Introduction to Stablecoins: Money has served as the cornerstone of economic systems for millennia, evolving first from tangible items to today's digital forms. This progression mirrors continuous efforts to enhance transactional efficiency, security, and reliability across an increasingly intricate globalized economy. A pivotal moment in financial history was the establishment of the Bretton Woods system post-World War II, which linked global currencies to the U.S. dollar and indirectly to gold. However, this system unraveled in 1971, paving the way for the rise of fiat currencies regulated by central governments and backed by nothing more than the “full faith and credit” of the issuing government. The 2008 financial crisis eroded trust in the conventional banking system and spurred the creation of Bitcoin. A decentralized monetary system, designed to operate independently from central banks and government control.

This transition towards decentralization set the stage for a notable advancement in monetary systems: stablecoins. Unlike Bitcoin, which is widely known for extreme volatility, stablecoins aim to maintain a constant value. They achieve stability by being tethered to fiat currencies, collateralized by other cryptocurrencies, or regulated through algorithmic mechanisms. This approach effectively tackles a major obstacle to the wider adoption of digital assets, making them more practical for everyday transactions and reliable as a store of value.

The rapid adoption of stablecoins is driven by a dual demand: the need for a reliable digital currency in global commerce and financial services, and its utility for speculative purposes within decentralized finance (DeFi). Reliability is particularly vital in regions suffering from economic instability. Stablecoins address critical issues such as hyperinflation, exemplified by countries like Venezuela and Lebanon, where the local currencies have lost trust and utility. Consequently, stablecoins have emerged as a pragmatic solution to real-world economic challenges. Furthermore, their inherent stability makes them ideal for underpinning DeFi applications, such as lending and derivatives markets.

The adoption and designs of stablecoins reflect different approaches to achieving stability. Broadly, they fall into four main categories: centralized, overcollateralized, algorithmic, and delta-neutral stablecoins. This article delves into each category, examining their design, use cases, and inherent trade-offs.

Centralized Stablecoins

Fiat-backed stablecoins, particularly USDT issued by Tether and USDC issued by Circle, are the most prevalent forms of stablecoins, collectively representing about 90% of the market. Both are pegged to the U.S. dollar and are typically categorized as centralized stablecoins. This classification stems from their reserves, which primarily consist of U.S. dollars and U.S. treasuries, subjecting them to rigorous oversight from regulators. The backing of these stablecoins is a key factor in their dominance, primarily due to the widespread trust in the dollar. This trust provides a level of confidence and security that assures holders of the stability and reliability of the peg.

Despite the scalability, size, and ease of use fiat-backed stablecoins offer, many in the industry criticize the irony of their centralized operations. There have been instances where regulators have taken action against stablecoins. For example, the New York Department of Financial Services (NYDFS) forced Binance to cease the issuance of its popularly used stablecoin (BUSD). This incident highlights the vulnerabilities and regulatory hurdles that even the most established digital asset companies can encounter. Despite these challenges, new companies continue to enter the market. For instance, PayPal has introduced its PYUSD stablecoin, which is backed by U.S. Treasury bills, and Ripple has announced plans to launch a similar stablecoin. Nonetheless, PYUSD has faced scrutiny with the SEC issuing a Subpoena to Paypal to investigate its issuance.

Additionally, Central Bank Digital Currencies (CBDCs) represent a pivotal development for stablecoins as central banks have begun to explore digital forms of their sovereign currencies. Unlike traditional stablecoins, CBDCs are state-backed and offer an increased layer of government oversight. At the time of writing, The Bahamas, Jamaica, and Nigeria have launched official CBDCs with most of the rest of the world experimenting and developing their iterations. The adoption of CBDCs could streamline monetary policy by allowing underserved populations access to digital wallets and reducing costs and friction associated with money production. However, it also raises significant privacy challenges as it would give governments unprecedented access to personal financial data. Despite the current market dominance of centralized stablecoins, many DeFi users have expressed concerns that these types of stablecoins defeat the fundamental purpose of using cryptocurrency due to having a centralized governing authority.

Overcollateralized Stablecoins

Overcollateralized stablecoins are the second most adopted type of stablecoin, providing a stable value pegged to traditional assets such as the U.S. dollar but backed mostly through digital asset collateral. This type of stablecoin involves lending more collateral in value than the stablecoins issued to ensure stability and security against market volatility. Since its launch in 2017, DAI has become the most popular overcollateralized stablecoin, and the third most popular stablecoin overall, behind USDC and USDT. DAI is backed by a mix of various types of assets, such as U.S. treasuries, Ethereum, and USDC. This has allowed DAI to be heavily utilized in DeFi for those looking to use a more censorship-resistant stablecoin. However, due to its high over-collateralization requirements, there is a limit to the amount of DAI that can be issued, ultimately severely limiting its scalability.

Curve USD (crvUSD) is another new stablecoin within the DeFi ecosystem, primarily designed to operate within the ecosystem of Curve, a stablecoin-focused AMM. It utilizes a Lending-Liquidating AMM Algorithm (LLAMMA) to manage collateral, dynamically adjusting it to mitigate large-scale liquidations and stabilize the token's value. This soft-liquidation mechanism reduces the potential for sudden financial loss and promotes gradual market corrections. Such features make crvUSD highly effective for facilitating low-slippage trades between different stablecoins, thereby bolstering user confidence in its stability. However, the nature of its stabilization mechanism may limit crvUSD's broader adoption outside of the Curve ecosystem.

