The Rise of Stablecoins in DeFi
Stablecoins are one of the fastest growing asset types in cryptocurrencies. Its goal is to track a specific peg (usually the U.S. dollar) to minimize volatility and provide a convenient unit of settlement for transactions.
They have become the lifeblood of the DeFi ecosystem and may be poised to capture other segments such as remittances and gaming. While differing in implementation, they all hope to avoid wild price swings and enable users to transact in units they are more familiar with in traditional finance. Stablecoins have become a bridge between the traditional economy and the crypto economy.
Different Types of Stablecoins
Currently, the total market capitalization of stablecoins across different blockchains exceeds $18 billion.
There are two main types of stablecoins: custody tokens and algorithmic tokens. The first, true to its name, uses a centralized way of storing fiat assets to secure the peg. These tokens are (theoretically) exchanged 1:1, so there should be no deviation. Among them, USDT, USDC and now BUSD are the most used.
Algorithmic approaches also typically use collateral (in the form of digital assets, rather than fiat currency), but unlike escrow-style tokens, it operates and is stable through smart contracts and algorithms. It uses economic incentives to incentivize arbitrageurs to maintain the stablecoin peg. Dai is the most famous stablecoin on the market, but there are others such as RSR, USDX, and sUSD. These coins exhibit greater volatility and sometimes struggle to maintain the peg.
The third type, but because the concept is still in the experimental stage, it is a relatively abstract type, which is CBDC or central bank digital currency. Concerned that DeFi's functional design could replace central banks, governments are looking into issuing their own cryptocurrencies. While some experiments like the Petro's have proven largely unsuccessful, there is hope for a digital yuan and other major digital currency expectations.
The key difference between an algorithmic class and an escrow class is ownership and review rights. The functional design of USDT and others enables the custodian to freeze assets and even cancel transactions. While these custodial ones may be easier to pick up, and their regulated situation simplifies their adoption, they present a real contradiction to the ethos of decentralization.
use stablecoins
Stablecoins become a kind of digital cash, so they become useful during hedging markets when users want a safe place but don’t want to convert back to fiat currency. In addition, the leverage strategy has also become a popular choice for users.
However, with MakerDAO nearly imploding in March, it became clear that stablecoins could play a bigger role in the ecosystem. Their stability characteristics make them an attractive diversification tool as well as a reliable collateral asset.
Before the incident, MakerDAO's stablecoin was backed by the volatile cryptocurrency ETH and then BAT. However, these tokens are extremely vulnerable to market volatility, and as March showed, when balance cannot be maintained, the system is exposed to too much risk. Currently, over 42% of all Dai is generated via USDC, making it the most popular collateralized asset on MakerDAO.
Various altcoins are often highly correlated, so stablecoins offer a way to reduce collateral risk.
However, with the popularity of DeFi liquidity income, the function of stablecoins has gained significant attention.
Compound was the first to issue governance tokens using liquidity proceeds. The decentralized lending app rewards users who borrow assets with a portion of governance tokens based on the associated rate of return.
It turns out that stablecoins are very popular with liquidity providers, which can bring them good returns even with high interest rates. This is partly due to the fact that the underlying assets borrowed are stable. Once attention turns to volatile tokens, the community has to adjust its distribution strategy.
This liquidity yield strategy drives stablecoin activity. As users take advantage of the synthesizability of dapps to maximize liquidity gains, multiple dapps start to link in transactions. Specifically, it has become crucial to trade stablecoins with minimal slippage, which makes Curve’s position even more prominent.
Unsurprisingly, Curve (total value locked primarily comprised of stablecoins) is least affected by price effects and shows real growth rather than inflation-driven appreciation.
Centralized vs. Decentralized
While centralized stablecoins have some drawbacks, they do well in facing regulatory issues and reaching individual users.
Therefore, the proportion of USDT and USDC in the DeFi field has increased. For most of the summer, Ethereum was the only meaningful DeFi ecosystem, so stablecoin inflows were concentrated on this blockchain.
Part of this can be seen in the cost. For example, USDT has been one of the largest gas fee generators on Ethereum.
This makes the cost of small transactions more expensive. It should come as no surprise that the average size of such deals has grown over the summer. These conditions are more favorable for whales because of their high trading volumes, but less favorable for individual users.
Therefore, we can logically see that the majority of transaction activity using stablecoins takes place on centralized exchanges. Dai as a dapp product has been iterated, but even this stablecoin is mostly traded on centralized platforms. High, unpredictable costs hinder the development of decentralized ecosystems.
High fee costs are also crowding out a lot of gaming activity on the network, a trend that will hurt commerce if it continues. While more and more places are now accepting cryptocurrencies, it doesn’t make sense to pay for coffee with cryptocurrencies if the transaction costs exceed the cost of a cup of coffee itself.
rely on the community
While centralized stablecoins may currently lead in transaction volume, decentralized (algorithmic) stablecoins are higher in terms of community engagement.
Ethereum has created a blueprint for a DeFi ecosystem, and one of its core components is a MakerDAO that generates stablecoins. Its success as a catalyst for the DeFi space has seen similar projects spring up on rival networks like Kava, Acala, JUST, and more. Algorithmic stablecoins allow users to participate as lenders, borrowers, arbitrageurs, and managers. With the trend towards governance coins and composability in full swing, algocoins make more sense, but it remains to be seen how regulators will respond to their continued growth.
outlook
outlook
Stablecoins have become one of the leading asset classes in the cryptocurrency industry. Their capitalization has surpassed well-known Bitcoin forks such as Litecoin and Doge, as well as remittance-focused projects such as XRP, and has a considerable advantage on Ethereum.
However, stablecoins still need to get out of DeFi to gain recognition as a commercial transaction medium. For Ethereum, this means dealing with fees and, more broadly, necessarily integrating with personal-oriented applications.
MakerDAO has already started this process with its game plan. If Ethereum maintains its lead as the number one dapp network in the industry, MakerDAO should continue to expand its role as a key financial infrastructure project, and Dai will also see usage growth.
However, custodial stablecoins should continue to maintain their dominance in the short to medium term, as their regulated nature makes them a natural tie to a centralized economy.
