Let’s talk about DeFi: Stablecoins
Written by our lead farmer, huf
Intro
Stablecoins are a category of cryptoassets that are meant to maintain a constant value (typically $1 USD). They have become an integral part of the ecosystem — in 2021, supply was up 388% to $140bn+ and annual transaction volume surpassed $5 trillion.
They become increasingly important in a bear market as investors look for safer hiding places to shield their crypto holdings from volatility in other tokens. But all stablecoins are not made the same, and investors should be prudent in which ones they decide to park their funds in. Let’s dive into the landscape.
Landscape
Centralized
Centralized stablecoins (e.g., USDC, USDT, BUSD). Backed by fiat reserves and issued by known legal entities subject to regulatory laws of their jurisdiction. USDC for example is issued by Circle in the US, USDT by Tether in Hong Kong, etc. For each 1 unit of stablecoin issued, these entities hold $1 USD of collateral in their reserves which serves as the coin’s backing. These reserves are externally audited on a regular basis.
Decentralized
Decentralized stablecoins are not controlled by a centralized entity, and instead are governed by decentralized autonomous organizations (DAOs) entirely on the blockchain. As centralized stablecoins have received regulatory scrutiny, there have been increased focus and investments into decentralized stablecoins which are further reach for regulators.
There are two main categories within decentralized stablecoins, based on how they maintain their peg: Over-collateralized and Algorithmic.
- Over-collateralized (e.g. DAI by Maker, MIM by Abracadabra). These stablecoins are issued in exchange for collateral deposited by users. For example, a user deposits 1 ETH (currently ~$2500) into an Abra vault and in exchange the protocol will issue her up to 90% or ~$2250 MIM.
- Algorithmic stablecoins (e.g., UST, FRAX, FEI) maintain their peg via various algorithmic incentives and are often partially collateralized. The most popular of which is UST issued by Terraform Labs. UST is partially collateralized by the Terra ecosystem’s native Luna token. When UST trades below $1, users can exchange 1 UST for $1 of LUNA; when UST trades above $1, LUNA holders can exchange $1 of LUNA for 1 UST. Others include FRAX, which uses a fractional reserve system and FEI by Tribe DAO which relies on ‘protocol controlled value’ (PCV) to maintain peg.
For the purposes of this article, we’ll ignore a 3rd category- ones that utilize a free-floating peg model, pioneered by Olympus Dao.
Liquidity
In addition to each stablecoin’s various peg mechanisms discussed above (e.g., overcollateralized, algorithmic, etc.), it’s important to keep liquidity under consideration. A stablecoin’s depth of liquidity on DEX’s is crucial in ensuring the peg is not lost. Even if the stablecoin’s underlying collateral / reserve assets are sound, if there isn’t sufficient liquidity, large trade volumes in one direction could cause a de-peg, at least on a temporary basis. As such, stablecoin issuers will often incentivize users to provide liquidity in various DEX’s.
Curve, Uniswap and SushiSwap are some of the more common DEX’s to trade stablecoins– with Curve having by far the largest transaction volume.
Current thoughts on MIM and UST
MIM
On Thursday 1/27, revelations came out regarding Wonderland’s pseudonymous CFO 0xSifu being Michael Patryn — the co-founder and convicted fraudster of Canadian crypto exchange QuadrigaCX which defrauded investors of ~$170M in 2019.
It was also revealed that Wonderland’s lead Daniele Sestagalli had been aware of 0xSifu’s identity yet failed to take any action. Investors thus fled Wonderland, driving its token $TIME down ~40%.
Given Daniele also leads Abracadabra, investor fear spread to the correlating Spell and MIM tokens. Investors began to remove collateral from Abracadabra, and dumping their holdings of the MIM stablecoin. Abracadabra TVL suffered a sharp drop from ~$6Bn to ~$3Bn. MIM also came under heavy sell pressure — resulting in a de-peg to a low of $0.951. The flagship MIM-3CRV pool on mainnet Curve went from a stable 50% MIM balance on early Thursday to a high of 95% MIM later in the day, only permitting swaps of relatively low value.
The peg has slowly recovered since then to $0.99+ but the MIM-3CRV pool still remains imbalanced at 91% MIM and 9% DAI/USDC/USDT:
As of 1/29, Dani and the Abra team have not disclosed any plans on how to get the ratio back to normalized levels. We would assume additional SPELL bribes to the MIM Curve pool gauge will need to play a role. However, until we see a healthier ratio closer to 50/50 or 60/40, we would be wary of holding any MIM at this point.
