---
title: 3.3 Stablecoins
description: Understanding the logic and variables behind stable coin mechanics
---

# 3.3 Stablecoins

Perhaps no topic in crypto is more controversial or enlightening, than that of ‘stable coins’. Before 2022, most people would not have thought much of these assets, beyond perhaps questioning the legitimacy of Tether (and being accused of being a conspiracy theorist). But since 2022, stablecoins have been responsible for an incredible loss of value across the industry - as well as a safe haven for investors and token holders during times of volatility and turbulence. The focus of this lecture, is on understanding the logic and variables behind how stable coins are created - and - what role stable coins are positioned to play in the evolution of crypto into the future. 

## What is a Stable Coin?

Let’s start with some basic definitions: _What is a stablecoin?_

A stable coin refers to a digital asset that is pegged to an external form of value, such that it only expands or contracts in value, based upon fluctuations in the external form of value. The intention behind stable coins is to provide reliable value from currencies and existing forms of stable value, in the world of crypto, whereby most tokens are volatile or in the process of price discovery.

The most commonly used stable coins are pegged to the US Dollar. However depending on the design and issuance of the stable coin in question, certain stable coins are far more reliable than others. This leads us to our macro orientator for stable coins, known as the Stable Coin Matrix: 

## The Stable Coin Matrix


![](@site/static/img/bootcamp/mod-em-3.3.1.png)


There are two fundamental considerations when understanding a stable coin, from a high level: 


1. How is the stable coin issued? Meaning specifically, what is required in order for a stable coin to be generated and used in the crypto-verse. 
2. How is the stable coin backed? Meaning what external value, lies behind the stable coin, providing the necessary foundations from which it can be issued. 

As the Matrix outlines, these options can be conceptualized on a horizontal and vertical grid. 

**Horizontally:** The spectrum trends from a stablecoin being _overcollateralized_ to it being _undercollateralized_. When a stable coin is overcollateralized, it means that for every stablecoin minted into existence, there is _more value backing the stablecoin_, than the value of the stablecoin itself. When a stablecoin is undercollateralized it means the opposite: That there is _less value backing the stable coin_, than the value of the stablecoin itself. This dichotomy becomes crystal clear with the examples below. 

**Vertically:** The spectrum trends from the top, with the stablecoin being issued by a centralized entity whereby a single authority can control supply and burn rates of the stable coin - usually with some legal precedent or license. The bottom end of the spectrum refers to decentralized issuance, meaning it is usually minted via smart-contract or DAO, and based upon certain functions being fulfilled via smart contract (exchange an accepted asset, and receive a new stablecoin). 

## 3 Different Types of Stablecoins

To date, the stablecoin matrix comprises three types of stablecoins. 

**Algorithmically Backed:** These stablecoins are perhaps most well known. An algorithmically backed stable coin attempts to maintain its peg through dynamic expansion and contraction of a secondary token supply. Examples of this include UST (Terra) and RSR (Reserve). The vulnerability of such stable coins have [been well documented.](http://www.wakeforestlawreview.com/2021/10/built-to-fail-the-inherent-fragility-of-algorithmic-stablecoins/) 

**Custodial:** These stablecoins are most used, and also most trusted. While they require trust in a centralized custodian (such as Circle in the case of USDC), they are ‘legally’ backed by the entity with a 1:1 ratio of stablecoin issued for backed value behind the stablecoin. As shown below, these are the most popular (and reliable) stablecoins to date. Note: They are also the basis of the crypto-dollar thesis (also discussed below). 

**Asset / Basket Backed:** These stablecoins are backed by a basket of assets, and tend to straddle the line between being centrally managed and decentralized in their access or issuance. Asset backed stable coins pool different types of value together - such that the value of the assets backing the stable coin are over-collateralized relative to the amount of stable value issued. An example of this would be DAI - or the now sunset _Diem_ project originally proposed by Facebook / Meta. Note: DAI is currently overcollateralized with a basket of assets, by [127](https://daistats.com/#/)% to every issued DAI stablecoin. 

While these three categories encompass the types of stablecoin innovation to date, the first (algorithmically backed) has been seriously questioned (and rarely implemented), while the third (asset-backed) remains limited in its total supply (as a significant amount of value must be collateralized in order for it to be trusted). The second option - custodial stable coins remain by far the most popular, and are also the most well positioned to thrive into the future. 

