JUL 13, 2022 • 21 Min Read
If you’re invested in crypto assets, you have probably held stablecoins in your portfolio at some point in time. Chances are, you have also heard of several high profile stablecoin depegging events, leaving unsuspecting holders unable to redeem their stablecoins at par value.
Stablecoins have become the backbone of DeFi, with nearly $150B in cumulative market cap. Of this, over 97% are in collateralized stablecoins while the remaining portion is made up of their undercollateralized counterparts. As the name suggests, fully collateralized stablecoins are backed by some sort of collateral – either fiat-collateral or crypto-collateral. Undercollateralized stablecoins, also known as algorithmic stablecoins, are either not backed by collateral at all or partially backed. FRAX is a notable example of a partially backed stablecoin, typically using financial incentives to encourage the market to keep the stablecoin at its peg. UST was a notable example of an uncollateralized stablecoin, and subsequently the risks of such a design.
Stablecoins are useful for market participants looking to avoid price volatility. They’ve also taken on the mantle of being the main medium of exchange when moving between different assets or transferring value from one entity to another. A reliable stablecoin is one that is able to hold its peg to a certain value – the most popular of which is the U.S. Dollar (USD). In this report, we explore some of the top collateralized USD stablecoins to understand the risks and benefits holders inherit while owning each of them.
Centralized stablecoins are IOUs for assets attached to a legal entity. Those assets could be cash reserves in a bank account (ideal case) or other liquid assets. A key difference between centralized stablecoins and their decentralized counterparts is the custodial nature of centralized stablecoins. Notably, holders of centralized stablecoins bear counterparty risk and censorship risk. The former deals with risks associated with bankruptcy or mismanagement of collateral by the issuer, while the latter deals with censorship by issuers or governments who can coerce the issuer.
Another point of risk with fiat-backed coins is that issuers have disproportionate commanding power when it comes to legitimizing a blockchain fork. For example, imagine if USDC had existed on Ethereum at the same time as the occurrence of the DAO hack. Only 1 of the USDCs on either Ethereum Classic or Ethereum would be redeemable at par by Circle. Whichever Circle chooses to support is therefore critical as most protocols and developers will follow suit. This centralization of power in DeFi poses risks that reach far outside the purview of the stable asset.
Currently, centralized stablecoins make up over 90% of stablecoin TVL; USDT, USDC, and BUSD consistently take the top three spots by market capitalization. We briefly explain the collateral backing and idiosyncrasies of notable coins below:
According to their latest quarterly assurance report, they’ve significantly reduced their exposure to commercial paper and certificates of deposits over the last year, while beefing up their U.S. Treasury Bill holdings to almost 50%.
Although they’ve committed to bringing down commercial paper holdings to zero, the current USDT collateral make-up still closely resembles a traditional money market fund. For the uninitiated, a money market fund is an investment entity that invests in liquid, short-term debt instruments. Money market funds are typically a safe haven for investors to part idle cash in, but may fall below par value during periods of market dislocation or panic when investors try to redeem funds all at once. And that’s something a stablecoin must take into consideration, given redemptions occur during periods of panic.
During the Covid crisis in March 2020, money market funds experienced large outflows as short-term funding markets dried up. To quote a Blackrock report, “for close to two weeks there was no bid in the secondary market in the U.S. for much of the commercial paper, bank certificates of deposits, or municipal debt.” And these are instruments that make up a significant portion of Tether’s backing. However, Tether is not bound by the same regulations traditional MMFs adhere to. Some of these include minimum liquidity levels, credit quality standards and portfolio transparency. This means Tether has somewhat free reign to invest USDT collateral assets as they see fit. Indeed, fair enough, since Tether is not actually a money market fund. However, many investors have been put off given they have only published attestations of their portfolio holdings and are yet to release a comprehensive audit.
As mentioned earlier, the recent UST unravel caused some panic within USDT markets, causing a slight depeg and capital outflows of 9% within the same week. USDC, the stablecoin issued by Circle, has arguably benefitted from lack of confidence in certain stablecoins, growing their market share from ~25% to ~36% since the beginning of the year.
USDC is backed by USD denominated cash as well as short-dated U.S. Treasuries – a far lower risk profile than the aforementioned Tether treasury. It has undergone annual audits since launch and provides monthly attestations of its balance sheet (compared to the less frequent quarterly attestation from Tether) verified by an independent auditor. Beyond that, they also provide weekly data on their USDC reserves here, though these figures are not verified by a third party.
