Talking nonsense about stablecoins.

The speculative frenzy surrounding stablecoins has long dissipated, so it's a good time to review. I have recorded all the points I can think of and summarized them, although the content may seem scattered.

What is Currency?#

Breaking down the term "stablecoin" into two parts, "stable" and "currency," we can discuss each word separately. Let's first look at what currency is. Let's summarize the definition of currency from Wikipedia:

https://en.wikipedia.org/wiki/Currency

In the early days, currency was simply a receipt symbolizing value stored in the form of commodities, with metals as symbols. It wasn't until the 10th to 9th centuries BC that actual coins were introduced. In Africa, there were various forms of value storage, including beads, ivory, weapons, livestock, and more.

During the coinage phase, copper, silver, and gold were used as currency.

Then came the era of paper money. During the Tang and Song dynasties, the simplification of lending and large-scale copper transactions led to the introduction of paper money, or banknotes. Initially, they were used as promissory notes for large-scale metal transactions.

The advantages of paper money: no need to transport physical gold or silver; facilitated interest-bearing loans with gold and silver; divided currency into credit-backed and asset-backed types. Made stock sales and redemptions possible.

The disadvantages of paper money are also evident: it cannot prevent authorities from printing money indiscriminately, causing the quantity of currency to exceed its backing.

By 1900, most industrialized countries had implemented some form of gold standard, retaining gold and silver but paying in the form of paper money. After the decoupling of the US dollar from gold in 1971, countries that enforced a gold standard ceased to exist.

The banknote phase, which is the current monetary system, no longer requires actual backing for legal tender currency and is purely issued based on debt itself.

Generally speaking, the description of the characteristics of currency includes the following three points: medium of exchange, store of value, and unit of account. In the cryptocurrency market, although tokens like ETH have significant price fluctuations, they still exist as the basic medium of exchange for the entire Ethereum ecosystem and can be considered a form of currency within a specific field. Including cryptocurrencies in the definition of currency, compared to paper money and banknotes, we can create the following table:

Cryptocurrencies as currencies have two main advantages:

Strong liquidity, not limited by geography.
Monetary policy is determined by algorithms and does not have the possibility of overissuance.

Of course, for value storage, it is difficult for purely on-chain DeFi operations to be accepted due to the significant volatility of cryptocurrencies. This is why stablecoins, as one of the three pillars of DeFi, have become essential.

What is Stability?#

In the cryptocurrency field, stablecoins usually refer to coins pegged to the US dollar. Although the US dollar, as a global reserve currency, has relatively small short-term fluctuations, it is not stable in the long run. Since decoupling from gold in 1971, the price of an ounce of gold has risen from $36 to $1700. It is worth noting that this increase occurred while gold production capacity was increasing (gold production capacity increased by 55% from 1995 to 2018).

In the long run, there is no absolute "stable" asset. "Stability" is always defined relative to the prices of other assets. Is the US dollar stable? In the long run, certainly not. Among gold, real estate, and commodities, it is difficult to find truly stable assets. Just look at the real estate bubble in Japan in the 1980s and the recent surge in natural gas prices in Europe. As for inflation rates, they are not assets, cannot be held, and the measurement of inflation rates only represents one aspect of overall price levels.

Since there are no absolutely stable assets, in addition to pegging to the US dollar and gold, there can be other forms of stablecoins. This opens the door for exploring other forms of stablecoins in the cryptocurrency world.

Current Stablecoin Market#

Returning to the topic of stablecoins, the most important ones are, of course, stablecoins pegged to the US dollar. In addition to these, there are projects attempting other types of stablecoins, including non-asset-backed stablecoins and CPI-pegged stablecoins. We will discuss these later.

Stablecoins can be classified based on different dimensions.

Based on the issuer, they can be centralized or decentralized.

Based on the collateralization method, they can be overcollateralized, fully collateralized, or uncollateralized.

The characteristics of major stablecoins are summarized as follows:

Among the total market value of stablecoins of $152 billion, centralized USD stablecoins account for over 90% of the market. In the recent tornado cash regulatory storm, Circle froze related accounts, drawing significant attention to the risks of centralized stablecoins from DeFi players. However, USDC and USDT's high market share still cannot be replaced in the short term.

Some Explorations#

Centralized stablecoins face long-standing issues, such as whether they are fully collateralized, regulatory and compliance risks, and address banning risks.

