The Rise and Rise of Stablecoins in DeFi
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The Rise and Rise of Stablecoins in DeFi
Stablecoins are one of the fastest-growing asset types in the crypto world. The purpose of these cryptocurrencies is to track a particular peg (usually the dollar) minimizing volatility and providing a convenient unit for transacting.
They have become the lifeblood of the DeFi ecosystem and may look to take over other sectors like remittance and gaming. While differing in implementation they look to avoid violent price fluctuations and enable users to transact in units more familiar to them from traditional finance. Stablecoins have become the bridge between traditional and crypto economies.
The different flavors of stability
Stablecoins currently account for over $18B in total market cap across different blockchains.
There are two main types of stablecoins: custodial backed tokens and algorithmic coins. The first, true to their name, use a centrally stored reserve of fiat assets to guarantee the peg. The tokens are (in theory) backed 1:1 and as such should not deviate from it. The most popular of these are USDT, USDC, and now BUSD.
The algorithmic approach often also uses collateral (in the form of digital assets and not fiat), but unlike custodial backed tokens, it is operated and stabilized through smart contracts and algorithms. It uses economic incentives to motivate arbitrageurs to maintain the peg of the stablecoin. Dai is the most famous stablecoin in the market, but there are others like RSR, USDX and sUSD. These coins exhibit more volatility and at times struggle to maintain the peg.
A third, but the more abstract type as the concept is still in an experimentation phase, is the CBDC or central bank digital currencies. Worried by the fact that DeFi constructs may displace central banks, governments are looking into issuing their own cryptocurrency assets. While some experiments like the Petro have proved largely unsuccessful, the expected arrival of the digital yuan and other major digital currencies has promise.
The key difference between algorithmic coins and their counterparts is ownership and censorship. The setup for USDT and the like enables the custodial agents to freeze assets and even reverse transactions. While these custodial offerings may have simpler onboarding and their regulated status simplifies their adoption, they present a real contradiction to the decentralization ethos.
Stablecoins became a sort of digital cash and as such became useful during risk-off moments in the market, when users wanted to flee to safety but did not want to convert back to fiat. Additionally, leveraging strategies became popular with users.
However, with the near-collapse of MakerDAO in March, it became apparent that stablecoins can have a bigger role in the ecosystem. Their stability feature makes them an interesting diversification instrument, as well as a solid collateral asset.
Prior to the event, MakerDAO’s stablecoin was backed by volatile cryptocurrencies ETH and then BAT. However, these tokens were highly susceptible to market swings, and as March showed when left unbalanced exposed the system to too much risk. At this time, over 42% of Dai is minted from USDC, making it the most popular collateral asset on MakerDAO.
Altcoins are often highly correlated, and as such stablecoins offer a way to reduce risk in the collateral pool.
However, with the DeFi yield farming boom stablecoins gained another major utility boost.
The first major governance token distribution utilizing yield farming was done by Compound. The decentralized loan application rewarded users for loaning and borrowing assets with a share of governance tokens (initially) based on the associated yields.
The stablecoins proved highly popular for farmers, and even with high-interest rates, the proposition was profitable. This was in part due to the fact that the underlying assets loaned and borrowed were stable. Once the attention turned to volatile tokens the community was forced to adjust the distribution strategy.