Overall, the lack of fear mongering over USDC indicates market participants seem to trust it more than USDT. However, USDT’s prominence on CEXs like Binance as the de facto quote asset on most trading pairs has given it an edge that is tough to usurp.
BUSD, or Binance USD, is a stablecoin developed in a partnership between Binance and Paxos. Its latest attestation shows that the collateral backing of BUSD is entirely in liquid dollars and U.S. Treasuries. Similar to USDC, Paxos has engaged an independent third party to provide monthly attestations of BUSD’s reserve accounts.
Although all of its reserves are currently in cash and treasuries, Paxos has no obligation to leave the BUSD reserves in those instruments. Its website states that its reserves (can be) held in either or both: (i) fiat cash in dedicated omnibus accounts at insured U.S. banks and/or (ii) U.S. Treasury bills (including through repurchase agreements and/or money-market funds invested in U.S. Treasury bills). In reality, an issuer can unilaterally change the make-up of the reserves and holders will only find out when the monthly attestation report is out.
TrueUSD is a stablecoin issued by Trust Token. Interestingly Trust Token appears to have the most frequent attestations of the lot, in the sense that it provides real-time updates. The on-chain live audit that can be downloaded by the public here. However the attestation report doesn’t detail the breakdown of cash and cash equivalents.
Another unique stablecoin in this category is flexUSD, which is crypto-collateralized stablecoin backed by USDC. It is marketed as an interest bearing stablecoin that pays interest directly into their wallet of choice. Users who would like to hold flexUSD and earn interest may mint flexUSD by exchanging USDC for the stablecoin on the Coinflex website. Since flexUSD is backed by USDC, holders of flexUSD bear the custodial risk associated with Coinflex and inherit custodial risk associated with USDC.
On Jun. 23, Coinflex halted withdrawals from the exchange citing “extreme market conditions & continued uncertainty involving a counterparty”. A few days later, they revealed that one of their customers had failed to repay a $47M debt, resulting in liquidity issues for the exchange.
This sent the flexUSD stablecoin tumbling on fears that it was no longer fully backed. This event is another sobering reminder that when a stablecoin inherits issuer risk, it inherits the risk of the issuer’s other business functions and dealings. Worse still, in the absence of transparency and proper audits and disclosures, assets in the reserve could be mismanaged or used for undisclosed activities unbeknownst to token holders.
To wrap up centralized stablecoins, we summarize the characteristics of the largest centralized stablecoins by market capitalization below.
Decentralized stablecoins are created to be a censorship-resistant, transparent alternative to the centralized category. They are typically crypto-collateral backed and have economic mechanisms which incentivize arbitrageurs to maintain the price around $1. Below, we will weigh out the risks and suitability of a few popular decentralized stablecoins.
MakerDAO is a stalwart among DeFi protocols and is currently the largest by Total Value Locked. Its native stablecoin, DAI, is created using a Collateralized Debt Position (CDP) model, and it has the highest market capitalization out of all stablecoins with on-chain custody.
For those new to MakerDAO, users mint DAI by depositing collateral assets into Maker vaults. Vaults have to be overcollateralized; the value of the collateral has to exceed 150% of the DAI value minted. “Stability fees” act as the borrowing rate for DAI and are charged directly to the vault owner. For a detailed read into Maker’s design, you can refer to our past reports here and here.
Initially, DAI was backed by a single collateral asset – ETH. Later, Multi Collateral DAI (MCD) was launched, allowing multiple types of crypto-collateral to be used to mint DAI. The backing of DAI has evolved dramatically over time as we see in the graph below. Maker is still making efforts to diversify its collateral base, going so far as to incorporate Real World Assets (RWA) as part of its collateral base. More recently, they’ve approved a $100M stablecoin vault for Huntingdon Valley Bank, which will use off-chain loans as collateral to mint DAI.
A diversified collateral make-up (as opposed to 100% ETH) implies lower systematic or asset-specific risk. However, one of the few criticisms of the DAI stablecoin is that its current collateral backing is comprised primarily of centralized stablecoins. Stablecoins came into prominence as collateral backing as a consequence of market turmoil. As was evident in May and Nov. 2021, crypto participants quickly sought refuge in stablecoins, with each of the events boosting DAI backing by $3.5B and $3B, respectively.
