Technologies of DeFi markets — Part 2: Stablecoins
Disclaimer: The article can also be read on our Lumos blog, where it was published initially.
The following text is taken from a paper that our alumnus Nikolas Haimerl had written during his Master studies at TU Vienna. Due to the length of the paper, we will publish the key parts of it in a two-part series. While the first part has already provided the necessary background information and put its focus on decentralized exchanges, this second part will take on the topic of stable coins and close out the paper. If you have not read the first part already, you can do so here.
Stablecoins
Key functionalities of cryptocurrencies such as their openness, decentralization and non-regularization also gave rise to issues that are persistent to date in traditional cryptocurrencies with heavy price fluctuation being one of them. Money is expected to have three capacities: a store of esteem, a unit of account, and a medium of trade. Stablecoins are a type of crypto asset made to supply the stability money needs to operate. As the title infers, they are planned to be cost steady with respect to a reference point, such as the USD. Currently, there exist over a hundred stablecoins or are about to make their entry in the market. The biggest three of them sum up to a market capitalization of $4.6 billion [10].
Functionality
Since the most pressing issue that stablecoins try to address is the fluctuation of the coin in relationship to some asset, it is quite common for stablecoins to use the asset itself as a peg and collateral. The peg is generally the asset that the stablecoin is trying to stay stable relative to. Variations of asset-based pegs have been introduced such as a combination of fiat currencies, commodities or even the consumer price index. To date, the most widely adopted peg is the USD with Tether being the biggest stablecoin [10].
Collateral
The most common method through which pegs are achieved is collateral. The basic idea of collateral is to store the same value of the stablecoin in a different asset ensuring that the circulating currency has redemption value. This however means that the storage of the pegged asset will have to meet certain security standards which cannot be provided by any entity. Often, banks are a choice for this storage which in return raises concerns about centralization. One way of mitigating the risks of centralization is to choose a peg that can be stored digitally such as another cryptocurrency. Another method would be to not use a collateral-based, but an algorithmic approach handling supply and demand which ultimately determines the price of the coin [10].
Mechanism
Either way, just like any other currency, stablecoins need some mechanism to adjust the price when it deviates from the peg. In the case of a fully collateralized stablecoin, this is done by simply issuing the pegged asset if the price is too high and by incentivizing users to supply the pegged asset when the price is too low. Arbitrageurs can earn money this way whilst helping to maintain the peg at the same time. Besides the issue of storing collateral the challenge of scalability has proven to be hard to overcome with this traditional approach. As the stablecoin is more widely adopted, more collateral will have to be acquired which leads to the issues of time taken to move the assets when it is being issued or acquired and can ultimately lead to scarcity of the peg. This problem has been addressed by restricting the number of users who are able to supply and redeem coins or collaterals.
In the case of Digix, an upper bound is established through a certain number of users who exclusively have the possibility to redeem collateral which promises to keep the benefit of stabilization without the problem of having to issue collateral assets to anyone who wants to redeem them in exchange for the stablecoins. Facebook’s Libra goes even further to also restrict the supply of collateral in exchange for stablecoins to a limited group of users, effectively establishing an upper and lower bound on the currency. The costs associated with these strategies are speed of adjustments since the number of users being able to participate in the stabilization process is limited and of course, the issue of oligopolies if the number of users with alleviated privileges is not sufficiently high or independent of each other [10].
Dual Coin
To circumvent the problems that are associated with having physical collaterals, dual coins were introduced where the collateral is a second cryp tocurrency. In contrast to the price stabilization mechanism described above, with dual coins, the secondary coin gets auctioned on-chain whenever the primary coin falls below the peg. The proceeds from the auction are then burned to contract the supply which will lead to a price increase until the stable price of the peg is reached. Likewise, whenever the price of the stablecoin exceeds the peg, the primary coin is minted to holders of the secondary coin, effectively increasing supply and decreasing the price.
However, dual coins come with regulatory hurdles due to restrictions on securities from the U.S Securities and Exchange Commission (SEC). These hurdles were enough for various coins to abandon their launch. Furthermore, in the dual coin scenario trust in the secondary coin would also have to be established as the incentive mechanism would fail to provide its stabilizing effect otherwise. Also, to be economically feasible the primary coin would need to be believed to appreciate relative to the peg over time as only then trading for the secondary coin would make sense. Additionally, scalability is also an issue in the dual coin scenario as auctions would need to be increasingly larger if the stablecoin were to be adopted more broadly. The coordination of an auction of that size could be reason enough for the stablecoin to not be a reasonable replacement for a national fiat currency in the first place [10].
