Stablecoins are supposed to be stable- they are supposed to remain pegged to a certain value, most commonly the US Dollar.
But, as the past few months have demonstrated, stablecoins do not always fulfil this expectation.
The spectacular collapse of the UST ecosystem, as well as the USDC depegging that occurred not long ago, show that perhaps stablecoins are not as stable as their name implies- but why?
This will be the focus of today’s exploration- to understand where stablecoins get their stability from, and how we can avoid further implosions.
Where do stablecoins come from?
While many have argued that Do Kwon was just out to rug people, and have blamed the USDC depegging as part of the US governments’ attacks on crypto, it was ultimately the market that decided to dump the coins when they felt these coins were not worth holding on to.
These coins were held by everyday consumers, who were free to buy and sell these tokens on the free market. And in every market, it is demand and supply that determines the price and quantity of every good sold- even for tokens and coins.
It is therefore important to understand what creates demand for a currency, and how stablecoins are supplied.
A very basic overview is that when more people want to hold a particular currency, the price of that currency appreciates as people are willing to pay more for it, causing the currency to appreciate and gain value.
Conversely, when less people want to hold a particular currency, demand falls and people hoping to sell the currency are forced to lower prices if they want to sell it.
Supply works in a similar way- if more people sell the currency, the price that each unit of currency can fetch decreases, and if less people sell the currency, the price of each unit of currency increases.
But how stablecoins are supplied is different from how other tokens are supplied. While you might mine Bitcoin or Ethereum, stablecoins are not. Instead, stablecoins are created when someone deposits money with the stablecoin issuer- who then issues the depositor an equivalent amount of stablecoins.
Most stablecoins are backed essentially with fiat currency- some may be backed with assets that can be exchanged with fiat, or with fiat currency directly, but there is no stablecoin that does not have collateral. Even algorithmic stablecoins like UST were collateralised in Luna, which in turn could be exchanged on the open market for fiat currencies.
Of course, the health of the stablecoin issuer can often be a single point of failure when it comes to the token’s value. The stablecoin functions as money because people who accept it as payment are confident that they can eventually exchange the stablecoin back to fiat on demand, either through the open market, or directly with the stablecoin issuer, who will return them the fiat that was deposited.
This is why collateral is seen as important- if for whatever reason, consumers decide not to hold their stablecoins, and redeem them for fiat, the stablecoin issuer must have enough left in reserve in order to fulfil the redemption request.
Different stablecoin issuers have different ideas on what amount of collateral is sufficient- leading to partial-reserve coins like FRAX, full reserve stablecoins like USDT, and over-collateralised coins like DAI.
Fundamentally, however, the amount of collateral they manage to obtain would limit the amount of stablecoins that they can issue.
Why would people hold stablecoins?
The other part of this equation is demand- when people opt to hold money instead of other assets. This could be because money is needed to buy goods and services (transaction demand for money), in case of emergencies (precautionary demand), or because it is a better alternative to holding other assets (speculative demand).
When consumers decide to exchange, for example, USD for USDC, they judge that USDC is either necessary to purchase goods and assets, that it is wise to hold it in case they need to make an emergency cash payment in USDC, or because USDC is a better asset to hold than others.
These reasons are important because they determine how stable the value of a stablecoin actually is- the more demand there is, the better the coin is able to withstand supply and demand shocks. If there is only a small, select group that uses the coin, then there is a very limited demand. Consequently, any change in demand will quickly lead to the abandonment of the stablecoin, as confidence erodes and everyone demands fiat currency back in exchange for their stablecoin holdings.
But users’ demands for stablecoins are not the only demand function to consider- Circle uses the deposits that they receive to purchase government bonds, which can be redeemed at maturity with interest. This is the bread and butter of how they make money.
But if withdrawal requests exceed what Circle’s reserves are able to bear, then Circle must sell some of their bonds before they can repay their customers.
And this means that if you hold USDC, an increase in the interest rate by the Federal Reserve can cause the price of bonds to fall, and suddenly the stablecoin issuer’s solvency is called into question.
So the stability of stablecoins is really dependent on two things: firstly, the financial health and management of the stablecoin issuer- which, as the USDC depegging shows, is not always guaranteed, even though the stablecoin issuer may make sound financial decisions; And secondly, the demand for the token itself.
Is there a way to make stablecoins more stable?
Clearly, if stability is dependent on stablecoin issuers and the demand for the token itself, then it is actually possible for the design of stablecoins to be improved upon.
The first is to remove the idea of a single stablecoin issuer- and allow for different issuers to also be granted permission to issue the same stablecoin. At the very least, this can mean that different branches of the same company, each with separate balance sheets and independent of each other, are all able to issue the stablecoin. In this way, while users will still use the same stablecoin, a stablecoin can be redeemed at any particular branch.
What this means is that even if one branch collapses, the others will remain independent, and there is a chance that they will have sufficient reserves to cover the stablecoins issued by the collapsed branch.
There is also the idea of improving the stablecoin ecosystem as a whole- which, while admittedly more difficult, is going to be a far greater guarantee of stability.
Increasing the number of merchants who are willing to accept stablecoins as payment, providing greater utility for stablecoins as a whole, can increase the demand for stablecoins to a point where stablecoin issuers can afford to make mistakes without jeopardising the whole ecosystem and threatening to wipe the entire project out.
Collateral will likely still matter- but it should not function as the primary guarantor of the token’s value. Instead, it should be the last line of defence, which is deployed only where necessary.
As John Law suggested, ‘Money is not the value for which goods are exchanged, but the value by which they are exchanged’- in other words, we do not use money because it has intrinsic value by itself, but merely as a placeholder of value, which we exchange for money later on.
Stablecoins have been in the media for the wrong reasons over the past few months- but there is a way to make them better, and the crypto world’s reputation will be better off because of it.