How Stablecoin Issuance Fits into the Big Picture of Crypto’s Market Outlook

April 28, 2022

Over the last year, a lot of ink has been spilt in the media and halls of government on the topic of stablecoins. These are a class of crypto tokens that follow the value of USD, and their goal is to remain pegged one-to-one with the value of the dollar.

The crypto market is notorious for its daily, and even hourly, price swings, so why has a crypto asset that rarely ever shifts in price gained so much attention lately?

In this article, we’ll look at how stablecoins fit into the bigger crypto picture. We’ll also look at how stablecoins are developed and enter the crypto market, and why some stablecoins could outperform others in the long term.

Stablecoins Became a Big Deal in Crypto Since 2020

According to CoinGecko’s stablecoins page at the time of writing, there are close to $190 billion worth of stablecoins circulating in a nearly $2 trillion crypto market. Stablecoins have been noticeably increasing their share of the total market month over month since 2020, and this is most likely due to the rise of decentralized finance (DeFi).

Sites like DeFi Llama track the total value locked (TVL), a metric similar to assets under management (AUM), in DeFi applications across dozens of different blockchains, and the current TVL for DeFi stands at $213 billion with much of this sum being accounted for by stablecoins.

In DeFi, Stablecoins are paired with other crypto tokens in liquidity pools for automatic market makers (AMMs), borrowed and lent in money markets, or put to work in other yield-bearing strategies.

DeFi had a TVL of less than a billion dollars until 2020, and it’s around this time that the number of stablecoins in circulation began taking off. It could be said that the growth of DeFi and the growth of stablecoins in the crypto market have risen hand in hand, and since DeFi TVL is measured in USD (instead of, say, BTC), USD stablecoins are DeFi’s de facto unit of account.

How DeFi Relies on Stablecoins to Facilitate Peer-to-Peer Finance

DeFi is a financial system that cuts out the middleman. Instead of dealing with a banker or broker, users can interact with smart contracts written on a blockchain. These coded contracts allow users to trade, borrow and lend, or earn yield with their tokens in a system sans human intermediaries.

Users in DeFi can exit their positions in directional assets like BTC by swapping their tokens for stablecoins on DEXs. It’s a way to buy, sell, take profit, and cut losses via dollars performed on-chain without having to offramp back into centralized exchanges (CEXs).

The most common mechanism for users to swap their assets on decentralized exchanges is the AMM, which facilitates trades on most DEXs by relying on liquidity pools. Usually, in traditional finance, asset exchanges are facilitated by order books and market makers; however, the AMM, a true DeFi innovation, bypasses these with liquidity pools.

In these liquidity pools, assets like BTC are often paired with stablecoins, and this makes it easier to price these tokens in dollars, given that stablecoins are tied to the US dollar, which is the reigning reserve currency of the world. To facilitate large volumes of swaps, the more BTC gets deposited into a liquidity pool, the more stablecoins are necessary for pairing.

This means that as the crypto market and DeFi grow, the supply of stablecoins in circulation needs to grow to accommodate this most basic of DeFi primitives, the decentralized token swap through an AMM. In addition, money markets, yield farming, and options markets all rely heavily on stablecoins to function.

Additionally, stablecoins can be posted as collateral, are the unit of account for people trading and taking profit, and they’re used to pay salaries in DeFi and Web3 startups, so demand for stablecoins is on the rise for multiple reasons.

What Kinds of Stablecoins Do People Use for DeFi?

The most widely circulating stablecoins are fiat-backed and centrally issued by companies like Tether (USDT) and Circle (USDC). In theory, these tokens are backed one-to-one by cash, and each token can be redeemed for one dollar outright (with a minor 1-2 days delay and redemption fee), which makes them a prime choice for DeFi users looking to turn their crypto back into cash.

One drawback for fiat-backed stablecoins is that they seem to be more prone to risks stemming from their centralized issuance. These tokens can be frozen on request, and they are exposed to off-chain hazards such as the whims of regulators and the banking system.

Consequently, other risk-averse options for minting stablecoins are gaining traction in DeFi. These alternatives reduce off-chain risk by being collateralized by other digital assets (crypto-backed), and then there are stablecoins that are fractionally collateralized or completely uncollateralized (algorithmic or the so-called “seignorage” coins).

The Difference Between Crypto-Backed and Algorithmic Stablecoins

Fiat-backed, crypto-backed, and algorithmic stablecoins can all be acquired from the market. However, only crypto-backed and algorithmic stablecoins can be minted in a decentralized manner, strictly through smart contracts, by users themselves.

For example, by depositing crypto assets like BTC on Hubble Protocol, users can create a collateral debt position (CDP) and borrow the stablecoin USDH against the value of their BTC. This introduces stablecoins into the DeFi ecosystem by allowing users to maintain long positions on their BTC while increasing their liquidity.

When a user wants to retrieve their BTC, they can repay their USDH loan and access their deposit. This system is reminiscent of precious metals backing the dollar, but the asset backing this unit of account is a piece of technology (the crypto token) rather than a commodity dug from the ground.

In the case of algorithmic stablecoins, as with Terra’s UST, stablecoins can be minted by users who purchase and “burn” Terra’s governance token, LUNA. In Terra’s design, UST can be burned in order to receive an equal amount of LUNA tokens, but UST is not technically collateralized by LUNA, and users exit their LUNA positions when minting UST.

Which Stablecoins are Best Bets for Future Growth?

There are many different stablecoins on the market that users can choose from, but there are really three major classifications: fiat-backed, crypto-backed, and algorithmic.

Although fiat-backed stablecoins have been branded “too big to fail,” their success and ability to grow with the crypto market depends on what happens outside of the blockchain. It’s unlikely that regulators will allow them to grow at a pace that can meet the exponential demand brought by DeFi.

This leaves crypto-backed and algorithmic stablecoins leading the charge to build a sustainable and decentralized financial system on blockchain technology. From here, the question is whether users want to maintain exposure to the crypto market or exit their positions.

At the end of the day, the decentralization of DeFi means that users are in control of the production of decentralized stablecoins entering the market. Which side are DeFi’s users on?

If users are short on the crypto market, then algorithmic or delta-neutral stablecoin strategies favor a short or bearish outlook on crypto. If users are long on crypto and believe assets like BTC will appreciate in value over time, then crypto-backed stablecoins are more favorable to holding this position and support a growing crypto market.