Decentralized Cash (aka "Stablecoins")
Note: Data in this section last updated March 13th, 2022
What are Stablecoins?
While DeFi has enormous potential to disrupt traditional finance, one thing limiting its development is price volatility. After all, how can we use cryptocurrencies as a medium of exchange if the value is so unpredictable? What good are double-digit interest rates if the value of the underlying assets can decrease by 50% overnight?
Stablecoins help mitigate this volatility. In a sense, a stablecoin is nothing more than a cryptocurrency pegged to a (relatively) secure asset such as the US Dollar. They can be used to buy things, lend and borrow, collect interest and even hold as a store of value. In effect, anything you can do with cash you can do with a stablecoin.
Total Stablecoin Supply
The stablecoin market has grown more than 500% in the past year alone, and currently stands at nearly $200B.
How Are Stablecoins Different from Traditional Cash?
While on the surface stablecoins might seem very similar to the digital money we use today, under the hood they are very different animals. Perhaps the most glaring distinction is in the ownership and control of the assets. The dollar is owned by the United States government – the Fed sets the rules and controls the supply, commercial banks distribute the funds through fractional reserve banking and depositors receive interest.
Stablecoins on the other hand, are a form of private money. They either are governed by a corporation or a DAO (to keep things simple you can think of this as a collective), users create and distribute the funds by depositing collateral and token owners claim the interest.
Today, there are three main types of stablecoins:
Fiat-Collateralized: Fiat-collateralized stablecoins such as Tether and USDC are (or at least claim to be) fully backed by cash. That is, for each $1 of Tether, there should be $1 sitting in a bank account somewhere. The problem with these coins is that, by definition, they are still centralized, relying on banks and other third-parties to keep custody of the collateral. This goes against the decentralized ethos of DeFi, as any centralized point in the chain makes the entire system vulnerable and serves as a magnet for regulators.
Crypto-Collateralized: Crypto-collateralized stablecoins such as Dai are, as the name suggest, backed by a basked of cryptocurrencies and use autonomous protocols to maintain the peg. While promising, crypto-collateralized stablecoins are currently very inefficient, requiring huge amounts of overcollateralization. That’s why the holy grail of DeFi has long been the creation of an Algorithmic Stablecoin.
Algorithmic: Algorithmic stablecoins are decentralized and do not require collateral. The peg is maintained through a complicated incentive program. In essence, when the price goes above $1, more coins are issued, diluting the supply and lowering the price. When it goes below $1, coins are bought back to raise the price.
While algorithmic stablecoins are great in theory, they may not be possible in practice. Economists are quick to point out that they violate the “impossible trinity”, which states that you can’t have a free capital flow, sovereign monetary policy and a fixed exchange rate at the same time.
Indeed, virtually every experiment in this space has failed because incentives stop working if people don’t believe there’s inherent value in the currency. Once trust is loss, everyone sells contributing to a “death spiral” that quickly reduces the value of the coin to zero.
Whether or not this problem is solved by the current batch of market participants, stablecoins will likely continue to play a major role in DeFi as they offer several core benefits:
Permissionless: Anyone can access stablecoins and use them to freely move assets across international borders
Cheaper: Although Ethereum is currently experiencing a significant fee problem, many competing networks offer near-zero fees for using stablecoins (much less than the 2-3% charged by Visa and Mastercard)
Faster: Stablecoin transactions and transfers are near instant and can be performed at any time
Programmable: It’s helpful to remember that stablecoins are software and, as such, can be easily programmed into smart contracts, creating a variety of potential use cases
Transparent: Anyone can view the underlying code and all transactions are easily discoverable on blockchain explorers
Who are the Key Players in the Stablecoin Market?
The market for stablecoins is currently dominated by the fiat-collateralized model, with Tether, USDC and BUSD holding a combined 82% market share.
Last updated
