Introduction

Stablecoins play a vital role in the crypto industry. As of July 25, 2024, the market value of stablecoins is approximately $165 billion, accounting for nearly 7% of the entire cryptocurrency market of $2.417 trillion. Among them, Tether (USDT), the leading stablecoin, is currently the third largest cryptocurrency by market value, second only to Bitcoin and Ethereum.

This article will explore stablecoins in depth, including definitions, classifications, and the important role of stablecoins in the field of digital currencies. Through a case study of Ethena USDe, we will explore its operating mechanism, potential risks, and whether USDe can be regarded as an "upgraded" version of Luna.

 Definition: What is a stablecoin?

According to the Financial Stability Board and the Bank for International Settlements, a stablecoin is "a cryptocurrency that aims to maintain a stable value relative to a specified asset, or a pool or basket of assets". Typically, stablecoins are pegged to a fiat currency, such as the US dollar.

 Motivation: Why do we need stablecoins?

There is no shortage of discussions about stablecoins. But the first question is: why do we need stablecoins?

• Compared with traditional assets

First, in the context of large-scale application of Web3, digital assets provide more convenient tradability than traditional assets. Stablecoins, as a medium of exchange with stable value, promote daily transactions, while also enabling fast and low-cost cross-border payments, avoiding processing delays and high fees in the traditional banking system.

• Compared with other cryptocurrencies

Second, stablecoins help reduce the impact of value fluctuations. Due to the inherent value volatility of mainstream cryptocurrencies such as BTC or ETH, they are not suitable as stablecoins. In times of market volatility, stablecoins provide unique value stability and act as a safe haven for value preservation.

 Classification: How do stablecoins remain "stable"?

• Collateralized stablecoins

Collateralized stablecoins are fully backed by other assets, ensuring that their value is supported by other forms of collateral. Assuming that these collaterals are properly managed and have viable redemption mechanisms, the value of such stablecoins is unlikely to fall below the value of their collateral assets due to potential arbitrage opportunities. Typical collateralized stablecoins include:

1. Fiat-collateralized stablecoins: backed by fiat currency reserves, such as the US dollar. Typical examples include Tether USD (USDT) and USD Coin (USDC), which are the top two stablecoins by market capitalization. As of July 2024, their combined market capitalization accounts for more than 90% of the total market capitalization of stablecoins.

2. Commodity-collateralized stablecoins: Backed by commodity reserves, such as gold or other real-world assets. A typical example is Tether Gold (XAUt), which uses gold as collateral.

3. Crypto-collateralized stablecoins: Backed by other cryptocurrency reserves, such as BTC or ETH. A typical example is DAI developed by MakerDAO, which uses ETH and other approved Ethereum assets as collateral.

• Algorithmic stablecoins

Algorithmic stablecoins maintain stability by ensuring the security of collateral through algorithms, or by adjusting market circulation (supply and demand status). Typical methods include:

1. Liquidation: In order to ensure that the value of all outstanding stablecoin debts is always fully collateralized, some stablecoins adopt a liquidation mechanism, that is, through auction liquidation of risky collateral with a value lower than its corresponding issued stablecoin. This mechanism usually also includes an initial over-collateralization (for example, a ratio of 150%) to provide a buffer between the value of the collateral and the corresponding stablecoin. Typical examples include the current largest algorithmic stablecoin DAI.

2. Destruction and minting: This method reduces the total supply by destroying existing tokens, or minting new tokens to increase the total supply, assuming that total demand remains unchanged. Assuming that the stablecoin falls from the target price of $1 to $0.9, the algorithm will automatically destroy a portion of the tokens to introduce more scarcity, resulting in a decrease in circulation, thereby pushing up the price of the stablecoin. Typical examples include TerraUSD (UST), which uses a built-in fixed exchange rate mechanism to create potential arbitrage opportunities for users through destruction and minting; however, the protocol failed to remain stable during the massive market decline, resulting in a loss of more than $40 billion, the largest loss in Web3 history.

3. Adjusting borrowing rates: This method controls the supply of stablecoins within the "borrowing yield framework" by raising or lowering the central borrowing rate under the assumption that people are generally profit-seeking (essentially providing potential income opportunities for stablecoin holders). Assuming that the stablecoin falls from the target price of $1 to $0.9, the algorithm will automatically increase the borrowing rate to attract (i.e. lock) more circulation, thereby pushing up the price of the stablecoin. Typical examples include Beanstalk (BEAN), which manages the circulation of BEAN by adjusting the loanable amount (called Soil).

Note

It is worth noting that these classification methods are not mutually exclusive. Stablecoins can implement multiple mechanisms simultaneously to maintain stability. For example, DAI is backed by cryptocurrency collateral and also uses algorithmic adjustments (i.e., liquidations). This combination of strategies can leverage the strengths of multiple mechanisms to mitigate potential weaknesses, thereby enhancing the overall stability and reliability of stablecoins.

 Security Risks and Solutions

Collateral Transparency

For stablecoins backed by fiat currencies or commodities, users may doubt whether the collateral is safely held and readily available for redemption. Many stablecoins address this issue by holding collateral at a third-party custodian (such as a bank), conducting regular audits, and publishing proof of reserve reports. These measures can enhance the transparency of collateral management, thereby alleviating public suspicion to a certain extent.

Volatility of Collateral Value

For cryptocurrency-collateralized stablecoins, whose underlying assets are more volatile than fiat currencies or commodities, large fluctuations in collateral value may lead to unexpected collateral value gaps. To address this problem, many stablecoins implement over-collateralization and liquidation mechanisms to mitigate the potential negative impact of collateral value fluctuations. Over-collateralization ensures to some extent that the value of collateral can remain within a safe range during market fluctuations, because the initial value of the cryptocurrency reserves exceeds the value of the issued stablecoins; the liquidation mechanism allows other users to liquidate stablecoins that are not sufficiently collateralized, thereby maintaining the stability of the stablecoin value.

