From payments to DeFi: A closer look at the evolving stablecoin ecosystem

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The rise of digital currencies, exemplified by Bitcoin (BTC), brought a groundbreaking shift in the financial landscape. 

However, it also brought to light a critical challenge: price volatility. Bitcoin and many other early cryptocurrencies exhibited extreme price fluctuations, making them difficult to use for everyday transactions or as a reliable store of value.

Users recognized the need for stability when dealing with digital assets, particularly when conducting business or holding assets for an extended period. This need for stability in the digital currency realm paved the way for the development of stablecoins.

As a result, stablecoins emerged to address the need for a reliable and consistent value in the digital currency space, employing various strategies such as asset pegging to fiat currencies or commodities and algorithmic mechanisms to achieve stability.

Stablecoins come in two primary categories, the first being collateralized stablecoins, like Tether (USDT), which are backed by real-world assets like fiat currencies or commodities, with each token linked to a specific asset to maintain stability.

The second type is algorithmic stablecoins, such as Dai (DAI) from MakerDAO, which don’t rely on physical collateral but instead use smart contracts and algorithms to manage supply and demand, striving to keep their price stable through decentralized governance and automated processes.

These stablecoins have since become integral components of the cryptocurrency ecosystem, enabling secure and stable digital transactions and opening up new possibilities for financial innovation. Here’s a closer look at some of the top stablecoins, how they came to be, and where they are now.

The birth of stablecoins

Tether (2014)

USDT launched in 2014 as a cryptocurrency created to bridge the gap between traditional fiat currencies and the digital currency ecosystem. It was founded by Tether, with Jan Ludovicus van der Velde serving as its CEO. 

USDT was introduced during a time when the cryptocurrency market was growing rapidly but lacked a stable asset-backed digital currency.

Its unique selling point was its peg to the United States dollar. Each USDT token was designed to represent one U.S. dollar.

USDT faced early controversies and skepticism. One major concern was whether Tether held the dollar reserves it claimed to back its tokens. The company’s opaque financial practices and lack of regular audits fueled doubts within the cryptocurrency community. However, in recent times, Tether has published information about its reserves.

Tether claims to hold enough reserves to maintain a 1:1 peg to dollars, backing every USDT in circulation. This peg to a fiat currency was intended to provide users with a reliable and stable digital currency for various use cases, including trading and remittances.

According to a full reserve breakdown in 2023, Tether is backed by cash, cash equivalents secured loans, corporate bonds and other investments, including digital tokens.

A spokesperson for Tether told Cointelegraph, “Tether’s Q2 2023 assurance report highlights our prudent investment strategy. We have 85% in cash and cash equivalents, around $72.5 billion in U.S. Treasurys, along with smaller holdings in assets like gold and Bitcoin. We are gradually eliminating secured loans from our reserves. Last quarter, we added $850 million to our excess reserves, totaling about $3.3 billion, further bolstering Tether’s stability.”

Tether reserve assets as of Q2 2023. Source: Tether

Still, Tether’s role in the cryptocurrency market has drawn scrutiny. It has become widely used to transfer value between different cryptocurrency exchanges, allowing traders to avoid using traditional banking systems. Some critics alleged that Tether was used to manipulate cryptocurrency prices, particularly Bitcoin, by creating synthetic demand.

Despite these controversies, Tether remained one of the most widely used stablecoins in the cryptocurrency ecosystem, serving as a crucial tool for traders and investors navigating the volatile crypto markets.

Dai (2017)

DAI is a decentralized stablecoin that operates within the Ethereum blockchain ecosystem. It was created by the MakerDAO project, which was founded in 2014 with the goal of establishing a decentralized and algorithmic stablecoin solution. 

Dai is not backed by a reserve of fiat currency. Instead, Dai is collateralized by a variety of cryptocurrencies, primarily Ether (ETH), which users lock up in a smart contract called a collateralized debt position (CDP).

Users who want to generate Dai deposit a certain amount of Ethereum into a CDP and then create DAI tokens based on the collateral’s value. The user can then use these DAI tokens as a stable medium of exchange or store of value.

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To ensure the stability of Dai, the MakerDAO system monitors the collateral’s value in the CDP. If the value of the collateral falls below a specified threshold (known as the liquidation ratio), the system can automatically sell the collateral to buy back Dai tokens and stabilize its value.

Additionally, the stability mechanisms of Dai have evolved over time. In addition to Ethereum, MakerDAO has introduced multicollateral Dai (MCD), allowing users to collateralize a wider range of assets, further diversifying the system and reducing its dependency on a single cryptocurrency. This evolution has made Dai more resilient and adaptable to market changes.

