This has dramatically increased the usability of stablecoins in decentralized exchanges (DEXes) liquidity pools, where the value of cryptocurrencies and layer 2 tokens is largely fixed in USD-pegged stablecoins.
Loan pools on loan DeFi platforms like AAVE have also opened up new income opportunities for stablecoin holders. There you can put your stablecoins into a liquidity pool at an interest rate that varies based on supply and demand.
If you hold a cryptocurrency and a stablecoin, you can become a liquidity provider for the relevant trading pool on a decentralized exchange. You can collect your trading fees in the LP token of that particular exchange, giving you an APY on the otherwise untapped liquidity locked in your stablecoins. The most prominent haven for stablecoin liquidity is Ethereum’s curve protocol, where you can take advantage of all stablecoins.
Things to consider when investing in stablecoin
If you are looking to invest some of your investment capital in stablecoins, please consider a few factors that affect the safety of your funds. The first parameter is the type of stablecoin. The most reliable are fiat-backed and over-collateralised.
The fiat-backed stablecoins are the ones that you can get for a fiat currency. An example of these stablecoins is Coinbase’s USD Coin (USDC). It works on the IOU principle: the issuer owes you the liquidity that you grant them in fiat money. This is a very reliable way to protect your liquidity while retaining the ability to monetize your on-chain liquidity on the respective blockchain. One of the most famous over-collateralized stablecoins is Tether (USDT), which is over-collateralised by fiat funds, securities, USD, etc
There are also algorithmic stablecoins backed by cryptocurrencies. There are several ways of supporting them, for example, MakerDAO and its DAI use the mechanism of cover when the amount of collateral exceeds the amount of token issuance. It is over-collateralised by Ether (ETH) locked in MakerDAO smart contracts. Such a mechanism must be very reliable.
Most algorithmic stablecoins are algorithmically backed by the blockchain’s native cryptocurrency. This system is used in Terra’s UST stablecoin, which is backed by LUNA – Terra’s native cryptocurrency. Its algorithm allows users to burn 1 USD worth of LUNA to mint 1 UST and vice versa.
For example, if the price of UST rises to $1.01, users can burn LUNA for UST and sell UST for USD with a profit of $0.01 per UST. This will increase UST supply and increase LUNA supply to bring UST price back to $1.
When the UST price falls below $1, say to $0.99, the algorithm allows users to buy 1 UST for $0.99 and burn it for $1 worth of LUNA, generating a similar profit of 0, 01 USD is achieved. This will reduce the UST supply and increase the LUNA supply to bring the UST price back to $1.
However, this cannot work. And it failed with Terra’s UST rapidly falling to $0.29 and LUNA’s price falling more than 97 percent. The algorithm just couldn’t handle the magnitude of the UST sell-off and mint enough LUNA to support its price. And when the UST fell as much as it did, it took so much additional supply of LUNA to bring its price back to $1 that LUNA’s price fell as much as it did.
This example shows how risky algorithmic stablecoins can be.
The other parameter to consider when choosing a stablecoin is decentralization. When a stablecoin is centrally issued, it is very reliable but can be blocked due to legal issues if the government agency gets into a fiscal jeopardy with regulators. Such a scenario can hurt the price of the stablecoin. Also, the money in a holder’s account must be transparent and legal, otherwise it can also be blocked.
But there are also decentralized stablecoins that have no central control. They are backed by non-centrally issued cryptocurrencies locked in non-centrally controlled smart contracts. And that makes it practically difficult to devalue the price of such a stablecoin through legal issues. It’s fitting when investors have assets of unclear provenance, but it’s worth keeping an eye on the decentralized Luna story.
The Tether USDT stablecoin is the most prominent example of a centrally issued stablecoin. In April, Tether Holdings Ltd. further details on his reserves confirming their validity.
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