UST
One of the largest cauldrons within Abracadabra had been the UST degenbox. This strategy leveraged UST deposits into Abracadabra via MIM borrowings and deposited the leveraged UST funds into Anchor protocol on the Terra ecosystem. It accounted for a massive $1Bn+ of UST deposits out of ~$6Bn total in Anchor Earn. Worse yet, $300M of the $1Bn was held by the Wonderland treasury at an extremely high liquidation price of $0.97.
As users withdrew funds from Abracadabra, that included large withdrawals from the UST degenbox strategy which put selling pressure on UST and fears of cascading liquidations should Wonderland’s position get liquidated.
The UST/3CRV pool on Curve reached a peak imbalance of 75% UST / 25% 3CRV later in the day, but has quickly recovered back to normalized levels thereafter. UST de-pegged to ~$0.95 at its lowest point on Curve. Fortunately, Abracadabra’s ChainLink oracle utilizes multiple different data sources and did not cause the cascading liquidations in degenbox that many had feared. It has also quickly fully reclaimed its peg.
While liquidations in the Abra degenbox were avoided, we don’t believe UST is fully out of the woods. There remain two main concerns with UST
- Anchor is the largest application on the Terra ecosystem, having attracted ~$6Bn of TVL due to its stable ~20% APY offered to depositors. This APY is meant to be paid via interest earned from borrowers. However, due to recent market conditions appetite for borrowings have declined significantly and the protocol is currently only generating ~8–9% APY for borrowers. The shortfall is made up for via Anchor’s yield reserve. However, the yield reserve has been declining steadily with less than a month remaining before the 20% APY must be reduced, or the yield topped up by Terraform Labs. Should a yield top-up fail to take place, we could see large withdrawals from the Anchor protocol, again putting significant sell pressure on UST.
- Second, recall that TFL maintains UST peg via a mint and burn mechanism of the LUNA coin. Whenever UST trades below $1, investors can exchange that UST for $1 worth of newly minted LUNA and sell to USDC. This sell pressure on LUNA beyond a certain point has a risk of causing cascading liquidations and further withdrawals from UST. Essentially creating a death spiral risking significant de-pegging of the UST, much like we saw with Iron Finance in 2021 (link).
Due to the above two factors, until there is a relative stabilization of the LUNA token price and further clarity on the Anchor yield reserve, we would recommend against holding UST for now.
LOOKING FORWARD
Investors looking to diversify away from MIM and UST until some of the above issues are resolved do have alternatives in the decentralized stablecoin space. We highlight a few options below:
FRAX
FRAX has maintained a tight peg since launching in Dec 2020, and has shown remarkable resiliency through both the May 2021 crash and the volatility over the past few days. The circulating supply has increased to nearly $3Bn and it now ranks as #7 largest stablecoin overall and the 4th largest among the decentralized stablecoins. With part of its supply backed by collateral and part algorithmically, it achieves a remarkably capital efficient means of achieving stability, and is being increasingly adopted within DeFi.
FRAX was also one of the first to take advantage of the Convex/Curve ecosystem to gain voting power and acquire significant liquidity to its pool. As a result, it also has deep liquidity in Curve and a very healthy ratio of assets in its FRAX/3CRV pool. FRAX has also recently proposed acquiring another $25M in Convex tokens which, if passed, should further help entrench the stablecoin within Curve.
FEI
The Tribe Dao pioneered the concept of ‘protocol controlled value’ when it launched the FEI stablecoin in early 2021. FEI maintains a tight peg by being 1:1 redeemable for protocol assets. It is the next largest decentralized stablecoin after FRAX, with a circulating supply of ~$600M.
Tribe Dao recently completed a merger with Rari Capital, a permissionless lending/borrowing protocol, which will drive increased adoption of the FEI stablecoin. The team has already announced its first combined product, Tribe Turbo — which allows users to mint and borrow FEI at 0% interest via depositing any collateral into Rari Fuse.
FEI does not have as deep of a liquidity pool within DEX’s (FEI-3CRV pool is ~$200M for example vs ~$3Bn of FRAX-3CRV). While this is largely due to the smaller circulating supply, we’d like to see the Tribe DAO further incentivize DEX liquidity as FEI adoption increases.
Summary
Stablecoins serve a very significant role within DeFi. However, not all stablecoins are created equal. Investors must be prudent in selecting which stablecoins to hold and farm with, given de-peg risk and liquidity risk. This was especially evident during the events of the last few days which saw MIM and UST — two of the most prominent decentralized stablecoins lose peg to various degrees due to mass exits.
While centralized stablecoins such as USDC may provide safe harbor, they have their own associated risk with respect to potential crackdowns from regulators. Within the decentralized space, we recommend investors consider FRAX and FEI as viable alternatives, at least while the dust settles with MIM and UST.
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