Stablecoins attempt to provide a safe haven alternative to investors in a highly volatile cryptocurrency environment. As the name suggests, stablecoins usually have a stable value irrespective of the market conditions and are typically set to 1 USD, although 1 EUR and 1 JPY are also commonly found. Stablecoins always attempt to peg their market value to some external reference.There are different flavors of stablecoins in the crypto ecosystem, depending upon how their pegs are maintained. Some are backed by fiat currencies (e.g., USD), while others are backed by commodities (e.g. gold, silver) or similar financial instruments. There are stablecoins that are dynamic in nature, and their peg is algorithmically adjusted continually through the use of smart contracts.This article will explore the types of stablecoins and see how they maintain their pegs. We will then visit how stablecoins under certain circumstances and market conditions, can lose their peg (meaning the stablecoins price deviates from $1) causing mass confusion and panic. Finally, we will share how USDB maintains its peg and mitigates any risks pertaining to market volatility or even deliberate manipulation.
Types of Stablecoins and Peg Maintenance Schemes
Stablecoins are cryptocurrencies that attempt to peg their market value to some external reference. By maintaining external references (mostly reserve assets) as collateral or by using algorithmic smart contracts to control demand and supply, stablecoins strive to maintain their price stability.
Also called Off-Chain collateralized stablecoins.In simple words, every fiat-backed stablecoin has a fiat currency backing it to maintain a 1:1 value association. Investors can use their fiat currency to purchase a stablecoin that they can later cash in and redeem for original currency.For example, if you have 10 USDTether (USDT) stablecoins then these 10 USDT coins have a backing of 10 USD in some financial form. This way 10 USDT always has a value of 10 USD.
“As of May 2022, Tether reported holding 83.74% of its reserves in cash, cash equivalents, short-term deposits, and commercial paper, 4.61% in corporate bonds, 5.27% in secured loans to unaffiliated entities, and 6.38% in other investments including digital tokens.” — https://tether.to/en/transparency
Other examples of fiat-backed stablecoins are USDC and TrueUSD.
Fiat-backed stablecoins are generally centralized as they are off-chain and are controlled and issued by a single entity. And just like any centralized system of asset management, as long as the trust is not broken, investors can rely on its peg value of 1 USD, for example. If under any circumstance, the backing reserves that maintain the supply and value of the stablecoins are incorrectly stated, lost, stolen, or lose their inherent value, investor confidence in the value of the associated stablecoin can be lost. With the value of the reserves less than that of the total supply of fiat-backed stablecoin, the peg can be lost and the stablecoins price can drop below 1 USD. Similarly, suppose the value of the reserve increases dramatically without the increase in the associated supply of the stablecoin. In that case, the peg will be lost and the stablecoins price will rise above 1 USD.Regular audits of the organization’s reserves are essential and must be carried out regularly to ensure the integrity and transparency of the underlying reserves.
As the name implies, these stablecoins are backed by other cryptocurrencies, like ETH, BTC, USDT, etc. As such, crypto backed stablecoins are on-chain stablecoins and are decentralized, unbiased, collateral-backed cryptocurrencies. Their value depends on the value of the underlying assets (or collateral), which can be volatile. Because crypto assets values can fluctuate, these stablecoins are generally overcollateralized to ensure the price stays as stable as possible. For example, a $1 crypto-backed stablecoin can have an underlying crypto asset worth at least $2. So if the price of crypto reserves drops, a sufficient amount of crypto reserve can still be used to back the stablecoin.DAI stablecoin is an example of crypto backed stablecoin, which is backed by a number of blue-chip ETH crypto assets and pegged to 1 USD.
Every crypto backed stablecoin in circulation is directly backed by excess collateral, meaning that the value of the collateral is higher than the value of the stablecoin debt. Naturally then, if the value of the underlying crypto reserve decreases drastically, the value of the associated stablecoin could be affected unless the crypto protocols adjust the circulation supply of the stablecoin in the market. DAI stablecoin has a solid mechanism in place to do just that and more to ensure their peg is maintained under high volatile conditions.If the crypto backed stablecoin is not effectively collateralized or under-collateralized, even a small change in the backing crypto reserves can drastically affect the value of the associated stablecoin.
Algorithmic stablecoins, in their purest form, are completely uncollateralized. Instead, an algorithm sells tokens if the price falls below the desired value and supplies tokens if the value goes beyond the desired amount. The number of these tokens in circulation changes regularly.Algorithmic stablecoin smart contracts have different mechanisms and models to maintain the peg. To maintain the peg, rebasing algorithmic stablecoins changes the base supply. The protocol mints or burns supply from circulation in proportion to the coin’s price divergence from the peg. If the coin price is greater than the peg, the protocol mints coins. If the coin price is less than the peg, the protocol burns coins.Seigniorage algorithmic stablecoins use a multi-coin system, wherein one coin’s price is designed to be stable and at least one other coin is designed to facilitate that stability.A fractional-algorithmic stablecoin is a combination of seigniorage and collateralization. A fractional algorithmic stablecoin aims to maintain its peg by combining mechanisms from pure uncollateralized stablecoins and their collateralized counterparts. FRAX is an example of a fractional algorithmic stablecoin.
Some algorithmic stablecoins maintain their peg with speculative arbitrage traders. As such, market markers and large accounts can significantly control, trade, and manipulate the demand and supply of the stablecoins and their peg facilitating tokens too (as in the case of Seigniorage stablecoins). As soon as the investors’ trust in the stability of the algorithm is lost, the peg is lost causing a chain reaction. The performance and integrity of such stablecoins heavily depend on how they behave under stressful environments with not just market volatility but also intentional attacks on the governing protocols.
USDB combines the benefits of algorithmic, crypto & fiat-backed stablecoins and employs three soon to be four strategies to maintain its peg:1. The Treasury, filled with a basket of crypto assets, that enables us to have stable backing2. We own the majority of the liquidity so we can do single-sided withdrawals to maintain the peg3. When USDB depegs and falls below $1 in value, USDB holders are offered a bond for FHM at an advantageous rate. By incentivizing the inflation of FHM through USDB bonding, investors strengthen the FHM treasury.The dollar amount of these bonds is finite, as only a certain amount is available on a rolling 24-hour period. This helps us manage risks from actors that intentionally target the stability of our protocol.Conversely, when USDB depegs and rises above $1 in value, a bond is offered to purchase USDB with DAI at a $1 per USDB valuation instantly. DAI is then deposited to FHM’s treasury and investors get USDB that can then be swapped for other stables or assets in a DEX.4. Fiat backing: With USDB moving into the e-commerce space there is a need to maintain a certain amount of off-chain collateral in order to further diversify risk and operate in the “real world”. Profits generated off-chain will be paired 1:1 with USDB giving that USDB a full 1 dollar backing.
The Balance Organization is formed to administrate business development in service to the greater vision of the interplay between FHM and USDB. As such, profits from all ventures engaging $USDB as a commercial exchange of value will be used to buy back and burn FHM in order to increase our deflationary velocity at a rate tied to our business success in product developments.