The True Security and Risks of Stablecoins
The Importance of Stablecoins in the Crypto Market
Even in the early days of crypto, a critical issue became apparent: we are operating in the realm of digital money. The fundamental difference from anything that came before is that we are now completely digital. This represents a new level of digitization. In the past, what we brought from the real world to the internet always had a real-world counterpart. However, cryptocurrencies no longer have a direct link to the real world. They can exist independently and, in many cases, refer to each other without requiring any real-world equivalent. This is both a significant advantage and a considerable disadvantage. In this article, we will explain exactly why.
Profits and losses from investments only become real when they are realized in the everyday currency. This is where crypto demonstrates significant differences from traditional systems.
The ability to exit the system is simply a form of interoperability that investors and users desire. It is not inherently an advantage that crypto can operate outside the traditional financial world if, in critical situations, one is trapped within it.
Mechanisms Behind Stablecoin Stability
Without boring the reader with technical details, it's important to note a central point: not all stablecoins are created equal. We will highlight the key aspects of the different types. Some projects use flashy names for marketing purposes, but fundamentally, there are only these two types. Don’t be misled by marketing jargon.
Fiat-backed stablecoins: Tokens backed by real-world currencies.
Crypto-backed stablecoins: Stablecoins that are backed by other assets, typically through the collateralization of debt.
The third type, known as algorithmic stablecoins, is a special category of crypto-backed tokens. They are, incidentally, the most dangerous and least transparent variant.
Fiat-backed Stablecoins: Advantages and Risks
The issuance is straightforward. A party takes fiat money into custody and creates a token equivalent that represents this value. The advantage is that it involves an entity that can be audited and held accountable. Ideally, this entity operates transparently and responsibly. In the worst case, it is opaque and operates in a legal grey area. This doesn't necessarily mean the funds are unsafe, but let's be honest: why would one need to operate in a tax haven or a country lacking legal foundations if the business is legitimate?
The advantage, which we also want to highlight, is that if the entity enjoys high trust, it can be a strong guarantor of stability. A fully regulated stablecoin operating in a well-regulated jurisdiction is extremely positive. However, these advantages come with a significant caveat: the jurisdiction decides what is legal and what is not. What is acceptable today can become uncertain tomorrow due to regulatory pressure.
It is generally wise to consider who benefits from a system. Those who issue stablecoins do not do so out of altruism. It is a business, and ideally, all parties benefit, including the regulator. This is when a stable solution is most likely to be found.
Crypto-backed Stablecoins: Stability Through Over-Collateralization
This solution often operates in a less regulated environment. The borrowing against assets is generally something that is open to everyone. As long as there is confidence in the value of the collateral, there are no issues. This brings us back to the initial point. Crypto is largely self-referential, at least from the perspective of many idealists. This is where the problems begin. If prices crash, the stablecoin comes under immense pressure. It is crucial to understand that the risk becomes particularly significant here. When assets plummet, people seek security. This means that the situation where security is most desired leads to a system that is likely to fail at that moment.
These are the purely financial aspects. In the crypto space, potential programming errors also come into play. The more complex the mechanism, the higher the likelihood of failure due to this lack of transparency. Who actually reads the code and has enough economic understanding to uncover its weaknesses? It requires a professional in both programming and finance. This is not only rare, but these parties often view each other critically or even antagonistically. Any crypto investor who denies this is acting out of ideology, not risk awareness.
Algorithmic Stablecoins: Balancing Complexity and Market Dynamics
This type has been one of the least secure in the past. Yet, new ones constantly emerge, touting their advancements and attempting to mislead users with technical jargon. They aim to appear highly technical because people tend to view complex technologies as superior. However, this is not necessarily true. Complexity does not equate to security. These implementations can either be dismissed as mere marketing ploys or become so complicated that even the developers no longer understand how they work. And that is, unfortunately, the truth.
Now, let's look at the functionality. This type of stablecoin takes the self-referential nature of digital assets to the extreme. They are algorithmic because they react to other assets within the system according to predefined rules. Whenever the stablecoin becomes unstable, either upwards or downwards, additional assets are issued to regulate this mechanism. Essentially, this doubles the risk because the stablecoin now depends not only on collateral but also on a token that is typically highly volatile. These additional tokens usually serve this sole purpose and have no other utility, unlike purely collateral-based tokens. It is crucial that a group of investors stands firmly behind the project and is willing to take on significant risks. These risks are higher than those of users who simply use the stablecoin. It is essential to understand that if this group does not exist or loses confidence, the entire mechanism is doomed to fail.
Key Stablecoin Failures and What They Teach Us
USDT: This stablecoin should be well-known. It is backed by real dollars, making it fiat-backed. In the past, it has come under significant pressure due to the threat of a ban by regulators. Since this has not happened, it seems at least likely that agreements have been found that are acceptable to both Tether Limited and at least the US government. However, this does not mean it will always be the case. There have been multiple discussions about whether the company actually has all the dollars it claims to have. This is the crucial part of fiat-backed stablecoins. Anyone with a basic understanding of the money market knows that billions of US dollars do not just sit in a bank account. Due to external pressure, Tether has been forced multiple times to disclose data and provide evidence. So far, these have been absolutely ridiculous. For instance, this image is supposed to prove the existence of several hundred billion dollars.
