What makes stablecoins more "stable"?

Author: Gordon Liao, Austin Bennett Source: Stanford Blockchain Translation: Shan Ouba, Golden Finance

Stability in the best and worst of times

With the introduction of new federal policies, the cryptocurrency market is more optimistic than ever. As of this writing, the price of Bitcoin is heading towards $100,000 per coin, and the mainstream cryptocurrency has risen by more than 50% in a week. Despite this, the prices of some top cryptocurrencies have remained stable - and this is precisely a good thing.

While speculation around the value of cryptocurrencies can bring vitality to the market, the accompanying volatility has become a major obstacle to the popularization of cryptocurrencies. Cryptocurrencies are traded very quickly, but when trading pairs fluctuate by more than 1% in an hour, the medium of exchange becomes unstable. Users want decentralization, but are not willing to pay the price for the possible risk of default. Stablecoins may be the answer to this problem—providing a sense of order in a market rife with uncertainty.

Stablecoins are cryptocurrencies that attempt to peg their value to an underlying asset, either a fiat currency like the U.S. dollar or a commodity like gold. By anchoring their value to another asset, these tokens remove the incentive to speculate on their value, thus stabilizing transactions. Using a stablecoin is similar to depositing your assets into a blockchain bank: users get the benefit of fast, decentralized financial infrastructure while retaining the value of your assets in a redeemable digital representation.

What makes a stablecoin “stable”?How do stablecoins maintain their value?To what extent should we use stablecoins?

To get some insight into these questions, I spoke with Dr. Gordon Liao, Chief Economist at Circle (one of the leading stablecoin providers), about the mechanics behind stablecoins and what they mean.

All dollars may be equal, but not all stablecoins

While the U.S. Treasury Department reports a significant increase in stablecoin usage in recent years, they have been around in the cryptocurrency market for years. Due to their low price volatility, stablecoins like Tether, USDC, and Dai have become popular choices for trading cryptocurrencies on and off exchanges. These stablecoins all aim to peg their value to $1, but the mechanisms for achieving this goal vary widely.

By design, some stablecoins prioritize decentralization, while others prioritize compliance. Although they are all pegged to the same asset, the process for acquiring these tokens is different, and some even require different kinds of assets to be minted. Clearly, designing a stablecoin is no easy task. However, Dr. Gordon Liao, chief economist at Circle, said a lot of progress has been made in this area.

He mentioned that asset-backed stablecoins have been studied very deeply, so the risks involved are relatively controllable. In particular, he stressed that the assets backing stablecoins must be highly liquid, and that they must be kept independently to protect the interests of stablecoin holders. In addition, providers also need to manage issues beyond stablecoins, such as credit, market, and operational risks. Given these complex issues, Dr. Liao’s team recently released the Token Capital Adequacy Framework to integrate these complex indicators into a unified standard. He hopes to promote the establishment of industry standards and enable users to choose providers more wisely.

Stability under different circumstances

Take Circle as an example. The company values ​​transparency and stability. Unlike its peers, Circle discloses the composition of its reserve assets and provides a third-party daily audit report on Circle’s reserve funds. Dr. Liao further explained that because of these reserves, users can always redeem USDC for an equivalent fiat currency in the long term. The assets backing USDC are held independently, which provides strong protection for stablecoin users.

In the short term, the spot price of USDC may deviate slightly from $1. This is because tokens such as USDC are traded on the secondary market, and the short-term inefficiency of the trading pair may cause the price to deviate slightly from its USD anchor. Dr. Liao gave an example, such as when the price of Bitcoin plummeted, traders would transfer funds into USDC as a "safer asset." This operation may artificially push the value of USDC to slightly above $1, but then the price will quickly return to the anchor value.

However, Circle itself does not experience a large amount of secondary market conversion of fiat currency to USDC. According to Dr. Liao, about 95% of USDC redemptions are done in the primary market, where users redeem directly through Circle as the issuer. This trend has not changed even during certain uncertain events, such as the collapse of Silicon Valley Bank. During the collapse of Silicon Valley Bank, USDC redemptions reached billions of dollars. Therefore, although the spot price of USDC sometimes varies slightly, it does not mean that USDC has lost its anchor. This is usually just a matter of temporary inefficiency in the market.

On the other hand, events like the collapse of Silicon Valley Bank may show that stablecoin asset transparency can sometimes be a double-edged sword. While transparency is a highly desirable feature of stablecoins, especially behind a company with a multi-billion dollar market value, revealing the specific location of assets may cause market panic. Despite this, it is difficult to find cryptocurrency advocates who support the concealment of financial information as the best means of financial security. Blockchain is built on "truth"; even if the truth sometimes brings some pain, it is always the best choice to let the public fully understand the problem.

Stablecoins and Decentralized Finance

In addition to acting as a store of value, stablecoins have long found important uses in powering decentralized finance (DeFi) applications. In fact, MakerDAO, one of the earliest major DeFi protocols, is a decentralized stablecoin provider that mints the popular US dollar stablecoin Dai through Ethereum lock-ups. Although Circle is a centralized financial institution, Dr. Liao still recognizes the importance of the DeFi ecosystem, calling it the core of the blockchain and Web3 space.

