What are the stablecoin wars?


Stablecoins have long been popular among crypto traders as a way to get in and out of volatile positions, and today even the traditional financial system has begun to embrace stablecoins as a more efficient means of moving money around. The market is dominated by Tether’s USDT which in terms of market cap is still far ahead of the pack. As it stands now, USDT has a market cap of $68.3bn followed by USDC, BUSD, DAI, and UST at $29.2bn, $12.7bn, $6.5bn, and $2.6bn respectively.

However, at a time when US regulators are scrutinizing Tether’s unusual accounting practices, other stablecoins seem to be closing in as the competition for stablecoin dominance heats up.

The utility and basics of stablecoins

Stablecoins have become an essential part of the crypto ecosystem. Most cryptocurrencies fluctuate dramatically which can be great for speculators who make quick day trades, but for certain use cases, stable prices are crucial. Stablecoins are designed to absorb reasonable fluctuations while retaining a fixed value. When it comes to real-world applicability, they behave more like strong fiat currencies such as the US dollar with the benefits of crypto. 

Without stablecoins, DeFi would not have taken off the way it has since early 2020, which indirectly means the NFT boom we are in right now would look a lot different. The current total value locked across blockchains stands at  $117.6bn, but it’s hard to imagine we would have reached those levels without Tether’s USDT and MakerDAO’s DAI paving the way.

There are two main types of stablecoins, and an emerging third category: 

  • Fiat-collateralized  
  • Crypto-collateralized  
  • Purely algorithmic

Fiat collateralized 

This type of stablecoin is collateralized by an equal amount of fiat currency, usually held by a central custodian. For a USDC for example, the centralized custodian receives 1 fiat USD and in turn mints 1 unit of USDC which equals 1 USD in value. Holders of these tokens are guaranteed the option, at any time, to redeem their token for fiat again. This type of stablecoin includes tokens pegged to fiat currencies like USDT, USDC, GUSD, TUSD and more.

Crypto collateralized

These stablecoins are backed up by another cryptocurrency which, unlike their fiat collateralized counterparts, makes it possible to keep third parties (i.e. a central custodian) out of the equation. Crypto collateralized stablecoins are generally over-collateralized. This means that as the price of the base cryptocurrency fluctuates, the price of the stablecoin remains unaffected. A good example of this type is DAI, the stablecoin created by the MakerDao project. Based on Ethereum, it is one of the most prominent stablecoins in the DeFi ecosystem embedded in many borrowing and lending protocols such as Aave and Compound

However, the use of DAI in many DeFi protocols has led to a massive surge in the demand for DAI which put too much pressure on the pegging mechanism, leading to situations where DAI traded at a significant premium to the Dollar. The Maker Foundation has taken emergency measures to try to restore the peg, diversifying the collateral supporting the peg which puts it in between fiat and crypto collateralized stablecoins.

Purely algorithmic

The third method for creating stablecoins is using smart contracts to maintain the peg in an automated and programmable way. There have been many experiments with this type of stablecoin in the past, and most of those projects were unable to maintain the peg in a reliable way and have since faded away. However, it seems there is renewed interest for algorithmic stablecoins with UST and UXD making a play for stablecoin dominance.

Stablecoin competition is heating up

The history of stablecoins began in 2014 with USDT, originally launched as Realcoin. For the first few years, the market cap of USDT steadily climbed its way up to $1bn during the ICO frenzy in 2017, and absolutely exploded starting 2020 when crypto winter thawed with a vengeance. It went from $5bn to $50bn in just 12 months to become the 5th largest cryptocurrency.

This coincides with the rise of DeFi, amidst increasing competition from other fiat-collateralized and crypto-collateralized stablecoins. Every new contender in the Layer 1 blockchain space competing with the slow and expensive Ethereum-based DeFi represents another ecosystem for stablecoins to dominate. Across lending, borrowing, farming, and liquidity-providing platforms, there is strong demand for USD stablecoins. Coins that arrive early stand to gain the most. 

In Solana for example, USDC was the first stablecoin available and now covers the vast majority of liquidity pools. USDT has since arrived as well, along with the purely algorithmic UST and UXD stablecoins and a few other small-cap stablecoins, but it’s clear they offer much less utility when compared to USDC. As other Ethereum alternatives mature such as Algorand, Terra, Avalanche, Fantom, and Klaytn, stablecoins need to move fast to secure market share in an industry that is growing exponentially.

The arrival of the killer stablecoin

Much like the long-awaited arrival of the “killer-app” that would catapult crypto into the mainstream, the crypto industry has long been waiting for the perfect algorithmic stablecoin to take over from all the others at once. An algorithmic stablecoin is one that can keep its peg using only software and rules. If we create one that truly works, it could scale infinitely to whatever size an economy needs.

Scaling in particular is an important component of stablecoins, besides maintaining a reliable peg. For example, DAI is the most widely used decentralized stablecoin on Ethereum, but it has severe issues scaling due to a supply-demand mismatch in its monetary policy. DAI’s scalability problem extends to all other stablecoins on Ethereum where the cost of minting is greater than the face value of the assets minted. Therefore, the money supply is bounded by the willingness of the market to carry the costs. This in turn limits the growth and adoption of DeFi. 

Purely algorithmic stablecoins solve the scalability issue, which is why they are considered the Holy Grail of Stablecoins. It would be like bitcoin, settled on-chain, but actually stable and with purchasing power. The two strongest players in this category are both fairly new but have immense potential. 

Terra’s UST is an algorithmic stablecoin, where the cost of minting is equal to the face value of the stablecoins minted. In order to mint 1 TerraUSD, only $1 worth of the LUNA, the reserve asset, must be burned. TerraUSD monetary policy is theoretically infinitely scalable, which could propel DeFi apps and protocols to achieve their full potential without restrictions. While UST was only launched in September 2020, Terra’s stablecoin for the Korean won has been integrated in the retail payments app CHAI since 2019 which has a significant user base in South Korea.

Multicoin’s ​​UXD Protocol creates fungible, USD-pegged stablecoins, called UXD, by accepting BTC (or other crypto) deposits and using it as collateral to short an equivalent amount of BTC-USD perpetual swap contracts or dated BTC futures. The long BTC spot is perfectly hedged by the 1x BTC-USD short, so the value of the combined position is always $1. While this is one of the newest players on the field, its plans to integrate with prominent dApps on the Solana blockchain such as Saber does make it a serious competitor in what is already a saturated market.


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