What Are Stablecoins?
Deep dive into the exponential rise in stablecoins & strategies for how to join in on the action
Dear Sunday Investors:
Welcome to this week’s edition of the Sunday Investor! To our new members, the format of this weekly newsletter will be a deep-dive into one investment-topic. This week, we will focus into the concept of stablecoins in the cryptocurrency market. We will discuss the top stablecoins in the market, the different technology powering each type of stablecoin as well as go into how we can invest in different DeFi strategies using each of these stablecoins in the market.
Read, enjoy and share with any friends. Let’s build wealth together.
Weekly Market Recap
Let’s dig into some of the most important events that happened in the markets in the last week:
Citadel CEO Ken Griffin outbids The ConstitutionDAO’s bid of $49M from 17,000 individual investors in US Constitution Auction
Brave Browser released its all-in-one crypto wallet which will take on competitors like MetaMask in the self-custody wallet space. Brave’s wallet is will support ETH, AVAX, and Polygon among other chains. Plans for SOL are in 2022 as well.
The KuCoin exchange announced the creation of the KuCoin Metaverse Fund this week, a $100 million fund that will center around funding metaverse development projects. Metaverse cryptos like $MANA, and $SAND mentioned in our previous newsletter continue their surge upwards to All-Time-Highs.
Staples Center in L.A. to Be Renamed Crypto.com Arena in a blockbuster 20 year $700M sponsorship deal
What is a Stablecoin?
Stablecoins are an asset class in crypto which are designed to combine the stability of a typical currency like the U.S. Dollar while also having the ability to trade quickly online like Bitcoin using the power of blockchain technology. The use of stablecoins have been exponentially increasing because they offer investors the best of both worlds being a volatility-free option in the crypto market with near-instant transfer times in a secure manner on the blockchain.
The total market capitalization for stablecoins has been on an exponential rise this year where the total market cap has risen from $30B in January 2021 to now sitting over $149B. With the overall stablecoin market evolving throughout this past year, let’s dig deeper into the potential reasons for why the stablecoin market has increased almost 500% since the beginning of this year.
This list above on CoinGecko displays the top 10 stablecoin assets in terms of market capitalization. Let’s dig deeper into the different technology powering these stablecoins above.
What Regulation is Surrounding Stablecoins?
Stablecoins continue to come under scrutiny by regulators, given the size of their $150 billion market and potential impact on the broader financial system. Just in October, the International Organization of Securities Commissions (IOSCO) said that stablecoins should be regulated the same as financial market infrastructure alongside payment systems and clearinghouses. The proposed rules specifically targeted stablecoins as regulators are seeing the importance of stablecoins and their ability to disrupt current ways of payment and other settlement transactions.
The President’s Working Group on Financial Markets (PWG), together with the Federal Deposit Insurance Corporation (FDIC) and Office of the Comptroller of the Currency (OCC), issued a joint Report on Stablecoins (the Report) earlier this month which sets out recommendations for the regulation of stablecoin issuers, custodial wallet providers, and others engaged in stablecoin activities.
The report announced no immediate changes to regulations of stablecoins, but a main takeaway from the report was the proposal for how congress should require stablecoin issuers to be FDIC-insured banks in the near future.
What Are The Different Types of Stablecoins?
As shown above, there are many different types of stablecoins in the open market with their own promises of backed-assets, as well as different technology used to keep their 1:1 peg with the U.S. Dollar.
Below, we will go over the four primary stablecoin types which are are characterized by their underlying collateral structure: centralized/fiat-backed, decentralized/crypto-backed, commodity-backed, and algorithmic.
Centralized Stablecoins:
Centralized stablecoins are the first and most common category of stablecoins in the crypto markets. USDT was the first stablecoin that began trading on Bitfinex exchange back in 2015. Because it was the first stablecoin in the market, it had a strong first-mover advantage which has made it consistently the #1 most used stablecoin on the market, and commonly used for trading pairs on the largest crypto exchanges.
Tether and other centralized stablecoins maintain their $1 peg through a 1:1 collateral system. They do this by holding cash in their reserves which are equal to the amount of stablecoin that is issued out to the open market.
