Introduction
Stablecoins play a vital role in the crypto industry. As of July 25, 2024, the market value of stablecoins is about $165 billion, accounting for nearly 7% of the entire cryptocurrency market of $2.417 trillion. Among them, the leading stablecoin Tether (USDT) is currently the third largest cryptocurrency by market value, second only to Bitcoin and Ethereum.
This article will explore stablecoins in depth, including their definitions, classifications, and the important role they play in the digital currency space. We will use a case study of Ethena USDe to explore its operating mechanism, potential risks, and whether USDe can be considered an “upgraded version” of Luna.
Definition: What are stablecoins?
According to the Financial Stability Board and the Bank for International Settlements, a stablecoin is "a cryptocurrency that aims to maintain a stable value relative to a specified asset, or a pool or basket of assets". Typically, stablecoins are pegged to fiat currencies such as the US dollar.
Motivation: Why do we need stablecoins?
There is no shortage of discussions about stablecoins in the market. But the first question is: Why do we need stablecoins?
Compared with traditional assets
First, in the context of large-scale application of Web3, digital assets provide more convenient tradability than traditional assets. Stablecoins, as a medium of exchange with stable value, facilitate daily transactions, while also enabling fast and low-cost cross-border payments, avoiding processing delays and high fees in the traditional banking system.
Compared to other cryptocurrencies
Secondly, stablecoins help reduce the impact of value fluctuations. Since mainstream cryptocurrencies such as BTC or ETH have inherent value volatility, they are not suitable as stablecoins. In times of market volatility, stablecoins provide unique value stability and act as a safe haven for value preservation.
Category: How do stablecoins remain “stable”?
Collateralized Stablecoins
Collateralized stablecoins are fully backed by other assets, ensuring that their value is supported by other forms of collateral. Assuming that these collaterals are properly managed and have viable redemption mechanisms, the value of such stablecoins is unlikely to fall below the value of their collateral assets due to potential arbitrage opportunities. Typical collateralized stablecoins include:
Fiat-collateralized stablecoins: Backed by fiat currency reserves, such as the U.S. dollar. Typical examples include Tether USD (USDT) and USD Coin (USDC), which are the top two stablecoins by market capitalization. As of July 2024, their combined market capitalization accounts for more than 90% of the total stablecoin market capitalization.
Commodity-collateralized stablecoins: Backed by a commodity reserve, such as gold or other real-world assets. A typical example is Tether Gold (XAUt), which uses gold as collateral.
Crypto-collateralized stablecoins: Backed by other cryptocurrency reserves, such as BTC or ETH. A typical example is DAI developed by MakerDAO, which uses ETH and other approved Ethereum assets as collateral.
Algorithmic Stablecoins
Algorithmic stablecoins use algorithms to ensure the security of collateral or adjust market circulation (supply and demand) to maintain stability. Typical methods include:
Liquidation: In order to ensure that the value of all outstanding stablecoin debts is always fully collateralized, some stablecoins adopt a liquidation mechanism, which is to liquidate risky collateral with a value lower than the corresponding stablecoin through auction. This mechanism usually also includes an initial over-collateralization (e.g., a 150% ratio) to provide a buffer between the collateral and the value of the corresponding stablecoin. Typical examples include DAI, the largest algorithmic stablecoin currently.
Destruction and minting: This method reduces the total supply by destroying existing tokens or increases the total supply by minting new tokens, assuming that the total demand remains unchanged. Assuming that the stablecoin falls from the target price of $1 to $0.9, the algorithm will automatically destroy a portion of the tokens to introduce more scarcity, resulting in a decrease in circulation, thereby pushing up the price of the stablecoin. Typical examples include TerraUSD (UST), which uses a built-in fixed exchange rate mechanism to create potential arbitrage opportunities for users through destruction and minting; however, during the massive market decline, the protocol failed to remain stable, resulting in a loss of more than $40 billion, the largest loss in Web3 history.
