In 2014, the first stablecoins were launched as cryptocurrencies designed to maintain a fixed value over time. However, it wasn’t until the rise of decentralized finance (DeFi) in 2017 that people started to take notice. Over the following few years, stablecoins surged in popularity and went mainstream, with Tether (USDT) and USD Coin (USDC) now ranking third and fourth in the world by cryptocurrency market cap, respectively, directly below Bitcoin and Ethereum. Including roughly 200 different varieties worldwide, stablecoins now have a combined market cap of US$190 billion.
This newfound popularity of stablecoins is not without good reason. They are often seen as a much safer alternative to volatile cryptocurrencies, especially when compared to altcoins, and a convenient way to store money between crypto trades. Significantly, some stablecoins are now even accepted by many shops as a means of payment.
However, stablecoins also have a number of drastic flaws that are now coming to public attention.
The Problem With Centralized Stablecoins
The biggest stablecoins today — USDT, USDC and Binance USD (BUSD) — are centralized, meaning they are wholly controlled by a central entity. In a sense, these companies function like independent banks that mint their own currencies. People who hold these centralized stablecoins bear risks.
Firstly, there is counterparty risk. To what extent can these companies be trusted to uphold their obligations? What if they go bankrupt? In addition, all of the top three stablecoins are collateralized with fiat, which brings its own risks. Tether, for example, came under public scrutiny in 2021 for refusing to disclose where they stored their collateral.
Secondly, there is the risk of censorship. Top stablecoin issuers have disproportionate power when it comes to legitimizing blockchain forks, giving the commanding organization the ability to strongly influence the market values of other cryptocurrencies.
Thirdly, there is increasing governmental pressure to regulate stablecoins in the near future, which means that centralized stablecoins may soon be forced to implement KYC procedures to continue operating, according to recommendations in a November 2021 report released by the White House and the US Department of the Treasury. Furthermore, there is increasing competition from Centralized Bank Digital Currencies (CBDCs), which nations around the world are looking to roll out in the coming years (China, for example, has already done so). CBDCs pose direct competition to centralized, fiat-backed stablecoins.
As a response to these drawbacks, 2017 saw the rise of decentralized stablecoins. These protocols utilize DeFi lending platforms to mint stablecoins via smart contracts when market makers deposit collateral. As the smart contracts run completely autonomously — i.e., without a centralized controlling organization — these stablecoins can mostly avoid the aforementioned risks of centralization.
The Problem With Algorithmic Stablecoins
In 2018, Terraform Labs (Terra) launched TerraUSD (UST), a decentralized stablecoin that used an algorithm to peg the value of 1 UST to the price of US$1 worth of LUNA, their governance token. The stablecoin quickly rose in popularity, causing the market cap of LUNA to skyrocket in turn and become a top ten coin by early 2022. UST was being built up for an array of retail payment purposes, and seemingly had a strong future.
However, everything came crashing down for Terra in May 2022 when two large UST withdrawals caused a significant trading pool imbalance. This precipitated a massive bank run, with UST holders worldwide scrambling to cash out their funds, which ultimately crashed the price of LUNA down to zero.
Terra’s downfall rested in the fact that they collateralized UST with their own cryptocurrency, which in turn based its value on the popularity of their stablecoin. Terra’s dramatic fall from grace was detrimental to the perceived reliability of stablecoins in general, and precipitated a clear move from algorithmic to centralized and collateralized stablecoins, with users now paying very close attention to the actual value of the collateral backing the stablecoins that they buy.
In fact, overcollateralization by an additional 50% to 100% is now being adopted as the go-to standard by new protocols, and is considered to be a far superior method for safeguarding against market crashes.
Market Share of Collateralized Stablecoins (Grew After Terra’s Collapse)
One of the biggest drawbacks of fiat-backed stablecoins gradually became apparent around early 2021, although most people didn’t notice it at the time. Over the ensuing months, inflation rates began to rise higher and faster, surging throughout the rest of the year and into 2022, with no end in sight. As of the time of this writing, US inflation rates are over 10% — meaning that USD-backed stablecoins have also lost over 10% of their value during the past year.
Stablecoins backed by fiat are inherently subject to inflation. All of the most popular stablecoins — including USDT, USDC and BUSD — are rapidly losing value. In fact, a whopping 92% of the stablecoin landscape is both centralized and fiat-backed, with a full 99% being backed by USD.