Example: If an issuer like USDT or USDC has $100M in fiat currency in their reserves, then they should only be able to distribute $100M in stablecoins.
The controversy has intensified over recent years into how these centralized crypto companies are audited and tracking their reserves. USDT or Tether has been in the news numerous times over the years for their non-transparent issuance process of USDT tokens. In March of 2019, Tether changed their website which initially said its USDT token was 'backed 1-to-1 by traditional currency' to add cash equivalents, receivables from loans, and other assets to its reserves.
Just last month, it was released that Tether will pay $41M to settle allegations that it lied in claiming USDT was fully backed by fiat currencies, which seemingly puts this behind them. With USDT, USDC and GUSD as some of the largest stablecoin assets that investors already use daily to trade on popular exchanges like Coinbase, we know that they will not be going anywhere in the future. But, it is also important to remember that there are other more trustless & decentralized options for stableassets as well.
Examples of centralized stablecoins: Tether (USDT), USD Coin (USDC), Gemini USD (GUSD), Binance USD (BUSD)
Decentralized Stablecoins:
Next up, we will dig into decentralized stablecoins which are backed by a crypto-asset such as Ethereum rather than fiat currencies in centralized versions. The prominent player in the game here is DAI which was made as one of DeFi’s first attempted to make a decentralized “Central Bank” in crypto.
Instead of relying on a centralized issuer to back assets like Tether or USD Coin, decentralized stablecoins rely on the technology of smart contracts to accomplish this. As Gemini explains, to get DAI tokens, you have to lock your cryptocurrency into a smart contract to obtain tokens of equal representative value. You can then put your stablecoin back into the same smart contract to withdraw your original collateral amount. These types of transactions are over-collateralized to buffer against high volatility in the crypto markets.
For example, if you want to buy $10,000 worth of DAI stablecoins, you would need to deposit $20,000 worth of ETH which equates to a 200% collateralized ratio. You have to do this because the excess collateral buffers DAI’s price in order for it to maintain stability and keep its peg at $1. However, if the ETH price substantially drops below a set threshold to your liquidation zone, your collateral is paid back into the smart contract and your position is liquidated.
The two challenges with decentralized stablecoins like DAI are how the current methods of over-collateralization limits capital efficiency, making it difficult for DAI to scale with demand; Another is how the current arbitrage tactics used to keep the price of DAI at $1 requires substantial capital than other centralized stablecoins.
Demand will continue to rise for decentralized stablecoins, so it will be interesting to see how Maker (the creator of DAI) or others will address the potential shortfalls listed above.
Examples of decentralized stablecoins: DAI
Commodity-Backed Stablecoins:
Commodity-backed stablecoins are essentially blockchain-based representations of commodities and are backed by reserves held by a central entity. The most popular commodity to be collateralized is gold as Tether Gold (XAUT) and Paxos Gold (PAXG) are two of the most liquid gold-backed stablecoins on the market.
It is important to note that these commodities such as gold fluctuate in price, so these assets do not have a constant 1:1 peg to the U.S. Dollar like the other categories of stableassets we have discussed.
Holders of XAUT or PAXG are also both able to trade their tokens for cash on the open market, or they are able to redeem their tokens for physical gold at specified locations as well. For many, holding physical gold or silver bars is not always a practical option, so these stablecoins give investors more flexibility if they want to invest in these other asset classes.
Examples of commodity-backed stablecoins: Tether Gold (XUAT), Paxos Gold (PAXG)
Algorithmic Stablecoins:
Algorithmic stablecoins are a newer and more experimental version of stablecoins. As their name mentions, instead of using fiat or cryptocurrency as collateral, their price stability happens from a combination of specialized algorithms and smart contracts that automatically manage the supply of tokens in circulation.
One of the most popular algorithmic stablecoins is TerraUSD (UST), which is the stablecoin connected to the Terra (LUNA) blockchain. How their native stablecoin UST maintains its price stability is by adjusting the supply according to real-time fluctuations in demand.
For example, when the value of one UST is below that of $1, users and arbitrageurs can burn one UST to get $1 worth of LUNA. When the value of one UST is above $1 dollar, they can burn $1 worth of LUNA to get one UST, collecting the “seigniorage” in the process.