Prisma Finance recently introduced a stablecoin called mkUSD, collateralized by Ethereum liquid staking tokens (LSTs). This design aims to maximize the utility of DeFi’s largest asset type by TVL, creating a flywheel effect with the protocol and the rest of DeFi. The protocol gained popularity with DeFi users looking to leverage their ETH LST. However, mkUSD faces some crucial scaling issues since it relies on the depth and liquidity of the LST market, and the complexity of its mechanisms limits its adoption to more experienced DeFi users. In addition to those challenges, both mkUSD and crvUSD face the same challenges as DAI, which have large collateralization requirements.

Algorithmic Stablecoins

To solve the scaling issues from over-collateralization, various protocols have decided to use algorithms to maintain stability. Algorithmic stablecoins are a type of cryptocurrency that maintains a stable value through on-chain algorithms. Terra, with its stablecoin UST, was one of the most well-known projects in this space. It used a dual-token system where UST was pegged to the U.S. dollar, and the second token, LUNA, was used to absorb the price volatility of UST. The stability of UST was theoretically maintained where UST and LUNA could be traded for $1 of each other. The stability of the system came under stress in May 2022, leading to a death spiral where the falling price of LUNA could not support the peg of UST, eventually resulting in both tokens collapsing, wiping out $60B worth of assets.

The fundamental flaw of algorithmic stablecoins lies in their dependency on continuous demand and market incentives to maintain stability. If demand for the stabilization token drops, the system can quickly destabilize. Moreover, algorithmic stablecoins face challenges with information lag such as potential on-chain delays and inaccuracies in price feeds which can cause the stablecoin to depeg. While algorithmic stablecoins represent a unique approach, their reliance on potentially unstable algorithms and market demand makes them inherently fragile and flawed.

Delta Neutral Stablecoins

While centralized and overcollateralized stablecoins dominate the market. Delta-neutral stablecoins, a relatively new type of stablecoin, have gained traction. Delta-neutral stablecoins aim to unlock the benefits of both algorithmic stablecoins and collateralized stablecoins. The core concept involves creating a token that is unaffected by price movements in the underlying collateral assets by balancing long and short positions. This strategy ensures that any gain or loss in the value of one position is offset by the opposite movement in another, maintaining the overall value of the stablecoin. For instance, if you hold $100 worth of ETH and simultaneously short $100 of ETH through perpetual futures, any price movement in ETH will impact both positions equally but in opposite directions, keeping the total value stable. This delta-neutral hedging mechanism provides the stability needed for the stablecoin.

This concept is being employed by Ethena, which has introduced a novel delta-neutral stablecoin, USDe. Ethena launched at the end of December last year and has already accumulated over $3.3B TVL in under six months, which makes it one of the fastest DeFi protocols to accomplish this feat. It is currently the largest delta-neutral stablecoin on the market.

USDe is built on a delta-neutral strategy, which balances staked ETH derivatives and short positions to maintain its peg to the dollar. This approach allows it to function independently from traditional financial systems, emphasizing its role as a "synthetic dollar" or "Internet Bond." One of the features of Ethena is its ability to generate yields for its holders. This yield comes from two main sources: the staking of Ethereum, which provides rewards from the Ethereum network itself, and the gains from short positions in Ethereum derivatives. This model helps stabilize the value of USDe and provides a potential income stream for its holders. Ethena's USDe achieves a 1:1 collateralization ratio by applying a delta-neutral strategy, where short positions in ETH futures counterbalance any devaluation in the underlying collateral. This approach sets it apart as the most capital-efficient synthetic dollar in the industry. Unlike other on-chain overcollateralized stablecoins that require a minimum collateral ratio of around 150% or higher, USDe's method allows for significant scalability without heavily relying on centralized collateral like U.S. Treasuries. Ethena is essentially trying to solve the stablecoin trilemma where stablecoins are only able to achieve two out of three of the following: Stability, Scalability, Censorship-Resistance.

Ethena represents an advancement in DeFi's pursuit of stable and scalable financial instruments. By leveraging DeFi and CeFi mechanisms and reducing the volatility traditionally associated with digital assets, Ethena could substantially widen the scope of DeFi applications, attracting more institutional involvement and fostering broader market stability.

However, this approach comes with its own set of challenges, particularly regarding the reliance on derivative markets, which introduces a layer of complexity and risk. For instance, negative funding rates in these markets can impact USDe's overall profitability and stability. Additionally, some critics argue this model essentially functions as a tokenized hedge fund marketed as a stablecoin, which raises concerns as USDe becomes larger and systematically embedded within DeFi.

The development of stablecoins is crucial for the growth of digital assets, offering various solutions to maintain stability in a volatile asset space. Each type addresses different needs and challenges, from centralized models like USDT and USDC to overcollateralized options such as DAI. Algorithmic stablecoins, despite their hopeful approach, have struggled with maintaining stability, as evidenced by the collapse of TerraUSD.

The ability to offer a stable yield-generating asset without reliance on traditional financial instruments as collateral does not come without challenges. Ethena critics believe that the stablecoin will collapse when funding rates eventually turn negative and that the stablecoin is a tokenized hedge fund. However, Ethena has created a sizable reserve fund of over $43M to make payments if funding rates turn negative. Nonetheless, the development of Ethena and future stablecoins will be crucial for the growth of DeFi and the adoption of digital assets.