A variant has been introduced by Celo which additionally to being stabilized by three other coins has an additional algorithmic market maker which uses redemption-based stabilization rather than auctions as it was the case in predecessors. This partially solves the scalability issue but it is still highly dependent on the desirability of the secondary coin [10].
A more recent development has been introduced to tackle mentioned the issues with dual coins. StatiCoin uses RiskCoin as the secondary coin which has s relatively higher value. ETH is used as collateral for the token contract to mint either of the two coins. Staticoin is pegged to 1$ while Riskcoin can be redeemed for:
vR = (vC- vSout) / vRout
with vC being the value of the entire contract in ETH, vSout the value of the outstanding StatiCoins and vRout the value of the Riskcoins outstanding.
This makes Staticoin unique as it is fully crypto-collateralized so there is no need for physical collaterals and it does not require over-collateralization to absorb volatility [10]. It does however come with significant risks. Above strike price:
pStrike = vSout / vE
the ETH stored in the contract can pay all StatiCoin in full and below the strike price, RiskCoins can become zero if the ETH price does not recover. This essentially means that if the collateral ETH depreciates significantly and stays low StatiCoin will fail as a currency [1].
Algorithmic Supply Adjustments
A different approach to ensuring stable prices is through algorithms controlling the supply of the coin. It is therefore independent of the use of collaterals. The main challenge here resides in the issue that it is difficult to estimate how much the supply would have to be changed in order to tackle a certain demand change. Unpredictable results from algorithmic supply estimates have plagued stablecoins in this field for some time [10].
A prominent example of algorithmic supply adjustment is SAGA (SGA) which strives to maintain a certain reserve ratio. The money model of the SAGA smart contract offers to buy back and destroy SGA tokens at a certain bid price or sells new SGA tokens at a stipulated ask price. The reserve ratio this model tries to maintain is the proportion of SGA market value that is backed by SAGA’s reserves. It represents the level of confidence that the market places in the SGA currency independent of the backing reserve [13].
Economic Developments
Stability
The success of stablecoins will inevitably be tied to whether they can perform what they promise: being stable. This is reflected in whether crypto exchanges adopt a coin and in the long run, it also decides whether the coin has the potential to replace a current fiat currency. The stability of the coin is the key feature and can be measured in absolute or relative means. Often the USD or Bitcoin are taken as a comparison to depict and rate the stability of a stable coin [6].
In 2018 the first paper was published on a thorough analysis of the stability of stablecoins and its influence on the Bitcoin price [14]. In this case, Tether was analysed and while at first there seemed to not be any evidence for manipulation of Bitcoin prices, in a consecutive study it was argued that Bitcoin prices are systematically manipulated through Tether. Furthermore, in 2020 it was found that some stablecoins are robust against large negative price changes in Bitcoin [4].
Absolute stability can be defined as zero variance whereas relative stability requires the volatility of an asset to be less than the asset it is compared to. None of the stablecoins is completely steady but all stablecoins are moderately steady. More particular, none of the stablecoins shows zero variance and homoscedasticity. While all stablecoins are more steady than Bitcoin and in this way are relatively stable with regards to Bitcoin, stablecoins are not as steady as the fiat monetary standards USD, the euro or the valuable metal gold. Hence, not even the relative stability of stablecoins holds against major benchmarks and is restricted to Bitcoin. The source of this instability of stablecoins is the excessive volatility of Bitcoin. An explanation for this can be derived from the fact that if an asset that is supposed to be stable is strongly connected to an asset that is very volatile (Bitcoin), the asset itself cannot be stable. The strong correlations between stablecoin returns and Bitcoin returns as well as stablecoin volatility and Bitcoin volatility and stablecoin trading volumes with Bitcoin trading volumes explain why stablecoins are not as stable as their name may suggest. Stablecoins have also been found to primarily be used for trading cryptocurrencies in particular in the use of opting in or out of the volatility, risk and therefore potential gains or losses of more speculative cryptocurrencies. This also contributes to the excess volatility of Bitcoin [6].