The advantages of high stablecoin backing are higher stability, which is exceptionally crucial during periods of market stress (see: Black Monday). However, since DAI inherits all the risks of its collateral backing, it inadvertently inherits all the centralization and custodial risk of USDC. Governance proposals have raised the PSM-USDC-A debt ceiling, which further increases DAI’s USDC exposure.
Taking external LP tokens used as collateral into account brings up 2 interesting corollaries. For the vast majority of LP tokens in Maker vaults, the underlying tokens that make up the LP token backing are essentially USDC and DAI. This means: 1) Maker is using more DAI to mint DAI and; 2) Maker’s USDC exposure is understated if one does not take the underlying LP assets into account.
Taking into account underlying LP assets brings Maker’s USDC exposure up to 66% (from 57%) and centralized stable exposure to 74% (after including USDP). Something interesting to note is that DAI’s collateral backing resembles a “safer centralized stablecoin” compared to USDT since 74% is indirectly held in cash and treasuries, while USDT has less than 60% in those same assets. Another revelation is that 12% of DAI backing is in DAI, which could have severe knock-on effects if DAI depegs extensively, although we believe this to be fairly unlikely.
This is an implication of integrating Gelato Network’s Uniswap v3 LP tokens. Since the integration last September, DAI’s backing via LP shares has skyrocketed. The Gelato integration enables DAI holders to earn up to 100x the fees on Uniswap v3’s USDC / DAI pool by leveraging their initial liquidity position. All of this is done in an automated fashion. Consequently, the USDC and DAI backing of Maker has increased as a result of the easy leverage.
An alternative to DAI for those uncomfortable with large amounts of centralized stable exposure is LUSD, which will be covered in another section. We’d also like to make an honorable mention for RAI.
Abracadabra is a CDP-based stablecoin platform, similar to DAI, that uses Kashi – the isolated lending market of Sushiswap. Their stablecoin, MIM, is backed by multiple assets. Users can deposit assets that range from typical blue chips like WBTC and ETH to more long-tail assets like interest-bearing tokens and SHIB. Compared to DAI, the collateral make-up of MIM is more susceptible to market risk, with just 20% of its backing in stablecoins. Strikingly, the largest asset backing MIM is FTT (FTX’s token), with ~34% of Abracadabra’s total backing. Naturally, this carries significant risk.
Before the Terra collapse, UST accounted for 40% of MIM collateral, with a ~40% share due to its “degen box” strategy which allowed users to lever up on UST to earn Anchor’s yield. The protocol managed to liquidate $1.3B UST but incurred bad debt to the tune of $12M. Fortunately, this was not enough to render the protocol insolvent.
Nevertheless, the backlash from the bad debt resulted in MIM depegging briefly. Consequently, this ordeal serves as a warning that overcollateralized stablecoins are still susceptible to depegs, especially when they are backed primarily by risky collateral (even Aave did not allow UST to be listed as collateral).
LUSD is the stablecoin issued by Liquity, and it has the second-highest market capitalization amongst decentralized stablecoins. LUSD is solely backed by ETH, using a CDP model that makes Liquity the only decentralized borrowing protocol that offers a single collateral asset. Furthermore, it offers a 110% collateral ratio for ETH, which is the most competitive collateralization rate on the market.
Liquity vastly differs from its competitors in having no human governance. System parameters such as supported collateral assets, collateral ratios, and fees are governed algorithmically. Minimizing human interference arguably makes Liquity the most decentralized stablecoin protocol and the least susceptible to governance capture. At the same time, it also makes the protocol the least flexible and growth-oriented of the lot. While appeasing users who prioritize protocol safety, this approach ultimately hinders community participation and LUSD adoption.
Interest-free loans benefit long-term borrowers who only pay a fee whenever LUSD is borrowed and redeemed. In contrast, other protocols utilize interest-rate loans which appease short-term borrowers but accrue significant fees in the long term.
As mentioned earlier, ETH is the only collateral asset used to mint LUSD. This philosophy stems from ETH being the most suitable asset under Liquity’s risk minimization framework. In theory, a single asset collateral introduces asset-specific risk. However, ETH is arguably the most decentralized and liquid collateral asset available.
DAI’s indirect centralization risk has been enough for Synthetix to begin unwinding their DAI/sUSD wrapper for other alternatives. In proposal SIP-189, the LUSD/sUSD wrapper was introduced to prevent the possibility of SNX stakers being susceptible to a DAI depegging event stemming from USDC censoring.
