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1、HOLDING STEADY:THE RISE OF STABLECOINSStablecoin Primer GRAYSCALE INSIGHTS|MARCH 2023In 1976,economist Friedrich Hayek wrote a paper titled“The Denationalization of Money,”where he argued that allowing private currencies to compete with each other would create a more stable monetary system.Hayek rea
2、soned that,unlike technology,the organic evolution of money was interrupted by the emergence of government-controlled currencies,and that government intervention in the system has led to instability and inflation.Hayek imagined a world with a competitive market for private currencies,each backed by
3、a variety of assets;a world where the value of each currency would be determined by supply and demand rather than the decisions of various sovereign entities.Today,proponents of Bitcoin like to reference Hayek.After all,the introduction of Bitcoin partially represents a move in the direction of what
4、 Hayek may have envisioned:a denationalized currency that isnt directly subject to control of a centralized entity,with a value determined by supply and demand.Though,critics note that Bitcoins volatile nature makes Bitcoin less than ideal in supporting a users daily purchasing power.Instead,we migh
5、t argue that Hayeks vision aligns closer to that of stablecoins.THE HOLY GRAILStablecoins are digital assets that are pegged to the value of a fiat currency or commodity,such as the US dollar or gold.By bringing fiat currencies,like the US Dollar,onto the blockchain,stablecoins intend to provide a f
6、ixed currency that can be traded against or used as a reliable store of value without requiring on-chain assets to be converted back into USD.“Intended”is the operative word.In the past,stablecoin projects have experienced multiple depegging events,resulting in damages that have varied from a few mi
7、llion dollars to a staggering$60 billion.For an idea of the damage that can result,you can visit Grayscale Researchs analysis of the collapse of the Terra/Luna ecosystem.Why do stablecoins continue to grow?Since inception,stablecoins have been one of the few token categories that have maintained mar
8、ket capitalization in both bull and bear markets,even when other major cryptocurrencies,like Bitcoin and Ethereum,have fluctuated wildly(Figure 1).Most cryptocurrencies tend to correlate in terms of market capitalization but stablecoins arent like most cryptocurrencies.The relatively steady market c
9、apitalization of stablecoins potentially indicates that most users are not redeeming their stablecoins for fiat.Rather,they are more likely to keep stablecoins within the crypto ecosystem.2The Rise of Stablecoins|2023 Grayscale Investments,LLCPlease review important disclosures&other information at
10、the end of this paper12345 In fact,stablecoins are gaining momentum;they now represent a significantly larger portion of the BTC and ETH market cap,surging from under 1%at the start of 2017 to over 20%as of March 2023(Figure 2).This growth reflects the rising appeal of stablecoins in comparison to t
11、heir larger cryptocurrency counterparts.So,why are stablecoins so popular?We believe the growth of stablecoins was primarily driven by the need for centralized and decentralized exchanges to access stable USD trading pairs,as evidenced by the correlation1 between stablecoin issuance with BTC/ETH tra
12、de volume(Figure 3).Increasingly,users seemed more incentivized to hold stablecoins especially since stablecoins occasionally offered competitive yields relative to traditional USD deposits.3The Rise of Stablecoins|2023 Grayscale Investments,LLCPlease review important disclosures&other information a
13、t the end of this paper12345Source:Coinmetrics,Grayscale Research,“Stablecoins”Market Cap comprises of USDT,USDC,BUSD,DAI,GUSD,HUSD,PAX,SAI,TUSD,and USDK,data as of 3/9/23Figure 1:Stablecoin Market Capitalization vs Bitcoin and Ethereum Market CapitalizationSource:Coinmetrics,Grayscale Research,“Sta
14、blecoins”Market Cap comprises of USDT,USDC,BUSD,DAI,GUSD,HUSD,PAX,SAI,TUSD,and USDK,data as of 3/9/23Figure 2:Stablecoin Market Cap as a%of BTC+ETH Market CapStablecoin pairs have become a backbone of cryptocurrency trading:since late 2022,90%of bitcoin trading volume has become denominated in stabl
