Talking about the risks of stablecoins in the DeFi ecosystem: Are stablecoins really stable enough?
Editor's Note: This article comes fromBlock beats BlockBeats (ID: BlockBeats), reprinted by Odaily with authorization.
Editor's Note: This article comes from
Block beats BlockBeats (ID: BlockBeats)
, reprinted by Odaily with authorization.
To be fair, as the crypto space has evolved, I think these three types of cryptocurrencies have become the mainstays of the industry: BTC, ETH (including ERC20 tokens), and stablecoins. But only recently have stablecoins started to gain traction as other major sources of asset liquidity, and they quickly took off in the industry.
For many years, there has been only one stablecoin that has received major attention in the crypto industry—Tether. This is indeed the case, and today it is still the king of stablecoins, accounting for 90% of the stablecoin market in terms of market capitalization, and its dominance is self-evident. But there are a few other projects in this space that are getting a lot of attention. For now, we’ll focus on USDT and two other projects that together represent the largest category of stablecoins: USDC and DAI.
Without stablecoins, a cryptocurrency liquidity pool would look a lot like Coinbase: deposits and withdrawals via wire transfers for cryptocurrencies and dollars.
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Stablecoins exist for two main reasons.
The first major reason is that banking can become cumbersome and unstable in the crypto space.
Even opening a bank account as a crypto institution is difficult, and banks tell account holders several times that their business doesn’t quite fit the bank’s risk profile. Even if you have opened an account, the account may be closed by the bank at any time. It can be said that there is no top player in the encryption field whose bank account has never been closed. And if the BTC/USD trading pair on your platform is backed by USD fiat currency, losing your bank account could mean the end of your trading platform.
So people in the crypto space generally don't trust banks and would rather not rely on them.
The second main reason is transferability.
If you have USD on Bittrex and want to send it to Coinbase, you're out of luck getting that done (unless you want to wait for the wire to clear). But if you have USDT on Kraken, you can send it to Binance, and if you have USDC on OKEx, you can send it to Uniswap.
USDT
For most of the time since the birth of cryptocurrencies, cryptography has relied on stablecoins. For years, USDT and Bitfinex have been the only fiat in and out channels for most non-US ecosystem users. The rest of the users are piggybacking on their banking and they just list all the markets against USDT instead of in favor of USD. So a user can convert USD to Tether, create an account, and then transfer to any exchange and trade other tokens, Tether's treasury really supports the entire industry.
But as more and more people pay attention to stablecoins, there are more and more doubts. And many people are worried that the collapse of stablecoins will bring systemic risks to the ecosystem. Wondering what would crash the markets of Binance, OKEx, Huobi, and Bitfinex all at once? The answer is USDT implosion.
USDC
Not all stablecoins are created equal, though. One question many cryptocurrency liquidity providers must answer is how trustworthy they really are. What should be the main trading pair of the trading platform? What should be the level of collateral for DeFi stablecoin loans?
The main advantages and disadvantages of these few stablecoins that most people agree with:
DAI
Advantages: The market is highly liquid and backed by US dollars.
Disadvantages: Unresolved regulatory issues, opaque fund certification, and bank management and control risks. There is currently no stablecoin with a broadly similar scope of application.
Advantages: US dollar endorsement, trustworthy, and compliance.
Disadvantages: general market liquidity, risk of bank control, blacklist can freeze user funds at any time. Similar to the volume of stablecoins such as TUSD, PAX, HUSD, BUSD, etc., and some other currencies (USDS, etc.) are also similar.
Advantages: No banking/centralization risk.
Disadvantages: The market is less liquid. There are similar DeFi stablecoins, such as sUSD.
How to make a trade-off between these stablecoins and choose the most suitable one?
1. How high is the usage of this stablecoin?
utilization rate
2. How easy is this stablecoin to create and redeem?
Although liquidity is very important, it is mainly the function of these two factors: market liquidity comes from the usage rate, and the stability of stablecoins comes from its exchange situation.
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utilization rate
No matter what platform you use, liquidity is important, in fact it may be the most important factor for stablecoins. What is the maximum issuance size that the stablecoin can maintain a stable exchange rate? How liquid do you expect your market to be?
USDT has by far the largest market liquidity. It trades billions of dollars every day, you can easily trade 100 million dollars on the exchange platform, and the premium of USDT will not even change by 1%, and no other stablecoin can do it currently. Of course, USDC is backed by the U.S. dollar 1:1, which has been emphasized many times by USDC."It's worth emphasizing how important this usage advantage is."USDT/USD trades represent a significant portion (perhaps the majority) of all over-the-counter (OTC) trading volume in the crypto space. Judging from the top three spot trading platforms by trading volume, their trading pairs are almost entirely based on USDT. USDT's market capitalization is 10 times that of its closest competitor, and its trading volume is nearly 100 times larger.
It’s also worth noting that USDT is particularly dominant outside of the West.
