The Evolution of Stablecoins

Published

December 9, 2024

Stablecoins represent one of the most important innovations in cryptocurrency, bridging the gap between volatile crypto assets and stable traditional currencies. However, their history contains important lessons about the challenges and risks of maintaining stability in decentralized systems.

The Great Unstablecoin: Understanding UST’s Collapse

The collapse of Terra’s UST stablecoin in May 2022 stands as a watershed moment in cryptocurrency history. To understand why it failed and what it teaches us, we need to examine its mechanism and the events that led to its downfall.

How UST Worked

Terra’s UST attempted to maintain its dollar peg through an algorithmic relationship with LUNA, its sister token. The system worked like this:

  • Users could always burn 1 UST to mint $1 worth of LUNA
  • Users could always burn $1 worth of LUNA to mint 1 UST
  • This mechanism was supposed to keep UST at $1 through arbitrage

The fatal flaw lay in its circular dependency: UST’s stability relied entirely on LUNA’s value, which in turn derived much of its value from UST’s utility. This created a potential death spiral if confidence wavered.

The Death Spiral Unfolds

On May 7, 2022, large UST withdrawals from Anchor Protocol (which was offering unsustainable 20% yields) triggered the beginning of the collapse:

  1. Initial selling pressure pushed UST slightly below its peg
  2. Traders began redeeming UST for LUNA, increasing LUNA’s supply
  3. LUNA’s price started falling due to increased supply
  4. This caused more UST holders to redeem, fearing loss of the peg
  5. The cycle accelerated, leading to hyperinflation of LUNA and complete collapse of UST

Within a week, over $40 billion in value was destroyed, affecting millions of users and triggering contagion throughout the crypto ecosystem.

Understanding Different Stablecoin Models

The UST collapse highlighted the importance of understanding different stablecoin designs and their risk profiles.

1. Fiat-Backed Stablecoins (e.g., USDC, USDT)

  • Backed 1:1 by traditional currency in bank accounts
  • Requires trust in the issuer and banking system
  • Most straightforward but most centralized
  • Examples: USDC by Circle, USDT by Tether

2. Crypto-Collateralized Stablecoins (e.g., DAI)

  • Backed by cryptocurrency held in smart contracts
  • Requires overcollateralization to handle volatility
  • More decentralized but less capital efficient
  • Examples: DAI by MakerDAO, sUSD by Synthetix

3. Algorithmic Stablecoins (e.g., failed UST)

  • Attempts to maintain peg through algorithmic incentives
  • No direct collateral backing
  • Highest risk of catastrophic failure
  • Historical examples: UST, IRON, BASIS

4. Hybrid Models (e.g., FRAX)

  • Combines multiple stability mechanisms
  • Partially collateralized, partially algorithmic
  • Attempts to balance efficiency and stability
  • Examples: FRAX, USDP

The New Wave: Understanding Delta-Neutral Stablecoins

A new class of stablecoins, exemplified by Ethena’s USDe, has emerged that uses sophisticated financial engineering to maintain stability. Let’s examine how they work and what makes them different.

How Delta-Neutral Stablecoins Work

These stablecoins maintain their peg through a combination of:

  1. Spot holdings of the underlying asset (like ETH)
  2. Short positions in perpetual futures markets
  3. Sophisticated risk management systems

Taking USDe as an example:

  • When users deposit ETH, the protocol:
    • Holds the ETH as collateral
    • Opens a corresponding short position
    • Mints USDe tokens
  • The opposing positions cancel out price exposure
  • Yield comes from funding rates on perpetual futures

Advantages of Delta-Neutral Design

  • Not dependent on faith in the system (unlike UST)
  • More capital efficient than overcollateralized models
  • Generates sustainable yield from market neutral activities
  • Less vulnerable to bank runs or confidence crises

Risks and Considerations

  • Reliance on functioning derivatives markets
  • Potential for basis risk between spot and futures
  • Smart contract risks
  • Market capacity limitations

Evaluating Stablecoin Safety

When assessing any stablecoin, consider these key factors:

  1. Collateralization Method
  • Is it fully backed by real assets?
  • How can backing be verified?
  • What’s the liquidation mechanism?
  1. Track Record
  • How long has it maintained its peg?
  • Has it weathered market stress?
  • What’s its daily trading volume?
  1. Transparency
  • Are reserves regularly audited?
  • Is the mechanism fully documented?
  • How decentralized is control?
  1. Market Depth
  • How much liquidity exists?
  • What’s the redemption process?
  • How efficient is price discovery?

Building a Stablecoin Strategy

Given these considerations, here’s a framework for using stablecoins safely:

  1. Core Holdings
  • Use proven, fully-backed stablecoins (USDC, USDT) for main positions
  • Verify reserves and audits regularly
  • Maintain multiple options for exit
  1. Yield Generation
  • Consider newer models like USDe for portion of holdings
  • Start small with new protocols
  • Monitor peg stability and market depth
  1. Risk Management
  • Never rely on a single stablecoin
  • Keep majority in conservative options
  • Have exit plans for each position

Remember that in the world of stablecoins, boring is often better. The goal is stability, not maximizing yield at any cost.