Algorithmic Stablecoins and Overcollateralized Stablecoins#

Let's first discuss algorithmic stablecoins and overcollateralized stablecoins. For stablecoins pegged to the US dollar, when the stablecoin price is above $1, additional currency can be minted. The problem lies in how to reduce the supply and increase the price when it falls below $1.

Rebase stablecoins like AMPL aim to anchor the price to $1, but not necessarily the value of holders' positions. During the expansion phase, the price of AMPL in wallets is higher than $1, and the quantity gradually increases. During the contraction phase, the process is reversed. The price and supply are always in an expansion and contraction process, never achieving the intended goal of stabilizing the price at $1, and the quantity of tokens in wallets also fluctuates, failing to stabilize the value of holdings.

Algorithmic stablecoins like Basis and ESD rely on selling bonds at a low price during the contraction phase to recover liquidity, with bond buyers expecting to profit from future bond issuance after the price returns. If you think about it, isn't this just continuing to issue debt after unpegging? After purchasing bonds, the coins are not destroyed but will be further issued in the future. Shrinking liquidity through debt expansion will inevitably result in more coins being issued in the future, so there is no actual monetary contraction. If actual monetary contraction is to be achieved, holders must voluntarily destroy their positions. The problem is, who would voluntarily reduce their positions to zero? Moreover, unlike collateralized stablecoins, there is no asset redemption after destruction. Therefore, after unpegging, the more bonds are purchased, the greater the expected selling pressure in the future. Seeing so much selling pressure in the future, no one will spend money to support the peg, especially since there is no collateral. These types of algorithmic stablecoins have no collateral and can only rely on increasing debt issuance to expand the currency supply, with no actual contraction method, so they are destined to fail.

Overcollateralized stablecoins typically use non-stable assets such as BTC and ETH as collateral. The methods of monetary contraction include raising interest rates, liquidating collateral, supporting treasury reserves, and governance token auctions. The main issues are twofold: the issuance is limited by the value of the collateral and the number of users willing to collateralize, and in extreme cases, significant collateral liquidation can occur when the collateral's price fluctuates greatly, resulting in insolvency.

Regarding the first issue, Maker has introduced other stablecoins as collateral, with centralized stablecoins accounting for over 60% of all collateral. Half of FRAX is also centralized stablecoins. The problem is that while centralized stablecoins solve the on-chain circulation problem of stablecoins, what problem does DAI, supported by USDC, solve? It's just arbitrage opportunities between different stablecoins, and they all circulate in the same way. The problems with USDC are the same as those with DAI.

As for the second issue, the risk of collateral's inherent instability can only be optimized through adjustments to LTV thresholds, liquidation methods, etc., but it cannot be completely eliminated. The governance token auction method is equivalent to selling stocks to expand capital. For protocols with a high market position, there will always be buyers for the tokens, which slightly offsets the risk of insolvency.

Several Special Projects#

UST handles contraction by releasing LUNA to purchase UST and reduce the UST supply. However, in the case of a rapid decline in LUNA, the amount of LUNA required to purchase 1 UST increases exponentially, resulting in a vicious cycle of continuous decline in both LUNA and UST. This approach of unlimited currency issuance to support stablecoins has already failed.

RAI releases ETH as collateral but does not have a strong anchoring relationship with any asset price. It only controls supply and demand by adjusting the redemption price. The redemption price refers to the value of collateral that can be obtained in a liquidation, i.e., the amount of collateral tokens. The redemption price is determined based on the difference between the redemption price and the current price. When the market price is higher than the redemption price, the redemption price gradually decreases. RAI holders expect to receive less ETH when redeeming RAI, so they sell RAI, and ETH holders can collateralize ETH, borrow RAI, and sell it, profiting when the price falls and buying back. You can refer to Vitalik Buterin's article for more details. The essence of RAI is also to control price fluctuations by adjusting the supply and demand of RAI through interest rate policies, and it can even implement negative interest rates (i.e., a decrease in the redemption price) compared to DAI. If zero interest rates have already been implemented but the stablecoin price is still higher than the peg, it is not possible to implement negative interest rates, which would invalidate the peg, but implementing negative interest rates can still stimulate borrowing demand and suppress stablecoin price increases. However, for RAI holders, the volatility is smaller than that of ETH, but it does not guarantee stablecoin value and even depreciates relative to the US dollar during appreciation. As long as the US dollar remains a reserve currency, there is still not much opportunity for this type of stablecoin path.

