5/19/2022

Stablecoins 101: How do asset pegs work?

  • Stablecoins are a cornerstone of the digital asset economy
  • The collapse of $UST was a shock to the entire digital asset ecosystem
  • It is important to understand the mechanisms stablecoins use to maintain their parity with the underlying asset
  • We take a deep dive into the different types of stablecoins to help you understand the risks involved
  • Yield App never had any exposure to $UST or LUNA as it never passed our risk assessment

The recent collapse of the Terra USD ($UST) stablecoin shook the digital asset ecosystem last week, exacerbating the already high volatility levels and causing fears among investors and regulators alike. Stablecoins are a cornerstone of the digital asset economy, representing a stable means of retaining value within the digital asset ecosystem. As such, their need to maintain parity with the assets they represent is paramount to the health of the entire cryptocurrency market.

Stablecoins are digital assets that are pegged to underlying real world assets, such as fiat currencies or gold. For example, the two largest stablecoins by market cap, USD Tether (USDT) and USD Coin (USDC) are pegged 1-to-1 to the value of the US dollar.

Stablecoins enable users to transfer money instantly at a low cost and are often used by investors or traders as a means to escape the volatility of the wider digital asset market without having to leave the ecosystem. As such, the growth of the stablecoin market has been parabolic, with 2021 alone seeing total assets shoot up 388%, from $29 billion to $140 billion, according to the “2022 Digital Asset Outlook” report from The Block.

READ: How stablecoins can help you increase yield in a bear market

It is no wonder, then, that the collapse of $UST last week was such a shock to the entire digital asset ecosystem. You can find out all about how $UST lost its peg and the downfall that followed from our dedicated blog. In this piece, we take a deep dive into the different types of stablecoins to help you understand how these assets are designed and some of the risks involved.

Types of stablecoins

The challenge for any stablecoin is to maintain its peg to the underlying asset. The largest stablecoins by market capitalization, USDT and USDC, achieve this by backing the tokens they issue with assets they hold in custody, such as commodities, fiat currencies, treasuries or other equivalent, liquid high credit grade assets stored in a bank or held at a custodian. Such stablecoins are also referred to as centralized stablecoins.

READ: How to live off the interest from your stablecoins

Meanwhile, decentralized or algorithmic stablecoins aim to achieve parity with their underlying asset using an algorithmic approach that is automatically executed by smart contracts. When it comes to algorithmic stablecoins, it is important to distinguish between those that over-collateralize their stables, such as DAI, and those that are under-collateralized or not collateralized at all.

Collateralized stablecoins: USDC & USDT

USDC, issued by Circle, is a centralized stablecoin that is fully backed by cash and short-dated US government obligations (debt securities that are considered to be risk-free). For the sake of transparency, Circle publishes attestation reports on its reserves every month, which can be accessed on its website.

Just like USDC, Tether USD (USDT) is a centralized and collateralized stablecoin, but its backing is slightly different. The third largest cryptocurrency in terms of market capitalization spreads its reserves between cash, cash equivalents and commercial paper (84%), corporate bonds and precious metals (5%), secured loans (5%) and other assets such as cryptocurrencies (6%).

READ: Why stablecoins are making the news: PayPal and the future of money

Recently, investors have voiced concerns that part of the commercial paper backing USDT consists of unsecured debt issued by corporations. However, Paolo Ardoino, CTO of Tether, recently stated that the majority of its reserves are now held in US Treasuries (a type of US government obligation) after having reduced its exposure to commercial paper over the last six months. According to Ardoino, a quarterly update on the reserves would be available later this month.

The recent market volatility following the de-pegging of the $UST stablecoin led to a temporary de-peg of USDT, which slid to $0.95 at one point on 12 May 2022. However, unlike $UST, Tether’s stablecoin had the liquidity and strong backing to restore the peg, in effect honoring its obligations to exchange USDT to US dollars at a rate of 1:1 regardless of exchange quoted prices. Such de-pegging events can happen during times of market volatility and are not necessarily cause for concern, as long as the stablecoin is properly collateralized and has undergone a thorough risk assessment.

Algorithmic stablecoins: UST

Unlike USDC and USDT, Terra USD (UST) is an algorithmic and decentralized stablecoin that is not backed by an equivalent of US dollar reserves. Terra used open market arbitrage incentives in combination with UST's sister token LUNA to hold UST at its peg.  

READ: Why did UST lose its peg and what can we learn from this?

A “mint and burn” mechanism allows UST to be minted while burning the US dollar equivalent of its sister token, LUNA, and vice versa. This approach has previously been criticized as unsustainable on concerns that UST was not insulated from market volatility. On 7 May 2022, we witnessed UST lose its peg to the US dollar, eventually causing the price of the LUNA token to lose nearly 100% of its value, while UST was trading at just $0.09 on Coinbase at the time of writing (17 May 2022).

As a reminder, Yield App has never had any exposure to $UST or LUNA in any of our yield-generating strategies, nor have we ever offered these assets on our platform, since they never passed our rigorous risk assessment.

Decentralized alternatives: DAI

Investors would be forgiven for fearing that any decentralized stablecoin could fail in the same way. However, not all decentralized stablecoins are created the same way. DAI, which Yield App supports on its platform, is not subject to the same level of risk as UST.

DAI is issued by MakerDAO, founded and built in 2015 by The Maker Foundation. It uses a series of smart contracts on the Ethereum blockchain to mint (create) and burn (destroy) the stablecoin DAI. DAI is an over-collateralized stablecoin, but the similarities with USDC and USDT end there.

  • To date, most of DAI’s composition is USDC.
  • DAI is entirely generated by its users on the blockchain.
  • DAI is an over-collateralized stablecoin whose peg to the US dollar is ensured by an integrated enforcement mechanism, which liquidates positions below the credit line.
  • The over-collateralization is what differentiates DAI from algorithmic stablecoins like UST.
  • DAI is the biggest decentralized stablecoin, no financial intermediaries are involved in its creation, maintenance, or destruction.
  • This makes DAI's balance sheet incredibly transparent, as every position is accessible via EtherScan.

READ: How to become a stablecoin millionaire

Source: Dai Stats

How DAI works

Users who wish to borrow DAI against their assets can deposit their collateral, such as BTC or ETH into MakerDAO's smart contracts to generate DAI against it. The mandatory fee for doing so is called a stability fee, similar to interest one would pay to take out a mortgage on their house. In this way, the user has created a line of credit against their collateral. Should the collateral fall below the credit line, the smart contract would automatically liquidate the position to maintain the peg to the US dollar.

Should DAI’s value drop below $1, holders are incentivized to return their stablecoins for the collateral, decreasing the supply of DAI and bringing the price back to parity with the dollar. When it is above $1, users are incentivized to mint the token, increasing the supply and decreasing the price.

The bottom line

As this blog demonstrates, not all stablecoins are made the same. From an investor’s point of view, it is therefore important to understand the mechanisms behind them and the risks they are exposed to.

While uncollateralized and decentralized stablecoins are a great idea in principle, the collapse of UST shows that these alternatives come with higher levels of risk. Before choosing where to allocate the low-risk part of your digital asset portfolio, it is important to conduct a thorough assessment.

READ: How to build a stablecoin strategy to protect and grow your portfolio

This is the hard work that goes on behind the scenes at Yield App. Our DeFi team applies our proprietary 135-point risk assessment framework to every single protocol before potential deployment, to ensure portfolio assets remain secure in all market conditions. In the current volatile environment, it is more important than ever to focus on security and due diligence to protect and continue growing one’s portfolio.

Do you want to earn the market’s leading interest rates on your digital assets? Sign up for a Yield App account today!

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