and trading stablecoins
Lending and Borrowing Fees:In DeFi ecosystems, stablecoin protocols often provide lending and borrowing services. They can charge fees for borrowers to access stablecoins and earn interest from lending out stablecoin reserves.
Seigniorage: Seigniorage is the profit generated by issuing and maintaining a stablecoin that is not fully backed by collateral. When the demand for the stablecoin increases, the protocol mints new stablecoins, sells them to the market at a premium, and generates profit from the price differential. Conversely, when the stablecoin's price exceeds the peg, the protocol may buy back and burn stablecoins to reduce the supply.
Reserve Management: Protocols that hold reserve assets such as, US dollars, cryptocurrencies, may generate income by investing these reserves in interest-bearing assets, such as bonds or lending pools. The interest earned becomes a source of revenue for the protocol.
Governance Token: The issuance and distribution of governance tokens associated with stablecoin protocols can have value. Protocols may benefit from the appreciation of the governance token's value over time.
Collateral Fees: If a stablecoin is backed by collateral assets, the protocol may charge fees for the use of these assets. Users providing collateral may have to pay fees for locking their assets into the protocol.

What's the future of stablecoins

The future of stablecoins will depend on a number of factors, including:

The level of regulatory clarity: Stablecoins are a relatively new asset class, and they are not yet fully regulated in many jurisdictions. This could hinder their adoption and growth.
The development of new technologies: The development of new technologies, such as central bank digital currencies (CBDCs), could also impact the future of stablecoins.
The overall state of the cryptocurrency market: The future of stablecoins will also depend on the overall state of the cryptocurrency market. If the cryptocurrency market continues to grow, then stablecoins are likely to become more popular.

If all factors remain constant we expect to see developments ranging from:

Stablecoin-backed securities
Stablecoin-based derivatives
Stablecoin-based DeFi protocols

Stablecoins Trading Volumes:

Stablecoins See Record Trading Volume on Centralized Exchanges in December 2023

Stablecoin trading volume on centralized exchanges (CEXs) surged to a record high of 995 billion dollars in December 2023, up 27.6% from the previous month.
Tether (USDT) remains the dominant stablecoin, capturing over 81% of the market share among the top 10 stablecoins.
FraxUSD (FDUSD) overtook USD Coin (USDC) as the second most popular stablecoin in January, with an 8.96% market share compared to USDC's 8.43%.
FDUSD's rise in popularity comes as its issuer, Circle, prepares for a potential US initial public offering (IPO)

Data as at January 31st 2024, by CCData