15、ecoins(Figure 4).Within decentralized finance(DeFi),the stablecoins Tether USD(USDT)and Circle USD Coin(USDC)smart contracts have burned2 a total of more than 200K ETH since August 2021 from base fees3,which makes those two most popular ERC-204 tokens on Ethereum in terms of utilization5.But stablec
16、oins have potential to be transformative far beyond trading applications.These tokens can provide access to USD outside of the local banking system a potential game-changer for those living in highly inflationary environments.Consider countries like Venezuela or Argentina,where citizens face stagger
17、ing year-over-year inflation rates of 114%and 79%,respectively.That 4The Rise of Stablecoins|2023 Grayscale Investments,LLCPlease review important disclosures&other information at the end of this paper12345Source:Coingecko,Grayscale Research,as of 3/11/2023Figure 3:Stablecoin Market Cap vs BTC/ETH t
18、rading volume1.https:/ethtps.info/Network/Ethereum2.“Burning”in the context of cryptocurrency typically refers to when a user takes a specified amount of cryptocurrency out of the circulating supply3.Every Ethereum block has a base fee.When the block is mined this base fee is“burned”,removing it fro
19、m circulation.4.The ERC-20 is a standard for fungible tokens on Ethereum.In other words,they have a property that makes each token be exactly the same(in type and value)as another token.E.G.1 USDC=1 USDC5.As of 3/7/2023 according to ultrasound.moneySource:Kaiko,as of January 2023Figure 4:Market Shar
20、e of BTC Trade Volume translates to nearly half the value of their life savings lost in just one year.Stablecoins may provide these citizens a promising solution.By offering users an accessible and stable alternative to local currencies,stablecoins may empower individuals to protect themselves again
21、st the impact of inflation and currency devaluation.Perhaps unsurprisingly,stablecoin usage seems to positively correlate with higher inflation rates;around one-third of small retail crypto transactions in Venezuela and Argentina were conducted using stablecoins from July 2021 to June 2022(Figure 5)
22、.Next,well take a quick tour of the three primary designs for stablecoins,and explore some of the current challenges facing them.Then,well consider the likely trajectory of stablecoins over the near term.STABLECOIN DESIGNSWhen the first stablecoins were issued in 2014,experimentation with various de
23、signs happened almost immediately.In this section,well review the most popular stablecoin design mechanisms,feature some notable projects from each design,and provide an update on the market landscape of each.Asset-backedAsset-backed stablecoins are the easiest to understand,because they are backed
24、1-to-1 with traditional assets,like cash,cash equivalents,treasuries,etc.Although there have been transparency 5The Rise of Stablecoins|2023 Grayscale Investments,LLCPlease review important disclosures&other information at the end of this paper12345Source:Chainalysis,Grayscale Research,data measured
25、 from July 2021-June 2022Figure 5:Share of$1K crypto transaction volume made up of stablecoins34%31%28%19%0%5%10%15%20%25%30%35%40%VenezuelaArgentinaBrazilMexicoconcerns associated with difficult-to-audit bank accounts,the 90%+of the stablecoin market cap is currently comprised of asset-backed stabl
26、ecoins such as USDT,Binance USD(BUSD),and USDC(Figure 6).Tethers USDT and Circles USDCTethers USDT currently the largest stablecoin in terms of market capitalization at$71bn6 was introduced in November 2014 as an asset-backed stablecoin on the Bitcoin blockchain.This centralized asset-backed structu
27、re allows Tether to exercise control over which addresses can transact with USDT and which entities can exchange USDT for fiat currency.Circles USDC the second largest stablecoin with a market capitalization of$43bn7 was launched in October 2018 as an ERC-20 token on the Ethereum blockchain.Like Tet
28、hers USDT,Circle also exercises control over the addresses that can send and receive USDC,and users can redeem USDC for fiat.Although both Tether and Circle are under centralized control,their controlling companies have indicated that they maintain a reserve of$1 for each USDT and USDC issued,albeit
29、 with varying compositions.USDC is primarily supported by US Treasury Bills and Cash and Equivalents,while USDT is supported by a more varied assortment of assets,including commercial paper,corporate bonds,money market funds,and other investments(Figure 7).Despite their centralized control,both USDT