Adjusting lending rates: This method controls the supply of stablecoins within the "lending yield framework" by raising or lowering the central lending rate, assuming that people are generally profit-seeking (essentially providing potential income opportunities for stablecoin holders). Assuming that the stablecoin falls from the target price of $1 to $0.9, the algorithm will automatically increase the lending rate to attract (i.e. lock) more circulation, thereby pushing up the price of the stablecoin. Typical examples include Beanstalk (BEAN), which manages the circulation of BEAN by adjusting the loanable amount (called Soil).
Notice
It is important to note that these classification approaches are not mutually exclusive. Stablecoins can implement multiple mechanisms simultaneously to maintain stability. For example, DAI is backed by cryptocurrency collateral while also using algorithmic adjustments (i.e., liquidations). This combination of strategies can leverage the strengths of multiple mechanisms to mitigate potential weaknesses, thereby enhancing the overall stability and reliability of the stablecoin.
Security risks and solutions
Collateral transparency
For stablecoins backed by fiat currencies or commodities, users may doubt whether the collateral is safely stored and readily available for redemption. Many stablecoins address this issue by holding collateral with a third-party custodian (such as a bank), conducting regular audits, and publishing proof of reserve reports. These measures can enhance the transparency of collateral management and thus alleviate public suspicion to a certain extent.
Fluctuations in the value of collateral
For cryptocurrency-collateralized stablecoins, their underlying assets are more volatile than fiat currencies or commodities, and large fluctuations in the value of collateral may lead to unexpected collateral value gaps. To address this problem, many stablecoins implement over-collateralization and liquidation mechanisms to mitigate the potential negative impact of fluctuations in the value of collateral. Over-collateralization ensures to some extent that the value of the collateral can remain within a safe range during market fluctuations, because the initial value of the cryptocurrency reserves exceeds the value of the issued stablecoins; the liquidation mechanism allows other users to liquidate stablecoins that are not sufficiently collateralized, thereby maintaining the stability of the stablecoin value.
Smart Contract Vulnerabilities
Stablecoins, especially algorithmic stablecoins, rely on complex smart contracts to implement their stabilization mechanisms. However, these smart contracts may also introduce new risks at the code level, such as reentrancy attacks, logic errors, or governance loopholes. Therefore, strict security audits and continuous security monitoring are essential to ensure the security and reliability of these protocols.
Market volatility
Sharp fluctuations in stablecoins and stablecoin-related tokens (such as sudden crashes in a short period of time) will undermine public trust in stablecoins and affect the stability of the value of stablecoins. In rapidly changing market environments (such as during black swan events), the originally designed stabilization mechanism may not be able to respond and adjust quickly, resulting in large price deviations. In high-demand or panic scenarios, automated market maker (AMM) designs may also lead to a shortage of stablecoin liquidity in exchange liquidity pools, further exacerbating price volatility. Markets with insufficient liquidity are particularly vulnerable to manipulation. In addition, stablecoins rely on oracles to determine external prices (such as US dollars or Ethereum), and incorrect oracle data may lead to stablecoin pricing errors, creating a new attack surface.
Mainstream Stablecoins
We selected the top 20 stablecoins from DefiLlama, which together account for more than 99% of the total stablecoin market capitalization (as of July 2024), as shown in the figure below.
Figure 1: Top 20 stablecoins by market capitalization; Source: DefiLlama
The market capitalization of these stablecoins shows a high degree of concentration, with the top 5 stablecoins (i.e. USDT, USDC, DAI, USDe, and FDUSD) accounting for 96% of the total market capitalization, and the top 20 stablecoins accounting for 99% of the total market capitalization. This indicates that the market is dominated by a few key players, which is consistent with the Pareto Principle.
Of the top 20 stablecoins, all are collateralized by some asset, such as USD, US Treasuries, or other cryptocurrencies. In addition, nine of these stablecoins incorporate algorithmic stabilization mechanisms to adjust the circulating supply or ensure the security of the collateral.