USD Coin (2018)

USD Coin (USDC) was launched in September 2018 as a joint venture between two well-known cryptocurrency companies, Circle and Coinbase. The stablecoin is also managed by Centre, a consortium co-founded by the two companies.

However, Circle and Coinbase dissolved Centre, the group responsible for overseeing USDC since 2018, in August 2023. As a result, Circle was given sole governance of USDC.

The coin temporarily lost its 1:1 peg with the U.S. dollar in March 2023 when Silicon Valley Bank, where Circle held $3.3 billion of its currency reserves, collapsed due to a liquidity crisis. While the coin briefly dipped to $0.87, Circle later confirmed that it was able to withdraw its reserves from SVB, restoring the 1:1 peg, but not without a blow to user confidence.

USDC’s primary purpose is to provide a digital representation of the U.S. dollar, making it easier for users to transact in the cryptocurrency space while avoiding the price volatility associated with other cryptocurrencies like Bitcoin or Ethereum. Each USDC token is meant to be backed by a corresponding amount of dollars held in reserve, which is regularly audited to maintain transparency and trust within the ecosystem.

Breakdown of Circle’s reserves. Source: Circle

USDC operates on the Ethereum blockchain as an ERC-20 token. However, it has since expanded to other blockchains like Alogrand, Stellar, Base and Optimism to increase its scalability and reduce transaction costs. This interoperability has broadened its use cases beyond just the Ethereum network, making it accessible to a more extensive range of users and applications.

Within the decentralized finance (DeFi) ecosystem, USDC is used in many ways. First, it functions as a source of liquidity in decentralized exchanges like Uniswap and Curve. Users provide USDC to these platforms, becoming liquidity providers and earning a share of the transaction fees generated by these pools. This offers a way to generate passive income from USDC holdings.

Additionally, USDC can be used as collateral for borrowing on DeFi lending platforms such as Compound and Aave. Users lock up their USDC assets as collateral, allowing them to borrow other cryptocurrencies or stablecoins. This enables leverage and liquidity without traditional intermediaries, and it also lets users earn interest on their USDC deposits while using them as collateral.

Furthermore, DeFi enthusiasts often engage in yield farming and staking using USDC. By participating in liquidity pools or staking their USDC tokens, users can receive rewards, typically in the form of governance tokens or interest.

TrueUSD (2018)

TrueUSD (TUSD) was released in March 2018 by TrustToken, a blockchain technology company focusing on creating asset-backed tokens. 

The coin has wavered from its 1:1 peg to the dollar at several points, one of the more recent incidents being when Prime Trust, a technology partner to the stablecoin, announced it was pausing TUSD mints.

In October 2023, the project came under fire as a hack at one of its third-party vendors potentially compromised the Know Your Customer data of TUSD users. TrueUSD quickly noted the reserves themselves were secure and never put at risk.

TrueUSD is often used in cryptocurrency trading and investment as a way to park funds during market volatility, offering traders a safe haven from crypto price fluctuations.

Binance USD (2019)

Binance USD (BUSD) is a collateralized stablecoin issued by Binance, one of the world’s largest cryptocurrency exchanges. It was introduced to the cryptocurrency market in September 2019. 

The value of BUSD is intended to remain close to 1:1 with the U.S. dollar, meaning that 1 BUSD is generally equivalent to 1 U.S. dollar. To achieve this stability, Binance holds equivalent amounts of U.S. dollars in reserve to back the BUSD tokens in circulation.

This reserve is regularly audited to ensure that it matches the total supply of BUSD, thus maintaining the coin’s peg to the U.S. dollar. This transparency and asset backing are essential for instilling trust among users and investors.

BUSD can be used for various purposes within the cryptocurrency space. Traders often use it as a stable medium to park their funds when they want to exit volatile cryptocurrency positions temporarily. It is also employed in trading pairs on Binance and other exchanges, allowing traders to move in and out of positions with ease.

Moreover, BUSD has found applications outside the trading world. It is commonly used in decentralized finance platforms and yield farming protocols like PancakeSwap as a stable asset to provide liquidity or collateralize loans. However, recently, Binance has started to wind down support for the BUSD stablecoin and plans to stop the support for BUSD entirely by 2024.

This decision was made due to its issuer, Paxos, being ordered to stop the minting of BUSD by the New York Department of Financial Services.