30、 and USDC have largely managed to maintain their respective pegs throughout various market cycles;their combined market caps surpass those of the next 10 stablecoin projects combined8.6The Rise of Stablecoins|2023 Grayscale Investments,LLCPlease review important disclosures&other information at the
31、end of this paper123456.As of February 20237.As of February 20238.As of February 2023Source:Coinmetrics,Grayscale Research,as of 3/2/2023Figure 6:Stablecoin Market Share Despite their popularity,asset-backed stablecoins are not immune to centralization risk as we clearly saw in early March 2023.On M
32、arch 10,2023,Silicon Valley Bank(SVB),a full-service bank that is known primarily for serving technology-related businesses,experienced a bank run9,which led to its failure and eventual receivership under the Federal Deposit Insurance Corporation(FDIC).$3.3bn cash of the total$42bn that collateraliz
33、ed USDC was held at SVB,which caused it to temporarily depeg from$1 to$0.88 on March 11,2023.Although USDC quickly recovered and traded back to$1 on March 12 after regulators announced they would make depositors whole,the event still exposed the centralization risk with which asset-backed stablecoin
34、s have to contend.Crypto-collateralized At a high level,crypto-collateralized stablecoins are stablecoins minted against overcollateralized loans.For example,assume that a user has$150 of ETH.If the user wanted to unlock$100 of liquidity from ETH without losing their ETH exposure,the user could find
35、 a stablecoin protocol that offered 150%collateralization ratio,deposit their$150 of ETH,and receive$100 of stablecoins as a form of a collateralized debt position(CDP).However,if the collateralization falls below 150%,the protocol partially liquidates the underlying crypto collateral(ETH)to bring t
36、he collateralization ratio back to 150%(Figure 8).7The Rise of Stablecoins|2023 Grayscale Investments,LLCPlease review important disclosures&other information at the end of this paper12345Source:Grayscale Research,Tether(as of 12/31/2022),Centre(as of 3/2/2023)Figure 7:USDT and USDC reserves breakdo
37、wn9.A bank run is a situation where a large number of depositors withdraw their funds from a bank at the same time due to concerns about the banks solvency or ability to meet its financial obligations.MakerDAOs DAI Rune Christensen founded MakerDAO in March 2015,with the initial goal of creating a s
38、tablecoin built on Ethereum,which would later become the DAI stablecoin(DAI).The project was first announced on Reddit under the name eDollar.Drawing inspiration from BitUSD,an early crypto-collateralized stablecoin,Christensen developed MakerDAO with ETH as the starting collateral and more sophisti
39、cated price stability mechanisms(we explored these sophisticated price stability mechanisms in Fundamental Value in Crypto:Decentralized Applications).Since then,DAI has grown to become the largest decentralized stablecoin in terms of market capitalization,with$6bn of DAI in circulation as of March
40、2023.DAIs stability mechanisms are complex.In addition to automatic liquidations that occur when the borrower goes under a certain collateral threshold,DAI also features both a“Stability Fee”and a“Savings Rate”that impact the DAI supply and demand curves,respectively,in order to maintain its peg.1.T
41、he Stability Fee represents the interest rate charged to the borrower for taking out a DAI loan,which helps to regulate DAIs supply.For example,if DAI demand is low,MakerDAO needs to shift the supply curve left by decreasing supply in order to maintain the peg.MakerDAO does this by increasing its St
42、ability Fee,making it more expensive for users to borrow DAI,and incentivises them to pay back their DAI loans.8The Rise of Stablecoins|2023 Grayscale Investments,LLCPlease review important disclosures&other information at the end of this paper12345Source:,kermankohli,Figure is for illustrative purp
43、oses onlyFigure 8:Example of how DAIs collateralization works2.The Savings Rate represents the interest rate DAI depositors receive,which helps MakerDAO regulate DAI demand.The higher the Savings Rate,the more demand there will be for DAI,which shifts the demand curve left.For example,if DAIs supply