## Examples of Stablecoins


![](@site/static/img/bootcamp/mod-em-3.3.2.png)


### USD Coin - Circle
USD Coin, or USDC, is issued by Circle. Each USDC is redeemable for one dollar, and is backed by one dollar (fiat). The entities holding the backed-value are audited on the monthly by the accounting firm Grant Thornton LLP. 

_Market Cap: $42.75 billion USD._

_Average 24 hour volume: $2.3 billion USD._

### USDT - Tether
Tether (USDT) is the largest stablecoin in crypto, and remains the most traded stable asset. Since its inception however, Tether has undergone a series of challenges and controversies, specifically pertaining to the reliability of its backed assets. Tether is the subsidiary of Bitfinex - one of the largest exchanges in crypto. Yet while many have speculated on the legitimacy of its 1:1 peg to USDT, both Bitfinex (British Virgin Islands) and Tether (Hong Kong) remain firmly outside of any regulatory jurisdiction that would be able to determine the truthfulness of the claims. 

_Market Cap: $65.8 billion USD._

_Average 24 hour volume: $21.8 billion USD._

### BUSD - Binance
Binance USD is a newcomer to the stablecoin game, launching in 2019, but becoming increasingly competitive in terms of volume and access. Similar to Tether and USDC, BUSD is a 1:1 backed stable coin with reserves guaranteed by Binance itself. 

_Market Cap: $22.0 billion USD._

_Average 24 hour volume: $7.7 billion USD._

### UST - Terra _(Failed)_

Terra remains one of the most infamous stablecoin experiments to date. Originally conceived as a design for an L1 ecosystem on Cosmos, Terra purported to offer its own algorithmic stable coin known as UST. The allure of building dApps on top of a stablecoin based L1 ecosystem was such that in March of 2022, Terra was valued at 94$ per token, for a total market cap of $40 billion USD. 

When the stable coin began to de-peg - meaning the price of the collateralized asset LUNA dropped to a point in which there was insufficient value backing each already issued stable coin. This created a hyperinflationary spiral, from which both LUNA and UST entirely devolved to zero.

Of particular note is that during this saga, the Terra team attempted to purchase billions of dollars of Bitcoin, to back their reserves. However, the sell-pressure and preceding 80 billion dollar market cap was far too much pressure for BTC to absorb the value of. This ultimately led to the liquidation of all of the BTC, and a total collapse to zero. 

_“The UST stablecoin algorithm created trillions of LUNA tokens, fell into a hyperinflationary spiral, and reduced the value of the original LUNA token by 99%.” ([Coinmarketcap](https://coinmarketcap.com/currencies/terra-luna/))_ 

A full case study of the event[ can be found here.](https://coinmarketcap.com/alexandria/article/are-algorithmic-stablecoins-dead-already-a-full-breakdown-of-the-terra-crash) 

### FRAX - Curve
Frax identifies as the ‘[first fractional reserve stable coin](https://frax.finance/)’. In reference to the types of stablecoins discussed above, FRAX sits firmly between two different options: _“The Frax Protocol introduced the world to the concept of a cryptocurrency being partially backed by collateral and partially stabilized algorithmically.”_ In addition to the variant backed stablecoin, FRAX also has a consumer-price index pegged asset, known as FPI. 

Ongoing data about the state of FRAX is available [here](https://facts.frax.finance/). 


![](@site/static/img/bootcamp/mod-em-3.3.3.png)


_Market Cap: $1 billion USD._

_Average 24 hour volume: $8.6 million USD._

### DAI - MakerDAO

DAI is discussed in detail in the following lecture on lending. But for now, we can say the following: It remains one of the oldest and most successful stable coins to date. It is significantly overcollateralized at 127% per stablecoin issued, and is predominantly backed by a basket of assets from both the real world and the world of crypto. 

_Market Cap: $5.2 billion USD._

_Average 24 hour volume: $198 million USD._

## Collateral Backing for Stable Coins

With these examples in mind, we can now start to scrutinize and dig into the weeds of the stabilization mechanisms for the different types of stablecoins. This specifically refers to the _collateralization ratio_ as well as the nature of _value_ used to support the stable asset. 