This image, which is a screenshot from an Excel spreadsheet, is genuinely all that the company behind USDT has delivered so far.
Given the enormous dominance of this stablecoin, this is more than dubious, and nothing has changed to this day.
Nonetheless, it must be noted that while several stablecoins have failed or become unstable, Tether has always managed to maintain value stability, making it the dominant stablecoin to this day, despite its massive risks.
USDC: Is issued by Circle in partnership with Coinbase. Coinbase is a big player in the market. This is a good sign, but not a guarantee. The main danger lies in the dominance of this single company. Although it seems unlikely, many companies in the crypto business have disappeared overnight. Coinbase is huge, but it also raises the question of how a large company can remain profitable and stable in a market that regularly sees 90% crashes. It would be desirable to have other large companies offering such solutions.
However, this is by no means simple. Users do not want a vast array of choices, even though this would be beneficial for risk management, as it complicates straightforward investing. We want to identify one successor and simply use it. But there are no native currencies on the blockchain. One must trust some party. This is also the case with banks or brokers. These risks exist there as well. However, they are more heavily regulated, have been in the market much longer, and enjoy a trust advantage that crypto does not have. The key takeaway here is that diversity can provide more security than relying on a single company.
Overall, USDC is considered trustworthy. Circle is registered as a money services business (MSB) with the Financial Crimes Enforcement Network (FinCEN), a bureau of the U.S. Department of the Treasury. This registration requires Circle to comply with anti-money laundering (AML) and know your customer (KYC) regulations.
Terra USD, FRAX u.v.m.: These stablecoins are difficult to describe generally. Many claim to have their own special implementation. In the end, it remains a mystery to the user from the outside. The best proof is the massive crash of Terra, whose responsible person ended up in jail. Such stories are not uncommon. Where there is money and power, fraudsters gather. This is a law of nature. Many were too eager to believe how safe and regulated everything is. And here comes a particularly piquant fact: the company behind Terra, namely the exchange FTX, was considered one of the most controlled exchanges in the USA. The US government must face the question: If it is so important to you to protect the users, which is often used as a reason for many bans, how is it possible that such an obvious fraud was not detected by the authorities who had insight behind the scenes? This example clearly shows that regulation does not always provide protection.
We have already mentioned the other point: do not be dazzled by fancy, techy algorithms. Any product that cannot be simply explained should be viewed critically. Many projects simply copy code from others and build upon it. This can be good in principle, as long as the original code is considered stable. However, it is usually the changes made by the new team that introduce insecurity. If the original code already has issues, it creates a cascade of problems. Complex mechanisms are not inherently bad, but in the event of an emergency, they have shown that it is more difficult to intervene in a complex system.
Regulatory Actions on Stablecoins
State actors are interested in regulating the stablecoin sector sooner rather than later. The sole reason for this is not just the oft-cited prevention of money laundering. Should stablecoins become more and more of a financial instrument, there is indeed a risk. Given the current instability, this would have massive impacts on the monetary system. If we assume that 20% of the financial world relied on crypto, it would definitely be a significant issue. The best approach pursued so far is to regulate to a certain extent to provide some security, but not so much as to push future developments into the dark zones of the internet.
This endeavor is sometimes complicated, as shown by the USDT problem. If one is strict and critical, one must actually say that it is not a secure asset at all. The system could collapse tomorrow, and governments would refer to the well-known investment risk in crypto, and that would be it. This is not a particularly secure environment for storing large amounts of money over time. And possibly, a government has no interest in that either. The fact that there is no safe haven can also be seen by financial authorities as a kind of stable chaos. No one is currently willing to keep significant amounts of their wealth there. And this forces them to return to the existing financial system repeatedly. However, this situation will gradually resolve over time. It seems to us that, at least for now, this is being exploited.
Another point that repeatedly arises in connection with stablecoins is the discussion of whether they could be used as a means of payment. This is not impossible, but seems unlikely. The central question is: what problems would this solve? Digital money already exists with more advantages than disadvantages compared to the crypto system. The motivation for this is low. The current crypto infrastructures are also hardly capable of handling this amount of potential transactions. It is also questionable whether they will ever be able to do so due to technical limitations. But that might be a topic for another article. As of now, it is unrealistic to assume this. There is simply no demand for it. However, what there is a demand for is the ability to move assets digitally in a simple and somewhat standardized manner. This would be quite an advantage, even for stocks, although little has been implemented so far. This is because the general problem of regulation must first be solved. Stablecoins are the forerunners of the much-touted Real World Assets (RWAs).
Risk Mitigation Strategies for Stablecoin Users
Now we come to perhaps the most important point of this journey. So far, we have mainly talked about problems, but how do you solve them as an investor? The most effective solution has already been implicitly mentioned: diversification. From a risk perspective, one could say that USDC is likely the safest of these assets. But this view would be too simplistic and reductive. In most cases, we also want interest on our deposits, even if they are fiat values. However, if it's just about short-term storage and profit-taking, USDC is the best choice.