Another popular algorithmic stablecoin is Ampleforth (AMPL). The entire circulating supply of AMPL is either automatically increased or decreased every 24 hours to ensure that the AMPL token stays at $1. If the price of AMPL is trading 5% or more above the $1 target, it will cause an expand of supply to AMPL holders and if the price is trading 5% or lower than $1, then the supply will decrease.
There are many ways that the algorithmic stablecoin market is evolving and it will be important to see the developments of similar tokens in this niche throughout the next year.
Examples of commodity-backed stablecoins: Ampleforth (AMPL), TerraUSD (UST), EmptySetDollar(ESD), Reserve (RSR)
The Future of The Stablecoin Market
Stablecoins provide the cryptocurrency investors a way to hold and transact in USD around the clock 24/7. The combination of their ease of use, privacy/security, and near instant transaction times have allowed them to grow exponentially in the crypto markets the last few years with no signs of slowing down. It will be important to keep an eye out for incoming regulations in the space, but it is safe to say that stablecoins will be here to stay.
I believe that the stablecoin market will continue to grow and evolve alongside the expansion of investments flowing into cryptocurrencies in the coming years and it will be exciting to see the innovation in use-cases that expand what is possible through stablecoins.
Investing Using Different Stablecoins
Now that we know the differences in stablecoins, what are the easiest ways to get access to them facilitate our investing strategies in the crypto market?
Buy Stablecoins and Earn 8%+ APY in Interest:
Use a Crypto Exchange like Voyager, BlockFi, or Gemini to exchange your fiat currency into stablecoins like USDC, GUSD, and USDT. On all of these crypto exchanges listed above, you are able to hold your stablecoin for 8%+ APY. I currently use all 3 of these platforms to hold stablecoins that earn interest every month as the current rates of 9% on Voyager exponentially beats Marcus by Goldman Sachs, the best high yield savings account on the market at 0.50%.
Use Stablecoins Across Decentralized Finance
The next step here is to jump into different DeFi protocols to earn yields on the open market. If you have not read this prior newsletter before, I would recommend taking a look for what’s needed to start investing.
First, you will want to set up your own self-custody Metamask Wallet (for ETH) or Terra Station Wallet (For LUNA/UST). Once these are set up, you are able to interact with some of the most popular DeFi protocols like Aave, Compound, Curve, and Maker.
Use DeFi Pulse to see the most active DeFi protocols ranked by the largest amounts of collateral locked in each DeFi platform
Examples of Stablecoin Strategies in DeFi:
Anchor Protocol (ANC): DeFi protocol on the Terra (LUNA) blockchain which offers a goal of 20% APY for the Terra stablecoin UST. Once you have Terra wallet installed, you are able to connect your wallet to the Anchor protocol to stake your UST for these rewards. For step-by-step instructions, the YouTube tutorial I followed is linked here.
Curve Finance (CRV): Curve is a decentralized exchange, known for its pegged-asset swaps like fiat-pegged stablecoins or assets that trade at a 1-1 ratio. With over $3 billion in deposits, Curve’s largest pool is known as 3pool and contains three stablecoins we mentioned today in DAI, USDC and USDT. These stablecoin pools have gained traction offering high liquidity and low fees (0.004%), and users are rewarded with CRV tokens on top of fees as a reward for providing liquidity.
Trader Joe (JOE): Trader Joe is a decentralized exchange that we mentioned in last week’s newsletter on the AVAX blockchain. The current yield farming strategies only with stablecoins are all at 22%+ APR as shown below. If you are a Trader Joe fan, their native token $JOE can be staked for over 30% APR as well on the platform. Overall great platform I would recommend experimenting with.
There are more numerous other DeFi protocols which we can go into futher, but we will save that for another newsletter! Leave a comment if you want me to talk about a specific DeFi protocol.
Next Week
Next week, we will be taking a week break from the Sunday Investor during Thanksgiving before a new post the first week of December!
What do you want to see next? More on Crypto, NFT’s, or Stocks? Comment here what you want to see and I will make it happen:
Not financial or tax advice. The content in this newsletter is for informational purposes only. Every investment and trading move involves risk. Do your own research when making a decision.