Some Simple Economics of Stablecoins and How They Work

Stablecoins are designed to maintain a stable value, typically pegged to a fiat currency like the US dollar. They're often used to reduce the volatility of cryptocurrencies.

To achieve stability, stablecoins usually hold a reserve of the underlying asset, such as US dollars. This reserve is typically stored in a separate account to maintain the illusion of decentralization.

The most popular stablecoin is the USDT, which is pegged to the US dollar at a 1:1 ratio. Its creator, Tether, claims to hold a corresponding amount of US dollars in reserve.

The peg is maintained through a combination of market forces and the issuer's actions. If the supply of the stablecoin exceeds the reserve, the issuer buys back the excess coins to maintain the peg.

A stablecoin is a type of cryptocurrency that's pegged to the value of a traditional currency like the US dollar.

It's designed to minimize price volatility, making it a more stable store of value compared to other cryptocurrencies.

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Stablecoins are often backed by a reserve asset, such as a fiat currency or a basket of assets, which helps maintain their value.

This reserve is typically held in a separate account to ensure it's not commingled with other assets.

The most widely used stablecoin is the USDT, which is pegged to the value of the US dollar.

It's issued by a company called Tether Limited, which claims to hold a corresponding amount of US dollars in a reserve account.

The idea behind stablecoins is to provide a more stable alternative to traditional cryptocurrencies like Bitcoin.

This can be useful for traders who want to avoid the price fluctuations associated with other cryptocurrencies.

In practice, stablecoins can be used for a variety of purposes, including trading, lending, and payments.

They can also be used as a hedge against price volatility in the cryptocurrency market.

The use of stablecoins has grown significantly in recent years, with many exchanges and platforms now supporting them.

This has helped to increase their adoption and use cases.

Stablecoins are still a relatively new concept, but they're becoming increasingly popular in the cryptocurrency space.

Their potential uses and benefits are still being explored and developed.

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Stabilization mechanisms are crucial for stablecoins to maintain their value relative to another asset. This is similar to a currency board, which is required to maintain a fixed exchange rate with a foreign currency and hold that foreign currency in reserves.

There are two broad categories of collateralized stablecoins: off-chain and on-chain. Off-chain stablecoins are backed by bank deposits or other cash-like assets traded in the traditional financial system, such as Tether and USD Coin. These stablecoins are typically fully collateralized by dollar-denominated assets.

Off-chain stablecoins require a custodian for the safekeeping of the collateral assets until the user redeems the stablecoins. This is in contrast to on-chain stablecoins, which are backed by assets that can be represented by tokens on a blockchain.

On-chain stablecoins, such as Liquity USD (LUSD) and Dollar on Chain (DoC), are collateralized by crypto assets and can be held in smart contracts. This eliminates the need for an issuer or a custodian to satisfy any claims.

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Uncollateralized stablecoins, on the other hand, are not backed by any external assets. Examples include Decentralized USD (USDD) and Terra Classic USD (USTC).

Here's a breakdown of the different types of stablecoins:

The three largest stablecoins, Tether, USD Coin, and Binance USD, comprise 91.4% of the total market cap of all stablecoins, as of November 10, 2022.

Achieving stability is crucial for stablecoins, and it's done by manipulating supply. You can influence the value of a token by changing the supply, not the demand.

The market value of a token depends on supply and demand, so to change the price, you need to influence supply. Reducing supply increases the price, and increasing supply decreases the price.

For level targeting, if the current price is below the target, you should reduce supply to increase the current price. This is the opposite of rate targeting, where if the current price is below target, you need to increase supply.

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Rate targeting measures the rate of change of the value, not the current value. It's like knowing your speed, not your position. This approach is used by the Icewater protocol, which measures inflation by measuring interest rates.

The Icewater protocol measures the future value of a token by introducing a new token that pays out the original token over time. If the value of the new token is stable relative to the original token, inflation can be stabilized.

To reduce the issued supply, you can buy back supply in exchange for assets. This can be done by selling external assets, such as ETH or BTC, or by encouraging users to close vaults and settle loans owed to the protocol.

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Stablecoins can achieve stability through two main methods: level targeting and rate targeting.

Level targeting involves adjusting supply to match a target price, whereas rate targeting focuses on stabilizing the rate of change in value. This is achieved by measuring inflation through interest rates, as seen in the Icewater protocol.

The key difference between level and rate targeting lies in their approach to stabilization. Level targeting aims to correct the current price, whereas rate targeting assumes the current price is acceptable and focuses on influencing the future path of the price.

Stablecoins can be categorized into three types based on their stabilization mechanisms: off-chain collateralized, on-chain collateralized, and uncollateralized.

On-chain collateralized stability methods use cryptocurrencies as collateral to back the value of a stablecoin, such as USDT or USDC. This approach ensures that the stablecoin's value is tied directly to the underlying collateral.

The collateral is stored on the blockchain, making it transparent and publicly accessible. This transparency allows for real-time monitoring of the collateral's value and ensures that the stablecoin's value remains stable.

On-chain collateralized methods can be more secure than traditional off-chain methods, as the collateral is not stored in a centralized location and is instead distributed across the blockchain. This decentralized approach reduces the risk of a single point of failure.

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The value of the collateral is typically determined by an oracle, which provides real-time market data to the smart contract. This ensures that the stablecoin's value remains pegged to the underlying collateral.

For example, if a user deposits 1,000 USDT as collateral, the smart contract will issue 1,000 USDC, which can be used for transactions. If the value of the USDT falls below a certain threshold, the smart contract will automatically liquidate the collateral and return the stablecoin to its original value.

Uncollateralized stablecoins, also known as algorithmic stablecoins, are not backed by any external assets. Examples include Decentralized USD (USDD) and Terra Classic USD (USTC) (formerly Terra USD).

These stablecoins experienced rapid growth during the first half of 2022, but their market capitalization fell back to 2021 levels after the collapse of Terra in May 2022. This collapse had a ripple effect throughout the digital asset ecosystem.

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The three largest stablecoins, Tether, USD Coin, and Binance USD, make up 91.4% of the total market cap of all stablecoins, as of November 10, 2022. This dominance is a stark contrast to the growth of uncollateralized stablecoins.

Uncollateralized stablecoins rely on complex algorithms to maintain their target price, whereas collateralized stablecoins are backed by external assets such as bank deposits or crypto assets.

Traditional level targeting assumes the existence of an external unit of account, such as the dollar. This method defines stability as having a stable value with respect to the unit of account.

One way to understand the challenge of building a stablecoin is to consider what happens if you want to build a coin that is itself the unit of account. This is known as level targeting.

Level targeting knows the value you want the stablecoin to have at any particular moment. It's like setting a target on a level playing field.

However, in the absence of an external unit of account, it's tempting to construct a new external unit of account, such as some commodity or combination of commodities. But this approach still assumes the existence of some other stable entity.

Commodity targeting assumes the existence of some other stable entity, or basket of entities. This means you need an off-chain oracle to tell you the price of, say, gold or a basket of precious metals.

Alternatively, you could assume the existence of some other stable on-chain asset, such as USDC. But this doesn't really solve the problem, it just kicks the can down the road.

Increasing equity can be a viable option for reducing liabilities, but it's not without its challenges.

Algorithmic stablecoins have tried to stabilize by buying and selling shares, but this approach is prone to a "death spiral" where a fall in the stablecoin price causes a fall in the share price and vice versa.

Selling equity works well at high share prices, making it a viable option for stability.

However, developing a system that switches between equity and external assets as share prices fluctuate can be complex and is beyond the scope of this discussion.

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