44、 increases,MakerDAO could increase its Savings Rate to increase DAI demand.DAIs underlying collateral is diversified,as well.While initially the protocol only accepted ETH as collateral,MakerDAO has expanded to accept other collateral,including USDC,wrapped Bitcoin(wBTC),Compound(COMP),Chainlink(LIN
45、K),and even real world assets each with their own collateralization ratios.Despite initial volatility in its early years,DAI has become more stable over time,even with higher fluctuations in ETHs price action(Figure 9).Despite having a cumulative collateralization ratio of 150%as of March 2023,crypt
46、o-collateralized stablecoins,like DAI,remain vulnerable to the fluctuations of their underlying collateral.On March 11,2023,it became apparent that the depegging of USDC,which was used as collateral for approximately 52%of DAIs underlying assets,had an adverse impact on the value of DAI.As USDC temp
47、orarily depegged to$0.88,the price of DAI also experienced a temporary decline from$1 to$0.89.However,the value of DAI eventually rebounded to$1 on March 12 after Circle announced that USDC would be made whole.9The Rise of Stablecoins|2023 Grayscale Investments,LLCPlease review important disclosures
48、&other information at the end of this paper12345Source:Coingecko,Grayscale Research,as of 3/9/2023Figure 9:DAIs price vs ETHs priceAlgorithmic Algorithmic stablecoins are not backed by any assets or cryptocurrencies,but are instead pegged through a seigniorage algorithm that incentivizes arbitrage.S
49、eigniorage a concept that stems from the issuance of currency historically refers to the monetary gain that governments reap in the issuance process.When it comes to cryptocurrency,seigniorage mechanisms are used to uphold the stability of a stablecoins value by tweaking its supply in response to de
50、mand.In essence,a seigniorage mechanism operates by adjusting the supply of a stablecoin contingent on its current market value.If the stablecoins worth exceeds its intended value,the mechanism intervenes to increase its supply by minting new tokens,which are then put up for sale in the open market.
51、The increase in the number of tokens theoretically results in a decrease in the price,ultimately bringing the value of the stablecoin back down to its desired level.On the flip side,if the value of the stablecoin is below the target value,the mechanism adjusts the supply by purchasing tokens from th
52、e market,thus reducing the number of tokens in circulation and,correspondingly,theoretically increasing the price to bring the stablecoins value back up to its intended level(Figure 10).Ultimately,the peg is maintained via arbitrage opportunities instead of collateralization.10The Rise of Stablecoin
53、s|2023 Grayscale Investments,LLCPlease review important disclosures&other information at the end of this paper12345Source:Grayscale Research,For illustrative purposes onlyFigure 10:Theoretical example of how an algorithmic stablecoin burns supply to return to pegTerra Luna The now infamous Terra net
54、work was launched in January 2018,and Terras stablecoin,UST,was launched in 2020.UST aimed to maintain its 1:1 parity with the U.S.dollar through a dynamic relationship with Terras native cryptocurrency,Luna(Figure 11).At the heart of this Luna-UST relationship was an arbitrage opportunity that aros
55、e every time UST deviated from its peg.When UST supply was low and the demand was high,its price surpassed$1 to a price like$1.01,for example.To bring UST back to its peg,Terra permitted users to burn 1 USD of Luna and mint 1 UST,which could be sold for$1.01,providing a profit of 1 cent.Users could
56、create as much UST as necessary by burning Luna until UST returned to$1.Conversely,when the supply was excessive and the demand was low,the opposite was incentivized.If the price of UST fell below$1 to a price like$.99,for example,Terra allowed users to purchase 1 UST for$0.99,then trade 1 UST for 1
57、 USD of Luna.This trade burned 1 UST and minted 1 USD of Luna,resulting in a profit of.01 USD.While seemingly insignificant,these earnings could accumulate with large-scale trades.Ultimately,a combination of market and mechanistic forces ended the Terra project.USTs price cratered in May 2022 when a
58、 combination of UST capital flight,a liquidity pool imbalance,and an exodus of users on a Terra DeFi protocol dramatically decreased USTs price(Figure 12).More specifically,when UST was trading below its peg of$1,users took advantage of the opportunity to buy UST at a discount,then exchanged it for$