Figure 2: Comparison of the top 20 stablecoins by market capitalization; Source: BlockSec
This phenomenon shows that despite the fact that algorithmic stablecoins claim to have excellent stabilization mechanism design, users show a clear preference for fully collateralized stablecoins, especially those backed by fiat currencies. As Frax founder Sam Kazemian said: "If you want to create a very large stablecoin, you want to become safer as you get bigger, not the other way around; as people use money, you want it to be safer."
Case Study: Ethena Labs - USDe
Over the past year, USDe, issued by Ethena Labs, has gained widespread attention. As of July 2024, it has become the fourth largest stablecoin by market capitalization, according to DefiLlama. This section will use USDe as a case study to explore its design principles and potential risks.
Design Principle
USDe can be considered a stablecoin based on a centralized exchange (CEX), and its stability mechanism currently relies mainly on the operational stability of CEX. Specifically, USDe uses mainstream cryptocurrencies as collateral and adopts a "delta hedging" strategy to maintain the stability of collateral assets.
So what is "delta hedging"? We can illustrate with the following example. If 1 ETH is used to mint USDe, then we say that the stablecoin is exposed to "positive delta of 1 ETH", which means that the value of the stablecoin is completely sensitive to the spot market price of ETH. Ideally, the goal of the stablecoin is to minimize this sensitivity, that is, to try to ensure that "delta is 0" to ensure stability to a greater extent. To achieve this goal, Ethena performs delta hedging by "shorting" on a perpetual contract with a notional position of 1 ETH. This strategy neutralizes the exposure of the collateral value to market fluctuations. Therefore, no matter how the ETH market price changes, the value of the collateral remains stable.
In addition, USDe's income consists of two main parts: staking income, which is the native income from ETH staking; and income from delta hedge derivative positions. The second part is further divided into two parts: 1) income from funding rates, which are regular payments between long and short positions on CEX; and 2) income from basis spreads, which are profits generated by the price difference between the spot market and futures contracts. According to Ethena's historical data analysis, this income combination remains positive during market downturns (such as the Terra incident and the FTX incident).
Security Risk
Centralization Risk
The main security concerns stem from the reliance on CEXs for delta hedging and custody for OTC settlement. We call this issue centralization risk. This dependency creates a vulnerability that could jeopardize the stability of stablecoins if these exchanges fail to function properly, either due to operational issues or bank runs. Although collateral is spread across multiple exchanges, more than 90% of collateral remains concentrated in three major exchanges: Binance, OKX, and Bybit.
Market Risk
In addition, market risks cannot be ignored. USDe's revenue mechanism may encounter a persistently negative funding rate, which may cause some parts of Ethena's revenue design to become negative. Although historical data shows that such negative revenue periods are relatively short (less than two weeks), it is necessary to consider the long-term adverse conditions that may arise in the future. Therefore, adequate countermeasures should always be prepared, such as sufficient reserve funds, to cope with this difficult period.
Conclusion
In summary, stablecoins play a vital role in the cryptocurrency ecosystem by providing stability and facilitating transactions amid market fluctuations. The classification of stablecoins ranges from fiat currency collateral to algorithmic mechanisms like Ethena USDe to RWA-backed stablecoins like Ondo, meeting various needs of the crypto community, but also presents risks such as collateral transparency, value volatility, and smart contract vulnerabilities.
As Ethena Labs continues to improve and innovate USDe, a key question emerges: Can USDe remain stable amid market volatility and avoid a crash like Luna? USDe’s underlying assets and economic model design are very different from Luna, but it should be closely watched whether USDe can truly remain stable and potentially take the lead in the competitive stablecoin space.
The huge market value and influence of stablecoins force us to pay attention to their security risks. Continuous security audits and security monitoring are indispensable to maintaining market stability and trust.