Unfortunately, similar to the broader cryptocurrency market, the DeFi ecosystem has also been affected by its history of volatility. For example, the spectacular collapse of the algorithmic US dollar stablecoin UST, which is managed by the Terra blockchain. The value of UST relies in part on its governance token LUNA, rather than an equivalent fiat currency reserve. Due to the symbiotic relationship between the two tokens, billions of dollars in value were destroyed when they suddenly collapsed at the same time. Therefore, Dr. Liao believes, “We want the safest store of value and unit of account to be the cornerstone of DeFi.” By this standard, USDC is undoubtedly a strong contender to support the ecosystem.

At the same time, DeFi advocates may argue that there is an inherent contradiction in using a centralized stablecoin like USDC to power DeFi infrastructure. If we really want to embody the idea of ​​decentralized finance, perhaps we need to adopt a stablecoin that is run through DAO governance, such as MakerDAO’s Dai. However, according to this argument, it is also reasonable to argue that using stablecoins pegged to national currencies to support the global DeFi system is also centralized - but this has not stopped the US dollar from becoming the gold standard for stablecoins. Dr. Liao has a different take on what DeFi really means: “In general, DeFi is not necessarily about decentralized governance or decentralized permission management, but about the ability to decentralize balance sheets.” By analyzing the failures of the traditional financial system, he explained, “The biggest innovation is that you can spread the risk across more participants who would not otherwise have access to the technology to participate.” He used the example of market making, noting that historically “highly sophisticated technology and highly sophisticated capital” were required to participate, resulting in a highly concentrated market structure dominated by high-frequency trading firms. Dr. Liao said, “What’s different about DeFi is that you can use technology to bring more participants in, not just professional firms, but also ordinary capital owners.” Decentralized exchanges (DEXs) are perhaps the best example of this collective impact. In addition to being a hub for meme coins, DEXs democratize traditional order books in a way that is fast and easy to use. As a teaching assistant for Stanford GSB’s Pathfinder course (BUSGEN 102), I’ve seen this firsthand. Students with absolutely no experience were suddenly traders and liquidity providers for our fictional “Red Coin” and “Blue Coin” on the Uniswap Sepolia testnet. No longer did they need to rely on centralized exchanges to trade — they could trade directly with each other. When DeFi offers this level of access, the issue of stablecoin centralization may seem insignificant. After all, if our goal is to truly achieve a decentralized financial infrastructure, then we should be able to work with all stablecoins without any problems — whether it’s USDC, Tether, or Dai — while recognizing that DeFi protocols may make the same choices. There may not be a “one-size-fits-all” stablecoin that works for all scenarios, but other options will always be available through exchange.

Modern Stablecoins

Given the different preferences within the crypto community, Circle has also taken important steps to make USDC interoperable across multiple blockchains. Dr. Liao mentioned a Circle software feature that allows users to destroy USDC tokens on one chain while minting an equal amount on another. He claimed that this feature is more seamless than the traditional method of using bridge protocols to transfer assets between blockchains, which often have many vulnerabilities. Dr. Liao also admitted that while Circle's trust-based intermediary behavior is centralized, as DeFi continues to expand, the need for such platforms will grow to prevent the field from becoming too fragmented.

Finding the right level of centralization (if any) in blockchains has also attracted a lot of regulatory interest. In addition to litigation, governments are also experimenting with a controversial new type of stablecoin, central bank digital currencies (CBDCs). Typically issued by central banks, these cryptocurrencies can be seen as stablecoin manifestations of national currencies. Based on blockchain implementations, they offer significant efficiency advantages over traditional banking systems; but at the same time, the very transparency that makes crypto projects successful may also be what makes them potentially dangerous.

While CBDCs may leverage blockchain technology, current implementations differ significantly from the stablecoin structure we know today. Perhaps the best-known example of a CBDC is e-CNY, a stablecoin pegged to the Chinese yuan and led by the People's Bank of China. As of July 2024, the token has been tested in 29 pilot regions, and users need to provide personal identification information to access it. However, due to the lackluster response, the Chinese government has become more aggressive in promoting its adoption, with some cities even requiring public sector employees to receive their salaries in the token.

Dr. Liao noted that regions where CBDCs have entered trial runs tend to be more controlled. In fact, the Royal Bank of Canada recently confirmed to CBC that they have shifted their focus on CBDC development, while Federal Reserve Chairman Jerome Powell has also claimed that the creation of a US dollar CBDC would require congressional approval. However, we may first see a government-backed US dollar stablecoin in Wyoming, the Wyoming Token, which is scheduled to launch in 2025. Regardless of the token provider, Dr. Liao stressed that high standards of reserve backing are still necessary.

Whether operated by government agencies, private companies, or smart contracts, the future of stablecoins remains an exciting prospect. Being based on real-world assets in the blockchain space may just be the key to bridging the gap between traditional banking institutions and the future of decentralized finance; but at the same time, we must remain vigilant to ensure that this balance is not lost. If the stablecoin infrastructure lacks sufficient decentralization, we may lose Satoshi's vision - blockchain may degenerate into the centralized institutions it originally sought to circumvent. However, without the support of a robust stablecoin, our tokens may be worthless - without the value to back them, and without someone to hold accountable, everything may get out of control.