59、1 worth of Luna for a modest profit,and subsequently 11The Rise of Stablecoins|2023 Grayscale Investments,LLCPlease review important disclosures&other information at the end of this paper12345Source:The Tie ResearchFigure 11:Luna UST Arbitrage Examplesold their Luna holdings.This activity created se
60、lling pressure on both UST and Luna,as we discussed in one of our previous market bytes.TRILEMMAEach of these stablecoin designs has its own unique flaw.In the industry,these tradeoffs are often referred to as the“Stablecoin Trilemma,”as it is impossible to achieve all three features at once.The cur
61、rent understanding is that stablecoin projects can only prioritize two of the following three features:In other words,in order to excel in two areas,stablecoin projects must inevitably make some compromises in the third area.In summary:Asset-backed stablecoins,like USDC and USDT,are known for their
62、stability and capital efficiency,with a 1:1 collateralization,but each has centralized control that poses a dependency risk,as we saw with USDCs exposure to Silicon Valley Bank.Crypto-collateralized stablecoins,like DAI,offer stability and decentralization,but they 12The Rise of Stablecoins|2023 Gra
63、yscale Investments,LLCPlease review important disclosures&other information at the end of this paper12345Source:CoingeckoFigure 12:UST Price1.Peg Stability 2.Decentralization3.Capital Efficiencyrequire a higher collateralization ratio for minting,making them less capital efficient than other options
64、.Algorithmic stablecoins,like UST,are decentralized and capital efficient,with a unique peg maintenance mechanism,but each lacks the operating history and its mechanism has inherent issues that pose a risk of potential price instability.Despite the current dominance of asset-backed stablecoins,which
65、 rely on centralized institutions,decentralized stablecoins that operate on incentive structures and underlying crypto prices are making headway.As the crypto ethos gains traction,we believe decentralized solutions will gain even more popularity.NEW DEVELOPMENTSCreating a stablecoin that solves“the
66、Trilemma”is a complex and challenging task.Despite the complexities,protocols are continually exploring and piloting new approaches and regulators and policymakers around the world are more actively involved in stablecoin development.Each presents new opportunities and challenges to navigate.Novel S
67、olutionsThere are more than a few notable projects that are experimenting with various stablecoin mechanisms.Frax Finances stablecoin,Frax,initially used a blend of algorithmic and crypto-collateralized models to maintain its peg,breaking away from most other stablecoins that are overcollateralized
68、or fully algorithmic.The algorithmic portion of the model allowed for greater scalability.The fractional model aimed to provide peg stability and defense during black swan events10,increasing user confidence due to collateral transparency.However,due to the struggles of algorithmic stablecoins in th
69、e past year,Frax has recently increased its collateral holdings as an added precaution.Other projects are exploring the possibility of using real-world assets(RWAs)as collateral,which would bring them closer to the traditional financial system and could enable access to more stable cash flows.MakerD
70、AO,for instance,has invested over$600 million worth of DAI into various RWAs,such as treasuries,real estate loans,and structured credit investments(Figure 13).Although RWAs only account for 13%of MakerDAOs total assets,they contribute more than 50%of the protocols annual revenue11.The growth in RWAs
71、 signifies a growing trend of integration between the traditional 13The Rise of Stablecoins|2023 Grayscale Investments,LLCPlease review important disclosures&other information at the end of this paper1234510.A black swan event refers to a rare and unexpected occurrence that has a significant impact
72、on society or the economy11.As of 3/7/23 based on https:/ market and DeFi.While collateralized RWAs produce similar centralization risks that exist with asset-backed stablecoins,they provide an opportunity for both wider acceptance among traditional institutions and access to more stable cash flows.