When it comes to interest rates, entirely new factors come into play. All fiat currencies are subject to inflation, and cryptocurrencies are no exception. Interest is a compensation for this. Usually, the highest interest rates are offered by highly demanded stablecoins, but these are not necessarily the safest. From experience, although it fluctuates, USDT currently offers the highest interest rates. Sometimes, even higher interest rates are paid on comparatively smaller stablecoins. But caution is advised here, as high interest is paid by the investor at a high risk. They are either in networks where there is significantly less liquidity or are generally poorly positioned in terms of liquidity. The high interest rates usually come from the operators themselves, who want to encourage investors to invest their money. And low liquidity means that the risk of a depeg occurring is increased.
Nevertheless, this plays a role in shaping one's portfolio. Missed profits can be frustrating, especially under high inflation pressure. Therefore, the potential to earn interest should definitely be part of risk management. They should be considered alongside the general security aspects that arise from the issuance.
To be more specific, we present a possible strategy here. It is important to mention that this is not a universally applicable template. Designing a professional strategy requires an in-depth analysis, including personal preferences. These are questions like: Is it important for me to earn the highest possible interest, or do I want to focus on longer-term storage? This usually results in a mix because there is no single strategy that fits all. Goals can be pursued proportionally, and they also change over time. For example, let's assume the following:
Current Market Conditions
1.) Bear Market:
The crypto market is currently in a bear market, characterized by falling prices and reduced market activity.
Reasoning: After significant price declines in major cryptocurrencies such as Bitcoin and Ethereum, as well as the overall cooling of the market, prices have fallen sharply. Investors are looking for stable assets, which makes stablecoins more attractive.
2.) High Demand for Stable Assets:
In times of uncertainty, the demand for stable assets such as stablecoins increases, as they offer a safe haven.
Reasoning: In bear markets, investors often withdraw capital from volatile assets and park it in stablecoins to avoid value losses.
Assumptions About Future Market Developments
1. Slow Transition to a Bull Market: The market is expected to gradually recover and transition into a bull market, but this transition will be slow and marked by uncertainty.
Reasoning: Historical patterns in the crypto market show that a period of consolidation often follows a bear market before a new upward trend begins. However, the recovery could be slowed by macroeconomic uncertainties and regulatory developments.
2. Stable or Slightly Increasing Interest Rates for Stablecoins: Interest rates for stablecoins are expected to remain stable or slightly increase to attract investors.
Reasoning: DeFi platforms and crypto exchanges continue to offer competitive interest rates to attract capital, especially during the market recovery phase.
3. Increased Regulatory Clarity and Security: Regulatory frameworks are expected to become clearer, increasing trust in stablecoins and their use.
Reasoning: Regulatory authorities worldwide are working on clear guidelines for stablecoins, which can lead to increased acceptance and stability.
Specific Assumptions for the Strategy:
USDC Remains Stable and Trustworthy
USDT Continues to Offer High Interest Rates, but with Increased Risk
DeFi Platforms Continue to Develop
Increasing Demand for Safe Investment Forms
Example Composition:
50% USDC (USD Coin):
Security: USDC is considered one of the safest stablecoins due to strong regulatory oversight and transparency.
Interest Rates: Lower but stable interest rates.
30% USDT (Tether):
Security: USDT offers higher interest rates but carries higher risks due to lower transparency and regulatory uncertainties.
Interest Rates: Higher interest rates, but associated with higher risks.
10% DAI:
Security: DAI is a crypto-backed stablecoin that offers a certain level of decentralization, reducing the risk of central points of failure.
Interest Rates: Medium interest rates, depending on usage in DeFi protocols.
10% Algorithmic Stablecoins (e.g., Frax):
Security: Highest risk but potentially high returns. These investments should be regularly monitored and quickly adjusted at signs of instability.
Interest Rates: Potentially very high interest rates.
Future Outlook for Stablecoins
Let's keep this part brief. It is expected that as the number of investors in the crypto space increases, interest in stablecoins will also grow. This is logical. Other currencies could also be of interest, some of which already exist, but due to their low liquidity, they are generally not very attractive. This is partly because the US dollar dominates asset trading, and also because low liquidity means that hardly any interest can be earned. It is a chicken-and-egg problem. However, additional currencies could bring Forex trading onto the crypto infrastructure.
Future questions that no one can answer include, for example, what would happen if significant amounts of fiat currencies remained in the crypto system, making the real value different solely due to the competition between the two systems. Money is most valuable where it can be used most effectively. If, hypothetically, no one wanted to trade with money outside of crypto, this would diminish the utility of real-world fiat. Very unlikely, but worth considering, as it shows that there is much more to this than meets the eye.
Conclusion: Weighing the Security and Risks of Stablecoins
The summary is simple: Pay very close attention. No stablecoin is the same as another. And that's a good thing. Without these differences, there would be no interest rate variations and thus fewer incentives. With well-planned risk management, you can turn this to your advantage. And by the way, we're here to help you with that!