FPI is a derivative product of FRAX that anchors the unadjusted US CPI index. FPI ensures the appreciation of the coin's value through protocol market-making profits, which can be synchronized with inflation rates. If the expected returns do not reach the inflation rate, they are achieved through the sale of FXS. The risk is that there is no guaranteed method to achieve returns that can keep up with inflation rates, resulting in unpegging risks.

OHM generates continuous income through staking OHM. Early OHM stakers can profit from the capital spent on subsequent high-priced purchases of OHM, which is a "first come, first profit, last come, loss" approach with strong Ponzi characteristics. Remember the (3,3) frenzy? Here, let's also take a look at the absurdity of "stablecoins supported by stablecoins." If 1 OHM = 1 DAI and both circulate on-chain, then why do we need OHM?

Aave and Curve Stablecoins#

Aave and Curve are about to launch stablecoins, and the specific details are not discussed here. In simple terms, they allow the issuance of USD stablecoins with protocol-locked assets as collateral, similar to DAI. Aave and Curve have locked assets of around $6 billion, while Maker has around $8 billion. The differences between these protocols are not significant. By issuing new stablecoins, the market share of decentralized stablecoins can be expanded. Uniswap has a locked value of over $5 billion and theoretically can also be used as collateral to create stablecoins. If Aave, Curve, and Uniswap are calculated based on 50% of their locked value, they can issue stablecoins worth $8-9 billion, increasing the non-stablecoin market size by 80%. However, they are still far from centralized stablecoins.

When we push this idea to the extreme, that is, when all locked assets can be collateralized to borrow stablecoins, we can see that they are essentially operating traditional commercial bank collateral lending businesses. Furthermore, we can see that only protocols with a sufficiently large locked value can issue stablecoins because only their assets have sufficient liquidity to execute liquidation, and there will be people willing to buy newly issued shares when they are insolvent. This process is similar to exchanges: when exchanges are large enough, they have sufficient liquidity for traders, and when funds are stolen, they have sufficient capital for compensation. When a few protocols control the major decentralized stablecoins, these protocols become the G-SIBs (Global Systemically Important Banks) of the cryptocurrency field, forming a de facto cryptocurrency banking cartel; if decentralized stablecoins become mainstream stablecoins in the future, the interest rate policies of these protocols will affect the entire market.

We can see that this structure is different from traditional commercial banks in two ways:

Different income structures. Commercial banks primarily rely on interest rate spreads for most of their profits, while DeFi protocols do not need interest rate spreads as their main source of income, such as Aave's flash loan income and Curve's transaction fees. This means that these protocols do not need to urgently expand their balance sheets to generate profits like banks.
Limited by the value of collateral. Decentralized stablecoins are limited by on-chain assets, making it difficult to scale their asset base. Maker is currently introducing real-world assets (RWA) as collateral, such as real estate and accounts receivable.

Regarding RWA assets, Mindao mentioned two points in a podcast: first, the review of assets itself is a traditional banking business involving professionalism and labor costs. Scaling this business requires an entire offline team, without economies of scale. Second, for borrowers, on-chain borrowing does not have a cost advantage because traditional banks can offer loans at lower costs.

On-chain uncollateralized loans may be a direction, but due to fewer sanctions, it is difficult to achieve significant scale.

Related to the previous point, on-chain lending collateral prices are transparent. The value of assets for bank loans always has room for manipulation. For example, in Zhejiang around 2010, a house worth 10 million could be valued at 12 million after a discount. This leads to systemic financial risks always being opaque, and the asset-liability structure of the entire financial system is like a black box. The scale of on-chain asset debt can be clearly calculated, although overestimation and underestimation of assets during expansion and contraction phases are inevitable, the overall balance can still be clearly calculated.

Brainstorming#

In the long run, perhaps Bitcoin has the potential to become a stablecoin. Zoltan Poszar discussed the possibility of currency transitioning from credit money to commodity money, which he called Bretton Woods III. If Bitcoin can serve as a reserve, the value of applications that enable the circulation of Bitcoin is unimaginable. By then, Bitcoin itself will become a stablecoin.