The 2 Major Stablecoin Risks That You NEED To Be Aware Of

Cryptocurrency is a historically volatile industry with price fluctuations exceeding 90% as a common occurrence.

As a response to this, founders and builders created stablecoins to allow users access to price stable coins, without the need to leave the blockchain and subject themselves to counterparty risk and censorship. 

But history has shown that even stablecoins are subject to both price fluctuations and censorship. 

So what is the way around this? 

In this article we will explore how YOU can identify a censorship resistance and truly stable stablecoin versus one that is subject to depegging and censorship. 

Quick Takes:

• Certain stablecoins can be censored, or blacklisted by financial authorities.
• Without a strong redeemability mechanism, stablecoins cannot reliably hold their peg

What Is the Purpose of Stablecoins?

Stablecoins are cryptocurrencies designed to provide financial stability without having to leave the blockchain. They're a solution to the price volatility of crypto markets. They have value because they are hypothetically redeemable for underlying assets such as fiat currencies, commodities, or other crypto. 

Whenever you hear of someone selling their crypto, more often than not it means they're buying stablecoins. It's convenient to trade stables like Tether because they're akin to holding electronic dollars, except you don't pay crypto-fiat conversion fees. And unlike electronic fiat money, you can transfer stablecoins to any wallet within minutes without having to ask anybody for permission. 

If you've ever wondered why there are so many stablecoins, it's because there are many different ways to design them. And not all stablecoins are built the same. There are many approaches and a lot that can go wrong. 

To make things easy, we have distilled all the stablecoins risks into 2 main points: censorship and de-pegging. 

Stablecoin Risk #1: Censorship

It's easy to overestimate how decentralized stable assets are. Behind the dollar-backing guarantees, there are large reserves held by Circle, iFinex Inc, and financial institutions. These stablecoin issuers are regulated, and law enforcement can request the blacklisting of wallet addresses.

(That means that blacklisted wallets cannot interact with the stablecoin in any way. Can't send, trade, swap, nor redeem amounts on other apps)

For someone who never questioned stablecoins, this might sound rare and insignificant. But did you know that Tether has been blacklisting wallets since 2017? That's $435M USDT from +800 (probably) non-custodial wallets.

While this shouldn't be possible in crypto, censorship has become more and more common every year without exception. The same can be said about Circle's USD (USDC):

As an exception, Paxos Dollar (USDP) and Binance Dollar (BUSD) barely have any blacklisting history. Although they could still do it anytime.

Censorship is a typical risk with fiat-backed stablecoins. So far, there aren't crypto-fiat alternatives that don't involve regulation. And if these companies were to ignore law enforcement, not only can that shut down the business, but also de-peg the stablecoin.

So what is the alternative? 

Decentralized, algorithmic stablecoins that rely on immutable smart contracts on the blockchain. 

Well designed smart contracts, such as Liquid Loans (which creates USDL) or Liquity (LUSD), generate stablecoins which cannot be blacklisted or censored by any individual and central party.

The protocol is completely finished, cannot be altered in any way, and is owned and operated by the people who use it.

Stablecoin Risk #2: De-pegging

Stablecoin de-pegging occurs when the token loses its 1:1 proportion with the underlying asset. One USDT should always equal 1 USD, just like 1 wBTC should always be worth 1 BTC, 1 PAXG 1 gold ounce, and so on. To achieve this standard, stablecoins use different ways to peg their coin to the underlying asset.

Note that depegging is an inevitable reality. Stablecoin prices, just like the price of any crypto or stock, is subject to fluctuations based on buying and selling through order books and liquidity pools. 

This can happen if an individual with a large amount of a certain stablecoin decides to sell it, the sell order will eat through liquidity and push the price down. 

The question is: Is there a redemption mechanism through which arbitrageurs can buy up the stablecoins and make a profit? And, is there enough collateral value to be redeemed? 

When there isn't enough collateral/liquidity and too many redemptions, the stablecoin can de-peg permanently and go to zero. 

The first ones to find out were the current CEO of EOS and Cardano, who invented the first-ever stablecoin. 