73、Other stablecoin projects are opting for completely new models in tackling the stablecoin trilemma.UXD protocol,which launched in late 2021,initially started as a decentralized stablecoin project on the Solana ecosystem.Instead of relying on crypto collateral or algorithmic mechanisms,UXDs stablecoi
74、n was backed by a delta neutral position consisting of a collateral and a short perpetual futures position.To achieve the delta-neutral position,an investor could hold a long Solana spot position and a short Solana perpetual futures position.If the price of Solana increases,the value of the long Sol
75、ana spot position held by the investor will rise while the value of the short Solana perpetual futures position will decrease.Nevertheless,the underlying value of the delta-neutral position will remain constant.Because the value of the position is balanced by a long and short position,the value rema
76、ins stable despite any underlying changes to the asset price.While its still too early to tell if this design is sustainable,the novel experimentation contributes to advancing the technology.Regulatory ScrutinyRecent regulatory focus seems to be on centralized stablecoins.For example,the New York De
77、partment of Financial Services(NYDFS)recently announced action against Paxos Trust(Paxos),a white-label stablecoin issuer,ordering them to cease issuance of the centralized stablecoin Binance USD(BUSD).BUSD was first issued in 2019 in a partnership between Paxos and the cryptocurrency exchange Binan
78、ce,and had reached a market cap of$23bn in November 2022.The NYDFS claimed 14The Rise of Stablecoins|2023 Grayscale Investments,LLCPlease review important disclosures&other information at the end of this paper12345Source:Dune,SebVentures,as of 3/9/2023,holdings subject to changeFigure 13:MakerDAOs R
79、WA holdingsPaxos“violated its obligation to conduct tailored,periodic risk assessments and due diligence refreshes of Binance and Paxos-issued BUSD customers to prevent bad actors from using the platform.”Moreover,the Securities and Exchange Commission(SEC)has issued a Wells Notice12 to Paxos,allegi
80、ng BUSD is a security.Since the announcements in early February 2023,the market cap of BUSD has dropped by nearly 50%13,from$16bn to$8bn(Figure 14).While this doesnt directly impact other centralized stablecoins,it exposes the extent to which centralized stablecoin issuers are subject to the actions
81、 of regulatory bodies.The March 2023 unwinding of Silvergate and the FDIC seizure of Signature,two large US banks that had supported crypto companies to varying extents,highlights a catch-22 that centralized stablecoins like USDC are currently facing.To purchase cryptocurrency,a user must interact w
82、ith the traditional banking system.Silvergates SEN and Signatures Signet networks provided crypto users with this point of interaction,allowing users to directly exchange fiat for crypto 24/7.With these fiat onramps no longer available,stablecoins could potentially fill the liquidity gap,allowing us
83、ers to deposit with a stablecoin issuer,receive stablecoins,and then transfer them to an exchange.However,stablecoin issuers,such as Circle,still require access to banks,which could be problematic if their banking options are reduced.At the same time,there seems to be broad international interest in
84、 the development of Central Bank Digital Currencies(CBDCs),which are centralized stablecoins issued by the government rather than a private company like Circle.Two-thirds of the central banks surveyed by the independent think tank Official Monetary and Financial Institutions Forum(OMFIF)have said th
85、at they would issue a 15The Rise of Stablecoins|2023 Grayscale Investments,LLCPlease review important disclosures&other information at the end of this paper12345Source:Coingecko,Grayscale ResearchFigure 14:BUSD Market Capitalization during NYDFS and SEC actions12.A“Wells Notice”is a correspondence t
86、hat the SEC sends informing the recipient of accusations that it plans to level against them and gives the recipient the chance to correct their behavior and provide a written response.13.As of 3/7/2023 according to CoingeckoCBDC in the next 10 years.In the future,competition from CBDCs could impact
87、 the development of other stablecoins.Yet,given that some existing CBDCs have been met with strong resistance because of risks to financial freedom,the future for stablecoins is still uncertain.CONCLUSIONStablecoins offer some refuge in a world of crypto volatility.However,optimizing their design is
88、 a complex and challenging task,requiring developers to address issues like liquidity,collateralization,regulation,and algorithmic stability.Nonetheless,stablecoins continue to capture interest and gain adoption across various sectors.Asset-backed stablecoins,like USDT and USDC,continue to maintain
89、dominance,while experimentation and development of new stablecoins and CBDCs continues.While increasing regulatory scrutiny in the crypto industry may impact the development and adoption of stablecoins in the short term,we believe their unique features and benefits make them a valuable asset long te
90、rm in the digital economy.As innovation continues in the cryptocurrency space,the potential for stablecoins to disrupt certain sectors of the traditional financial system remains significant.16The Rise of Stablecoins|2023 Grayscale Investments,LLCPlease review important disclosures&other information
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