### _The Collateralization Ratio:_

Refers to the extent to which a stablecoin is backed by something else of quantifiable value. There are four possible collateralization ratios: 


1. **Over Collateralized:** Whereby more value per asset is held in reserve, backing the stablecoin that is issued. 
2. **Under Collateralization:** Whereby less value per asset is held in reserve, backing the stablecoin that is issued. Note: Undercollateralized stable coins are short lived and will not exist for long, unless they are able to re-establish the parity in some manner (either by adding assets, or removing stables from the market). 
3. **Equilibrium Backing**: Whereby there is a perfect 1:1 ratio between the reserve asset and the stable coin. 
4. **Fractional Backing:** Whereby a basket of assets, together back the stable value that is issued. 

The following diagram below outlines these different collateral models: 


![](@site/static/img/bootcamp/mod-em-3.3.4.png)


As a general rule of thumb: Centralized stablecoins (from the Matrix above) tend to be 1:1 backed, as there is a legal precedent for their claim of equilibrium. Decentralized stablecoins are either overcollateralized, fractionalized, or undercollateralized (with algorithmic stablecoins being the most common undercollateralized suspect). 


![](@site/static/img/bootcamp/mod-em-3.3.5.png)


## _The Underlying Value: Exogenous vs. Endogenous Value_

The second criteria refers to the nature of the value used to back the stablecoin in question. _Exogenous value_ refers to value that is not native to the protocol issuing the stable coin. You can think of this as ‘stand alone value’ or ‘value that exists regardless of whether there is a stablecoin or not’. Examples of _exogenous value_ would include fiat currency, Bitcoin, Ethereum, or other established assets like real-estate, a basket of currencies, or commodities. Meanwhile, _Endogenous value_ refers to value created by the protocol itself, or within the system of the protocol. Examples of _endogenous value_ would be the native token of the protocol in question (for example LUNA for UST). 


![](@site/static/img/bootcamp/mod-em-3.3.6.png)


Since the collapse of Terra / LUNA, the majority of stablecoin theorists have moved towards stablecoins requiring exogenous value reserves. The nature of these exogenous reserves remains open to discussion. 

## A Breakdown of Advantages and Disadvantages With Current Stablecoins According to Vitalik

In his [December, 2022 blog,](https://vitalik.eth.limo/general/2022/12/05/excited.html) Vitalik delves into the world of stablecoins, and outlines in his opinion the underlying advantages and disadvantages of the different approaches that exist to date. 


![](@site/static/img/bootcamp/mod-em-3.3.7.png)


This graphic nicely outlines the state of current stablecoin options, as of 2022 / 2023: Centralized stablecoins, remain most in demand and most trusted. DAO governed ‘real-world asset’ backed stable coins provide a decentralized option, but still remain somewhat vulnerable under certain circumstances (and depending on what it is backed by specifically). Meanwhile a highly collateralized oftentimes _negative interest yielding instrument_ [such as RAI](https://www.stakingrewards.com/journal/rai-decentralised-semi-stable-coin/) can be both decentralized and peg-resilient, yet also remaining limited in scale and not necessarily remaining stuck at 1 USD of value.  

## Stable Coins as a breakout technology in crypto?

On the whole, stablecoins account [for 140 billion dollars of value](https://defillama.com/stablecoins) in the crypto verse. 


![](@site/static/img/bootcamp/mod-em-3.3.8.png)


With the dominance of Tether sitting at 46.69% there remains ample room for competitors to increase stablecoin market share. What the existing volume has demonstrated however, is that stablecoins are one of crypto’s first _killer dApps_, bringing serious value and innovation into the crypto verse - from which many other products and services can flourish. 

## Stablecoins: The Crypto-dollar Emergent? Central Bank Digital Currencies

The final point of discussion on this topic, is indeed twofold: 

1. What happens if a Central Bank launches a digital currency? So called **CBDCs** are under development from a number of different countries. Would these instruments rival existing stable coins, or would they operate fundamentally separately? 
2. Second, is there the potential for the emergence of a crypto-dollar? That is to say, since almost all stablecoins are denominated in USD, there is the capacity for the United States Dollar to remain the defacto crypto-reserve standard, regardless of what happens to fiat currencies, or Bitcoin. Is the United States aware of this positioning and could this be leveraged to expand the longevity of the US Dollars’ reign as the world’s reserve currency? 