The most recent one, Terra UST, fell from $1 to $0.02 in May 2022. Terra collapsed fundamentally because there was not enough collateral backing the UST stablecoins. When users frantically exited UST, the stablecoin sold off entirely and there was nobody left to buy it back up. 

We’ve seen Tether, the largest stablecoin, de-peg multiple times, however, it was able to recover. 

It's worth noting that Tether is neither 1:1 redeemable. At least not in a decentralized way. Many hurdles ensure that most investors don't get that right:

• Register on Tether.to and pass full KYC verification ($150 fee included)
• You can only redeem the minimum amount of 100,000 USDT
• You redeem 1 USDT for $0.99, as there is a 0.1% fee up to $1,000 (1M USDT)
• Tether excludes US investors with income over $200K or net worth over $1M

What a catch.

So what is the solution to the depegging risk?

How To Solve Stablecoin Depegging

Over-collateralization and decentralized redemption mechanisms are the way to solve depegging risk of stablecoins. 

In USDL and LUSD, there will ALWAYS be more PLS or ETH value than the borrowed stablecoins.

So in the instance of a bank run, all users will be able to redeem their stablecoin for the underlying collateral.

In addition, a user holding either stablecoin will not need to KYC, or hold a ridiculously sized value in order to redeem.

Redemptions are instant and permissionless. 

Better Stablecoins

If we are to make blockchains more usable for nations, businesses, and people, we need to build stablecoins which are truly censorship resistant and do not run the risk of losing their value by de-pegging. 

Luckily, we do have stablecoins which contain these properties. 

USDL

USDL is a fully-backed, algorithmic stablecoin which is generated when PLS is locked up in the Liquid Loans contract. 

The system is designed in such a way that there will never be more USDL minted from the total value of PLS locked in all of the vaults. 

This ensures that any holder of USDL can always redeem their stablecoin for a $1 worth of PLS. 

This is important because in the event of a huge market sell of USDL, arbitrageurs can buy it off market and redeem it within the protocol, to push the price back up. 

In addition, USDL cannot be censored. There is no central party within Liquid Loans that has the admin keys to blacklist or invalidate certain USDL coins. The Liquid Loans protocol is a completely immutable, finished product. 

LUSD

LUSD is the Ethereum equivalent of USDL. It is a crypto-backed algorithmic stablecoin created by Liquity. 

Like the Liquid Loans Protocol, it's a governance-free, censorship-resistant protocol. LUSD is directly redeemable for $1 worth of ETH and has no borrowing interest rates.

Compared to CeFi (fiat-backed) stablecoins, LUSD has stayed above the $1 minimum for over a year without exception. 

LUSD has by far the healthiest price chart of any stablecoin that has existed as long as it has. 

DAI

Dai deserves an honorable mention as another semi-decentralized stablecoin on the Ethereum network. 

Dai is a stablecoin generated by the MakerDao protocol which allows users to mint Dai from various overcollateralized cryptocurrencies. 

Dai is similarly censorship resistant, in that there is no central issuer with admin keys which can invalidate your coins. 

Unfortunately, Dai has introduced USDC as collateral, which we have discussed before as not being censorship resistant. So this adds a layer of counterparty risk for the underlying redeemable capital. 

As you can see above, the majority of Dai collateral is USDC.

So it's not centralized because there's no organization regulating it. But it's neither decentralized because most of DAI's collateral is USDC. 

The biggest pro and con is that you can choose among 20+ tokens as collateral, but it requires 150%, if not more to avoid liquidations.

In addition, MakerDao is a protocol which has governance via Dao, which means the rules of the protocol can be changed on its users. 

Closing Thoughts

Stablecoins are an essential part of a DeFi ecosystem. Businesses need them for payments and investors need them for bear markets. 

Stablecoins have two major risks that need to be remedied before they can be widely adopted.

Firstly, many of the top stablecoins (USDT and USDC) can literally be turned off by their central issuers. The solution to this is algorithmic stablecoins from decentralized smart contracts.

Secondly, stablecoins run the risk of depegging from the price they are intended to hold. The solution to this is reliable, fast, and permissionless  redeemability mechanisms inside decentralized smart contracts.