Smart Contract Vulnerabilities

Stablecoins, especially algorithmic stablecoins, rely on complex smart contracts to implement their stabilization mechanisms. However, these smart contracts may also introduce new risks at the code level, such as reentrancy attacks, logic errors, or governance vulnerabilities. Therefore, strict security audits and continuous security monitoring are essential to ensure the security and reliability of these protocols.

Market Volatility

Sharp fluctuations in stablecoins and stablecoin-related tokens (such as sudden crashes in a short period of time) can undermine public trust in stablecoins and affect the stability of stablecoin value. In rapidly changing market environments (such as during black swan events), the originally designed stabilization mechanism may not be able to respond and adjust quickly, resulting in large price deviations. In high demand or panic scenarios, automated market maker (AMM) designs may also lead to a shortage of stablecoin liquidity in exchange liquidity pools, further exacerbating price volatility. Markets with insufficient liquidity are particularly vulnerable to manipulation. In addition, stablecoins rely on oracles to determine external prices (such as US dollars or Ethereum), and incorrect oracle data may cause stablecoin pricing errors, creating a new attack surface.

Figure 1: Top 20 stablecoins by market capitalization; Source: DefiLlama

The market capitalization of these stablecoins shows a high degree of concentration, with the top 5 stablecoins (i.e., USDT, USDC, DAI, USDe, and FDUSD) accounting for 96% of the total market capitalization, and the top 20 stablecoins accounting for 99% of the total market capitalization. This shows that the market is dominated by a few key players, consistent with the Pareto Principle.

Of the top 20 stablecoins, all are collateralized by some asset (such as USD, U.S. Treasuries, or other cryptocurrencies). In addition, 9 of these stablecoins also incorporate algorithmic stabilization mechanisms to adjust the circulating supply or ensure the security of the collateral.

Figure 2: Comparison of the top 20 stablecoins by market value; Source: BlockSec

This phenomenon shows that although algorithmic stablecoins claim that their stabilization mechanism design is excellent, users show a clear preference for fully collateralized stablecoins, especially those backed by fiat currencies. As Frax founder Sam Kazemian said: "If you want to create a very large stablecoin, you want to become safer as you get bigger, not the other way around; as people use money, you want it to be safer." Case Study: Ethena Labs - USDe Over the past year, USDe, issued by Ethena Labs, has gained widespread attention. As of July 2024, it has become the fourth largest stablecoin by market capitalization, according to DefiLlama. This section will use USDe as a case study to explore its design principles and potential risks.

Design Principles

USDe can be considered as a stablecoin based on a centralized exchange (CEX), and its stability mechanism currently relies mainly on the operational stability of CEX. Specifically, USDe uses mainstream cryptocurrencies as collateral and adopts a "delta hedging" strategy to maintain the stability of the collateral assets.

So what is "delta hedging"? We can illustrate it with the following example. If 1 ETH is used to mint USDe, then we say that the stablecoin is exposed to "positive delta of 1 ETH", which means that the value of the stablecoin is completely sensitive to the spot market price of ETH. Ideally, the goal of a stablecoin is to minimize this sensitivity, that is, to try to ensure that "delta is 0" to ensure stability to a greater extent. To achieve this goal, Ethena performs delta hedging by "shorting" a perpetual contract with a nominal position of 1 ETH. This strategy neutralizes the exposure of the collateral value to market fluctuations. Therefore, no matter how the ETH market price changes, the value of the collateral always remains stable.

In addition, USDe's income consists of two main parts: staking income, which is the native income from ETH staking; and income from delta hedge derivative positions. The second part is further divided into two parts: 1) income from funding rates, which are regular payments between long and short positions on CEX; and 2) income from basis spreads, which are profits generated by the price difference between the spot market and futures contracts. According to Ethena's historical data analysis, this income combination remains positive during market downturns (such as the Terra incident and the FTX incident).

Security Risks

• Centralization Risk

The main security issues stem from the reliance on CEXs for delta hedging and the custody approach for OTC settlement. We call this issue centralization risk. This dependency creates a vulnerability that could jeopardize the stability of stablecoins if these exchanges fail to function properly—either due to operational issues or bank runs. Although collateral is distributed across multiple exchanges, more than 90% of collateral remains concentrated in three major exchanges: Binance, OKX, and Bybit.

• Market Risk

In addition, market risk cannot be ignored. USDe's yield mechanism may encounter persistently negative funding rates, which could cause some parts of Ethena's yield design to become negative. Although historical data shows that such negative yield periods are relatively short (less than two weeks), it is important to consider the long-term adverse conditions that may arise in the future. Therefore, adequate countermeasures, such as sufficient reserve funds, should always be prepared to cope with this difficult period.

 Conclusion

In summary, stablecoins play a vital role in the cryptocurrency ecosystem by providing stability and facilitating transactions during market fluctuations. The classification of stablecoins ranges from fiat currency collateral to algorithmic mechanisms like Ethena USDe to RWA-backed stablecoins like Ondo, meeting various needs of the crypto community, but also presents risks such as collateral transparency, value volatility, and smart contract vulnerabilities.

As Ethena Labs continues to improve and innovate USDe, a key question emerges: Can USDe remain stable in market fluctuations and avoid a crash like Luna? USDe's underlying assets and economic model design are still very different from Luna, but it is also worth paying close attention to whether USDe can truly remain stable and potentially take the lead in the highly competitive stablecoin field.

The huge market value and influence of stablecoins force us to pay attention to their security risks. Continuous security audits and security monitoring are indispensable to maintaining market stability and trust.