Not All Stablecoins Are Created Equal

Stablecoins are digital assets that aim to stay “stable” relative to another asset, usually on a one-to-one basis. By design, stablecoins aim to minimize volatility by providing a consistent value, often equivalent to 1 unit of their reserve asset, such as an ounce of gold or $1 USD. The underlying reserve assets may still fluctuate in value, for example if the price of an ounce of gold changes or the U.S. dollar strengthens or weakens against another fiat currency like the Euro.

Each stablecoin has its own unique operating model or “tokenomics,” reference asset, and asset reserve execution. Investors should understand how a stablecoin is collateralized, what type of asset it’s collateralized with, and how it maintains its target or “pegged” price.

The most common type of stablecoin is fiat-backed and uses fiat currency as its reference asset with varying sources of collateralization. There are also crypto-backed, commodity-backed and algorithmic stablecoins. Algorithmic stablecoins may be non-collateralized (e.g., UST) or have fiat, crypto, or commodities as part of the algorithmic reserve (e.g., DAI)

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Stablecoins provide an on-ramp for fiat currency into the crypto ecosystem and are used by institutions and individual investors to move funds quickly between wallets, including cross-border activity, and to trade seamlessly in and out of crypto asset positions. Some stablecoins themselves are even a focus for arbitrage profit traders, based on the tokenomics of how the stablecoin maintains its peg to its reference asset. Additionally, stablecoins are lent and borrowed to support market making and trading activity as well as personal liquidity. This activity generates opportunities for lenders like BlockFi to pay clients competitive interest rates on their stablecoins for the right to re-lend those funds to clients on the other side of the market.

There is a risk that stablecoins can depeg from their reserve asset, whether that s gold, a fiat currency, such as the Euro or U.S. dollar, or another crypto. The stablecoins price is a reflection of investor confidence in the stablecoins underlying value. Where stablecoins have verified collateral or reserves that closely match the reserve asset, theres been less documented investor speculation on the value of the stablecoin itself. Undercollateralized or uncollateralized stablecoins, whose pegs rely on algorithms, have been more scrutinized.

Depegging scenarios will vary widely depending on the underlying mechanisms for keeping the stablecoin stable relative to its reserve asset and the issuer s ability to provide transparency into their applicable reserves. Most stablecoins post monthly or weekly audited attestations of their reserves on their websites (see table above for examples).

For more info on earning crypto interest on stablecoins and other cryptoassets, speak to your Private Client contact or fill out this form to be put in touch with a member of the Private Client team.

In May 2022, Terra blockchain’s U.S. dollar stablecoin (UST) depegged from its 1:1 reference to the U.S. dollar as UST’s market value fell to a few cents. UST’s peg to the dollar was maintained using a non-collateralized algorithmic relationship with Terra blockchain's native token, LUNA. The algorithm let users swap 1 UST for $1 of LUNA, burning or destroying that UST in the process. The same was true in reverse. As demand for UST would decrease, the price of UST would dip slightly below $1. Arbitrage traders would buy that UST at a discount for less than a dollar and trade it one-to-one for $1 of LUNA, making a small profit. This process of buying and burning UST for LUNA pushed the value of UST back to $1 as the supply for UST decreased (and LUNA increased). This cycle would continue on one condition: market participants needed to continue to believe they would make a profit with LUNA if they bought UST when it dipped below $1.

Terraform Labs, which built the Terra blockchain and issued UST, also built a lending dApp called Anchor Protocol. Seemingly, most investors bought UST to for a stake  in the Anchor Protocol for a promise of 20% APY. When Anchor announced interest rates would start to increase or decrease in line with the actual amount of lending on the protocol, many investors decided to exit their UST position at the same time. Since the main exit strategy was to burn UST for LUNA, the market saw a flood of increasing LUNA supply, but now without the demand for UST on the other side to keep buying the UST as it dipped below $1. The investor confidence that they’d make a couple cents of profit on the arbitrage trade to buy UST and burn it for LUNA was no longer there. Without significant demand for UST, the algorithm then began to mint an ever-increasing amount of LUNA to lower the price relative to UST in an attempt to preserve the 1:1 U.S. dollar peg. With supply of LUNA spiking, equally without enough buyers, the price began to collapse. Once the unraveling of investor confidence for UST and LUNA started, even more investors tried to sell their coins on the way down, further exacerbating the decline and creating a freefall in the price of both coins.

While there were attempts to restabilize the peg by infusing ~$3 billion of capital back into UST, this capital infusion was only a fraction of the coin’s $18 billion market cap. Without enough of the corresponding reference asset of U.S. dollars, investor confidence crumbled.

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