Market Performance
The year 2020 has undoubtedly been an economically and socially challenging year. The market crash in March followed by a very aggressive V-shaped recovery of major indexes such as the S&P 500 was historical. From the perspective of stablecoins, this was an interesting time, as their stability and therefore popularity was put to a test. 2020 was the first year in which stablecoins existed in which a major market crash of the magnitude of 2020 occurred. Therefore, it makes sense to take a closer look at how the stablecoin market responded especially to the crash of the cryptocurrency market in mid-march. Following an overview of how stablecoins performed during the 2020 financial market crisis with respect to stability and popularity and how the performance of stablecoins in this period related to different design aspects of stablecoins will be given [7].
The average daily trade volume in the cryptocurrency market was $123 billion which accounts for more than half of market capitalization in the stipulated time period. With a 3% market share Tether is the biggest stablecoin and the trading volume of Tether was a multiple of its market capitalization. Meaning that on average Tether was traded more than once per day per coin. In 2019 two thirds of the Bitcoin liquidation volume was due to exchanges against Tether. Why Tether was more popular as a means of liquidation than its peg the USD could be explained by the fact, that on-chain transactions are faster than wire transactions. The proportions of the market share to their traded volume are depicted in Figures 3 and 4 [7]. Quite remarkable is the fact that Bitcoin had a smaller trading volume than USDT as shown in Figure 4 despite amounting only to a fraction of the market volume as shown in Figure 3.
The financial market crash in mid-March saw a 30% drop in the USA, Asia and Europe, more than 50% in crude oil prices and a more than 10% drop in gold prices. The cryptocurrencies Bitcoin and Ether dropped by around 50% which resulted in heavy strains on the blockchain infrastructures and service applications such as cryptocurrency exchanges. The stable coin DAI saw liquidation at almost zero prices due to the Ether price crash on March 12, 2020. The reason for that was the heavy liquidation of the collateral of DAI as a response to the price crash of Ether [7].
When looking at how stable the actual stablecoin exchange rate (SX-rate) was compared to the USD, Figure 5 gives an overview of what happened during the cryptocurrency crash on the 12th of march (Black Thursday). Some USD pegged stablecoins showed to be able to hold the peg within 1% (ex. USDT, USDC). Gold-pegged stable-coins showed similar trends but were less severe. Figure 6 shows the boxplots of the log-returns of the stablecoins.
From Figure 7, the on-chain liquidation mechanism used with DAI is visible. The stabilization mechanism of MAKERDAO’s smart contract which issues out loans in DAI liquidated strongly in mid-March hence the spike in volume traded in order to keep the price stable. In the case of Tether, while market volatility was up the traded volume stayed low in relation to other stablecoins. This can be explained by the fact that Tether mainly is used to liquidate Bitcoin and since Bitcoin was at a low price not a lot of liquidation took place.
Looking at the volatility of the stablecoins during the crisis, Figure 8 shows how stablecoins reacted. The volatility is depicted by its exponential weighted moving average. While USDC stayed stable three other USD-pegged stablecoins showed significant jumps in volatility. There was no difference in the jump of volatility between off-chain or on-chain collaterals. The gold-pegged collaterals only showed moderate to low increases in volatility, implying that they are generally the more reliable value store in times of economic downturn. Although the gold-pegged coins did a better job during the crash they showed overall higher volatility than other USD collateralized coins [7].
At last market capitalization relative to before the crash gives valuable insights into the trust of stablecoins. This is visualized in Figure 9. USDC and Tether showed stable market capitalization before the crash and would increase by more than 60% through April 2020. Due to large amounts of automatic DAI liquidations, the DAI fell by 40% in the days during and after the market crash. Summarizing the market events for stablecoins in 2020, it was detectable that the two largest capitalized and fiat collateralized stablecoins provided liquidity and stability during the cryptocurrency crash in 2020. All stablecoins except for one would trade at prices at or above their pegs in the weeks after the trend. This means that demand for stablecoins was increased during the market crash and stablecoins are a valid option for cryptocurrency investors looking to secure their holdings [7].
Conclusion
In this second part about the DeFi market, stablecoins were analyzed. With cryptocurrencies becoming more widely adopted, a need for more stable and predictable coins has been tried to be met by stablecoins. Through traditional and non-traditional algorithmic market makers some have proven to be a relatively stable alternative during the financial crisis of 2020. In the future, they will have to move away from collaterals limiting them in scale and speed and introduce more sophisticated algorithmic and incentive-based strategies in order for the stablecoin to hold their pegs.
References
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