TerraUSD (2020)

TerraClassicUSD (USTC) — formerly known as TerraUSD (UST) — is a stablecoin released in 2018 that was algorithmically stabilized rather than being backed by a reserve of traditional assets like fiat-collateralized stablecoins. 

USTC distinguished itself by operating on a unique algorithmic mechanism that used incentives and disincentives to keep its value close to $1. One of the key features of USTC was its use of Luna (LUNA), the native cryptocurrency of the Terra blockchain, as collateral.

When USTC’s price deviated from its $1 target, a mechanism called the Terra Stability Reserve came into play. If TerraUSD was trading above $1, users could mint new TerraUSD by locking up Luna as collateral. Conversely, when TerraUSD was trading below $1, users could redeem it for Luna at a profit, effectively balancing the supply and demand to bring the price back to its target.

On May 7, 2022, USTC depegged from the dollar after a series of trades took advantage of a “shallow” pool on the decentralized exchange 3pool, causing the coin to lose its peg to the dollar.

Efforts to restore the peg worked briefly but were ultimately unsuccessful. During the same period, the complementary token, LUNA, originally intended to provide price stability to UST, suffered a dramatic decline, plummeting from $80 to $0.005.

The following day, on May 25, Terra’s network validators voted in favor of a transformative proposal presented by Do Kwon, one of the project’s co-founders. This proposal sought to launch a new blockchain called Terra 2.0, which would notably exclude a stablecoin component.

Under this plan, previous holders of LUNA and UST would receive the new blockchain’s native token, Terra (LUNA2), based on the amount of these tokens they held. This transition aimed to recalibrate the Terra ecosystem and diversify its offerings.

Importantly, the original Terra blockchain would continue to function alongside Terra 2.0, and its token would be renamed to Luna Classic (LUNC), while TerraUSD was rebranded as TerraClassicUSD or USTC.

Overall, this saga called into question the practicality and stability of algorithmically balanced stablecoins, as user trust in such ecosystems and $50 billion in value evaporated.

The evolving landscape of stablecoin projects

Regulatory changes are a significant factor influencing the stablecoin landscape. Governments and regulatory bodies are increasingly scrutinizing stablecoins due to financial stability, consumer protection and Anti-Money Laundering (AML) compliance concerns. In October, U.S. Federal Reserve Board Governor Michelle Bowman argued against the use of stablecoins due to their low level of regulation.

Some countries are actively working on regulatory frameworks to address stablecoin issuance and usage within their jurisdictions. These regulations may require stablecoin issuers to adhere to specific reserve and reporting requirements. For example, Singapore requires stablecoins to maintain minimum base capital and liquid assets to reduce the risk of insolvency.

In July, the Financial Stability Board (FSB), which monitors and makes regulations regarding the global financial system, created a cryptocurrency regulatory proposal. The FSB suggested that global stablecoin issuers establish a governance body and that the minimum reserve asset ratio be set at 1:1 unless the issuer “is subject to adequate prudential requirements” like commercial bank standards.

Stablecoin projects themselves have also been evolving along with changing legal and economic conditions.

Competition among stablecoin projects has increased transparency, with many issuers providing regular audits and attestation reports to prove their asset backing and stability. Cross-chain interoperability is also a growing trend, allowing stablecoins to move seamlessly between blockchain networks.

Tether’s spokesperson said, “The potential advantages and challenges of stablecoins moving seamlessly between different blockchain networks are significant […] This capability enhances interoperability, allowing users to transact across various ecosystems, fostering a more interconnected blockchain space. Additionally, it grants access to unique features and applications on different blockchains, enabling users to leverage the strengths of each network for specific use cases.”

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DeFi is another industry where stablecoins are growing in popularity. Flex Yang, founder of Hope.money, a stablecoin protocol backed by crypto-native reserves, told Cointelegraph, “Stablecoins also play a pivotal role in the DeFi ecosystem, enabling users to engage in lending, borrowing, trading and earning interest without exposing themselves to the volatility of other cryptocurrencies. For instance, staking USDT for a year can result in an annualized return of approximately 6%.”

Stablecoins also enable yield farming and liquidity provisioning in DeFi. Users can provide liquidity to decentralized exchanges and automated market makers by pairing stablecoins with other cryptocurrencies. This process, known as liquidity provisioning, allows users to earn fees and incentives while maintaining the stability of their assets.

As stablecoins play a crucial role in the broader cryptocurrency and financial landscape, expect ongoing innovation, partnerships and adaptation to market dynamics.

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