Near Liquity’s inception, there was concern regarding LUSD’s use case as almost all LUSD resided within the Stability Pool. Unsurprisingly, this resulted in illiquidity in DEXs and lending markets which made LUSD a decentralized stablecoin with low utility. However, today, the Stability Pool makes up 46% of all LUSD deposits, down from 73% in April. The reasons are two-fold. The first reason is Synthetix introducing usage by creating a LUSD/sUSD Wrapper on Optimism (1 sUSD can be minted for 1 LUSD and vice versa).
But also, to incentivize wrapping and create deeper liquidity in DEXs, yield farming opportunities were introduced. This resulted in Optimism amassing 14% of all LUSD, up 56% from April.
Secondly, the Fei PSM acted as yet another sinkhole, amassing 11% of all LUSD. LUSD within the Stability Pool collapsed and hit an all-time low of 21%. This was short-lived as market turmoil in mid-June resulted in cascading liquidations within ETH-backed collateral positions. Accounting for additional LQTY rewards, liquidation rewards for Stability Pool depositors reached an all-time high of 750% APR as the pool absorbed LUSD with haste. This is evident in the above chart from the “V” shaped reversal in mid-June.
Furthermore, high concentrations of LUSD in the Stability Pool are not indicative of users mostly borrowing to farm LQTY and liquidation rewards. A closer analysis of the Stability Pool shines light on the different LUSD users.
There are currently 133 users who borrowed and deposited LUSD into the Stability Pool which only amounted to 11% of all users. However, 60% of all deposited LUSD were not from users who borrowed LUSD. This suggests that over 55M LUSD was publicly traded on exchanges, which is only possible through sufficient liquidity pools and demand. Furthermore, those who just borrowed made up 32% of all users but were responsible for 68% of LUSD supply. Meaning there is strong demand for the 116M LUSD circulating or being utilized elsewhere.
Vesta is a fork of Liquity built on Arbitrum, an L2 Optimistic Rollup. Vesta, however, has made major changes that defy Liquity’s philosophy of decentralization and risk minimization. These changes include giving governance control over enabling multi-collateral asset types for minting VST (the decentralized stablecoin), fees from minting, liquidation penalties, and token incentives.
In Vesta, ETH is the second most utilized asset to mint VST, representing 17% of total VST minted. The largest collateral asset, quite surprisingly, is gOHM with 69% (nice) of total collateral backing. OlympusDAO had initially provided $250K in OHM collateral to mint VST via their incubation program. But today, over $14M worth of gOHM collateral is locked with $3.6M VST minted.
Using an asset like gOHM to back a stablecoin obviously carries far more risk. However, it will be interesting to keep tabs on Liquity and Vesta’s growth side-by-side to see if the market validates Liquity’s minimalist approach or Vesta’s approach.
alUSD is the stablecoin minted by Alchemix, a protocol pioneering self-repaying loans. Collateral assets in Alchemix are largely yield bearing tokens. Users deposit assets like DAI as collateral, and mint up to 50% of the collateral value in the alUSD stablecoin. On the backend, the protocol delegates the DAI to interest yielding vaults like Yearn vaults. The debt is “self-repaying” as the yield generated from the collateral is used to automatically pay down the user’s loan.
Compared to the other protocols, the collateralization ratio to mint alUSD with ETH Is relatively high at 200%, versus Maker’s 130-150%, Liquity’s 110%, and Abracabra’s 111%. You can look at this as the price a user pays for no stability fees, borrowing costs, and no liquidations. Alchemix has also enabled centralized stablecoins as collateral, but the USDT and USDC vault capacities are heavily underutilized, alluding again to the high collateralization ratio compared to its peers.
As mentioned earlier, Alchemix loans can’t be liquidated. Importantly, however, it’s not like that risk disappears – it’s just transformed into a new type of risk. Rather than users getting liquidated, that risk now appears in the alUSD peg. If the value of collateral tanks, so does the implied price of alUSD. This is somewhat minimized given Alchemix collateral is limited to stablecoins and various flavors of ETH (liquid ETH, stETH, and rETH). Users can also choose to use their collateral to pay down their loan at any point in time.
sUSD is a synthetic stablecoin issued by staking Synthetix’s governance token, SNX. With a minimum collateralization ratio of 350%, the sUSD in existence is backed by a “global debt pool” that is the counterparty to all trades on Synthetix. Unlike other collateralized stablecoins, borrowers with undercollateralized positions have a 24 hour window to save their collateral from liquidation. Furthermore, there is a 0.25% fee on burning and minting synthetic assets – all of which go to SNX stakers.