Part of the reason is that the local banking business is more difficult to do, so the online value of USDC is relatively low; another part of the reason is that people are more suspicious of supervision. Many people in the West will think when they see stablecoins:
Oh man, I wish this was backed by a FDIC insured bank account!
Many people are wondering why the news about Tether's lawsuit didn't crash the price of USDT?
The answer may be that the people who care most about this news are not those using Tether. However, the need for a digital form of wealth that is independent of any large government or institution and that can be easily transferred tends to drive demand for USDT.
Although USDC will be used in the encryption field of the United States and some institutions, DAI is also used in DeFi. But overall, USDT has always been the leader in the stablecoin industry.
So, if your trading platform wants to be able to serve the majority of crypto clients and is expected to have transaction volumes in the hundreds of millions of dollars, USDT is by far the easiest choice. It will allow the vast majority of crypto clients and volume into your pool, while neither DAI nor US bank accounts will. And USDT will also be able to take advantage of the comprehensive liquidity of the world's top spot encryption trading platforms.
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convertibility
USDT has a lot of transactions, but is it a stablecoin? Is it worth $1?
At the end of the day, there is only one thing that makes something a true stablecoin: it can be exchanged for $1.
All market liquidity ultimately depends on this. If you can't redeem the stablecoin, and no liquidity provider is willing to buy a lot at $0.98, then there's nothing stopping it from falling to $0.90, or $0.50, or $0.10.
In this regard, USDC wins. You can convert 1 USD to 1USDC with no fees, no size limit, and instant delivery using its self-built portal, Coinbase, FTX's USD Basket, and many OTC counters. If you want $2 billion in stablecoins, someone will be willing to sell you USDC for less than $1.01. If you bid 50% of the market cap, someone will buy it at more than $0.99: it's purely arbitrage because they're confident they can create/exchange. What if trying to do this with other coins?
1 USDC = 1 USD is very true, what about USDT?
The answer here is complex.
There is a fee for USDT creation and exchange, and no one will bid $1/piece to buy $5 billion USDT because they can redeem at most $0.999. And the difference with USDC is that the creation and redemption time of USDC is as long as the ETH block, while USDT may take several days. It's not on Silvergate's SEN, the gold standard for instant crypto transfers in U.S. dollars; it's not even bankable in the US. And this process is more of a manual operation, which will cause artificial delays.
But beyond that, questions remain about the money backing USDT. There have been rumors for years that USDT is not supported. A year ago, it was revealed that hundreds of millions of dollars backing USDT had been frozen by multiple governments because they used third-party payment processors.
So, what happens when you try to create or exchange USDT with USD?
First you have to pay a 0. 10% handling fee. Second, you will most likely spend a day waiting for the wire to clear and process.
So is it useful or not? Can your USDT really be exchanged back to USD?
Generally speaking, the answer is yes. Over the past few years, billions of USDT have been created and exchanged. It's clumsy, slow, expensive, and sometimes you'll even run into resistance (it's scary!), but eventually you can do it, and some people's massive operations do.
What about its banking situation? It has been relatively stable over the past year or two, although prior to that Tether was bouncing from bank to bank. It's possible that this could happen again, which could cause significant delays.
USDT is not perfect, but 95% to 100% USD backed, depending on how you treat frozen funds. And, assuming they are short by $500 million, Bitfinex generates more than enough to make up for it if necessary. LEO is also likely to raise enough capital to bridge the gap.
So, the final conclusion is that you can create and exchange USDT, but it can be slow, expensive, and sometimes disruptive.
What about DAI, how is it created and redeemed?
Creation is not cheap, and while anyone can do it, it's not cheap: you have to lock up more than $1 for each DAI, because DAI is not backed by USD, but by ETH; Volatility, DAI requires a lot of additional collateral.
And the exchange is almost non-existent. You can exchange your DAI for your ETH, but only if you created it. In theory, everyone who creates and sells can buy back their DAI and unwind their ETH loan.
But if A creates 1 million DAI and sells it to B, B can't redeem it because he doesn't have any ETH to loan to Maker. So when DAI changes hands on exchanges, DEXs, and lending pools, it loses a lot of its convertibility.
Worse, if A creates 1 million DAI and sells it, and then forgets the password - this 1 million DAI will never be redeemable, because the remaining total redemption power will be 1 million less than the circulating DAI.
There is another way to redeem: you can initiate Maker's emergency shutdown procedure.
But doing so would require owning and potentially losing $25 million in Maker, then waiting for a cooldown period, shutting down the entire Maker protocol, and taking price and liquidation risk on the asset. Only Maker itself and a16z in the world have enough MKR to initiate a shutdown, and if anyone else tries to accumulate this amount, 2.5 ADV of MKR will have to be purchased in a short period of time. In fact, this is not a reasonable choice.
So when it comes to creation and exchange, there is a clear hierarchy: USDC > USDT > DAI.
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So, how to solve all this?
If you're trying to figure out what to list, many things matter, with fluidity and recognition being key. Therefore, many exchanges choose USDT over USDC: they may get more liquidity and trading volume in the market, and be able to serve more customers.