sUSD and other synthetic assets such as sBTC and sETH are pegged to their price using Chainlink and Uniswap v3 oracles. The advantages of synthetic assets over vanilla assets is the trader experience – most notably, zero slippage. Mainly used in atomic swaps now, you can trade sUSD for another synthetic asset such as sETH or sBTC for the same dollar value minus fees. sUSD often acts as an intermediary asset in multi-asset trades to reduce slippage. Example: swapping DAI to BTC involves swapping DAI for sUSD, sUSD to sBTC with no slippage, and then sBTC to BTC. And all of this happens atomically, inside a single transaction.
sUSD is one of the older decentralized stablecoins. However, its growth has been limited given the strict collateralization criteria. Additionally, minting sUSD is usually done by staking SNX and becoming a part of the protocol’s global debt pool. While sUSD can be minted as a loan using ETH and LUSD collateral too, they account for just 15% of collateral in Synthetix.
To wrap up decentralized stablecoins, we summarize the characteristics of the largest decentralized stablecoins by market capitalization below.
How have collateralized stablecoins, both centralized and decentralized, fared in terms of holding their peg? As a market fraught with volatility, stablecoins have proven their merit. We assess the price stability of the stablecoins on Ethereum by looking at how often they’ve deviated at least $0.01 from their $1 peg in the last month.
Generally speaking, and perhaps unsurprisingly, decentralized stablecoins experienced more deviations from the peg compared to centralized stablecoins. Those backed with more volatile collateral assets were more susceptible to going off-peg, compared to those with more stable assets backing it. DAI, for instance, rarely deviated. This is likely attributable to over 70% of its collateral backing consisting of centralized stablecoins. LUSD and MIM experienced the most deviations from peg, which is expected given their collateral backing is mostly volatile assets. LUSD’s deviations more frequently occur to the upside as buyers look to take advantage of increased stability pool APRs, and borrowers buy LUSD to reduce their debt. This typically happens when the price of ETH falls rather quickly.
Despite USDT trading as low as 0.95 post-Terra fallout, centralized stablecoins have been more successful at holding their peg on a consistent basis. When USDT saw $7B of redemptions in 48H, the company successfully redeemed them at par, eventually giving arbitrageurs the confidence to step in and close the peg.
While even the more popular decentralized stablecoins seem to have centralization risk, user priorities are rooted in the true stability of the stablecoin – and rightly so. From this perspective, DAI and others with significant centralized stablecoin backing seem to be making a clear trade-off in order to invigorate growth and usage.
From a capital efficiency perspective, centralized stablecoins are the clear winner as they are typically backed 1:1 by the equivalent value of the backed asset. On the other hand, virtually all decentralized stablecoins that have weathered the storm are over-collateralized.
Unsurprisingly, USDT and USDC are still the preferred medium of exchange on Ethereum. This is followed by DAI, which shouldn’t come as much of a surprise. Between the first two, USDC comes out top in terms of total transaction value, unique users, and number of transactions. Average transaction size for USDC is almost 3 times higher than USDT, which indicates that it is more popular amongst “whales”. Again, this is likely attributable to their safer “collateral backing” which consists of US dollar cash or treasuries.
Our analysis of the more widely used stablecoins suggests that the market currently prefers stability and liquidity over decentralization and capital efficiency.
However, with stablecoin regulation on the horizon, it is likely a matter of time before centralized stablecoin providers start enforcing KYC/AML and other requirements – a move we believe will catalyze the demand for truly decentralized money. After the failure of algorithmic stablecoins earlier this year, it seems like overcollateralized stables have a better chance of fulfilling that vision.
Stablecoins are undoubtedly a crucial and potent component of crypto infrastructure, as the de facto medium of exchange for crypto assets and “legitimizer” of chains in the event of forks. Having that much power concentrated in centralized entities susceptible to regulation and censorship is a significant risk for the entire crypto ecosystem.
With more than $130B of TVL in centralized stablecoins, the size of the pie is massive. Coincidentally, as we were writing this report, Aave announced plans to launch a new collateral-backed stablecoin, GHO. Once again, this is a sign that the stablecoin wars are just getting started as several of them start to reach escape velocity. Whether it is Aave’s GHO or an improved version of DAI or LUSD, any protocol that builds a truly decentralized and scalable stablecoin faces no small challenge, yet its success is both necessary and unparalleled.
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