But that's not the topic of this article. The topic of this article is risk, especially with regard to DeFi.
DeFi, like most CeFi, runs on stablecoins. As the industry continues to scale, especially looking at the recent successes of Compound and others, it becomes increasingly important to understand the resilience of coins.
There are lots of questions to ask, but for now let's focus on one example: If you have a DeFi lending platform (like Compound, or Synthetix, or Maker), how worried should you be about stablecoin risk? Generally speaking, how worried should DeFi be about the explosion of stablecoins, and which stablecoins are the most worrying?
Market liquidity is important here, but not so much. Of course, you have less market impact on $10 million part-time USDT than USDC or DAI, but we're not really worried about the 0.50% here; all relevant protocols require closer to a 20% margin. So which stablecoins are most likely to blow up below $0.80 or above $1.20?
Suppose someone tries (or is asked to) buy or sell $200 million in ETH/X, what effect does that have on X? The main concern here is that a major source of demand (possibly from a protocol’s liquidation) could blow up the stablecoin, causing half of the DeFi market to sell off and create cascading liquidations.
From this perspective, USDC is pretty good. You can create/exchange essentially unlimited amounts of USDC quickly and costlessly. So, if someone really wants to sell $20 million of USDC, the liquidity provider can buy it for $0.99 and quickly convert it all - and use this as a loop if they need to, buying into more and more things. USDC isn't the most liquid market, but it's resilient because its creation and exchange work so well.
USDT is similar to USDC. If USDT plummets, liquidity providers can buy USDT and exchange it.
However, since redemption can take a day (sometimes more), and the total amount of balance sheets ready to be arbitraged is limited, it is difficult for the world to trade more than $200 million per cycle (day).
So very large USDT buys or sells can create temporary dislocations that may take weeks to fully recover. And we've seen this before: USDT went to $0.90 for a few weeks, or $1.10. But for USDT, it won't be easy to spend more money, because people will eventually realize that they can earn 30% of profits every day by buying and exchanging or creating and selling; $100 million balance sheets (think trading platform revenues, loan books, and VC firms) come into play.
Even if Tether were never able to recover the frozen funds, that would only shave a few percent off the stock price considering its $10 billion market cap.
Therefore, Tethers will bend, but are unlikely to break completely. It's not perfect, and in a big crash it could move 5-10%, adding more pressure to lending. But it probably won't let an industry collapse on its own.
What about DAI? Frankly, DAI is scary, really scary.
This is a really cool idea and protocol - a decentralized dollar without a bank account.
But its creation is slow and expensive, and requires permanently locking up additional capital. During a market crash, many people may need to sell ETH/DAI to meet margin calls, creating buying pressure on DAI.
And locking all the necessary collateral will put a lot of pressure on the balance sheet of the crypto liquidity provider, making it difficult to scale up too much. So DAI may be liquidated, which is really scary! Many positions that were originally safe may be liquidated because of DAI.
But even so, it's not as bad as going the other way. What if a group of clients collectively lend 500 million DAI and 400 million ETH. Then ETH rose by 18%. what happens?"These clients are now close to bankruptcy and must be liquidated. That means, someone has to take their place - someone has to buy their 500 million DAI in exchange for 472 million ETH. Even if they could collect 472 million ETH without impact, that would mean they bought 500 million DAI for $0.98. What can they do with this DAI?"
In a real sense, basically no liquidity provider can exchange so much DAI. Remember, you can only redeem what you create. And the biggest market maker may not be the one who created it. Therefore, liquidity providers cannot buy at 0.98 yuan and then exchange to make money. They can't even buy at $0.90, spend a week converting, and make money, they just "can't convert."
So fundamentally, there was nothing stopping it from going down, down a lot.
How much balance sheet is the world willing to spend on a non-convertible stablecoin with $500 million in selling pressure and no prospect of being able to sell it? At what price will they buy it? I don't know, maybe $0.5? Maybe someone will stand up and say:
I am willing to buy 500 million DAI for $0.50, which sounds like a good deal, oh yes, I have exactly 250 million in cash, ready to deploy to a decentralized I'm sure my risk manager won't mind.
DAI is brittle. When it bends it breaks, and breaks badly.
We know that the claim that DAI is scarier and more at risk of crashing than USDT won't be popular with many, but we think it's true.
Of course, this is not to judge which project is better overall. DAI’s innovation, coolness, and decentralization are all important, and USDT has the most market liquidity, which is very important for daily practicality.
But at the end of the day, if something goes wrong with a loan, it doesn't matter whether it's due to ETH/DAI liquidation or a bank freeze: it's bad either way. And in terms of liquidity, whether it's market depth or crash risk, DAI is a house of cards.
This is why we believe DAI is one of the biggest existential risks in DeFi. Similar to how CeFi is built on USDT, many areas are based on DAI. Unlike ETH, the system is built on the assumption that DAI does not move.
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So how does this affect DeFi?
1. Protocol should be established so that DAI drops to $0.5 without unnecessary systemic failure.
2. DEXs should not use DAI as the only stable currency.
