Centralized v Decentralized Stablecoins: Which are Safer?

On March 10, 2023, USDC depegged from the dollar after the bank run on Silicon Valley Bank, which stored $3 billion in USDC cash reserves. Does this mean that centralized stablecoins can no longer be trusted any more than decentralized algorithmic stablecoins??

TL;DR

• Centralized stablecoins are issued and governed by a company and minted when clients deposit funds (usually USD). A centralized stablecoin should be 100% backed by liquid reserves and those reserves should pass regular audits.
• Decentralized stablecoins are governed by smart contracts; their creators can’t influence the issuance. Decentralized stablecoins can be backed by crypto collateral or use an algorithm that regulates supply and demand to maintain the peg.
• Ultimately, what keeps a stablecoin pegged is the market’s trust in it. FUD (fear, uncertainty, and doubt) campaigns in the media can easily destabilize a stablecoin.  If a stablecoin does not  have an exact 1:1 parity with the base asset, it should trade within an extremely tight window around it.
• Depegging occurs when a stablecoin starts to trade outside of that window. A stablecoin can depeg permanently and become useless, as happened with Terra’s UST.
• When using centralized stablecoins, you’re exposed to several risks: the issuer can lose access to its reserves or face regulatory action, for example. However, major centralized stablecoins are surprisingly resilient and usually regain the peg, so think twice before panic-selling.

• Decentralized stablecoins fall into 3 types: collateralized (DAI), algorithmic , (UST), and mixed (USDD).
• Decentralized stablecoins can depeg due to market manipulation, flaws in the algorithm, or a market-wide negative event. They can have trouble repegging due to lack of  capital and/or because their algorithms can’t withstand the sell pressure.
• To protect yourself, don’t hold  all of your money  in just one stablecoin - but don’t overreact to FUD, either.
• Aptos supports both bridged stablecoins (USDT, USDC, DAI) and native ones (MOD). On Liquidswap, stablecoins are traded in special stable pools that use a different liquidity curve to minimize slippage.

Stablecoins 101

Definition

A stablecoin is a cryptocurrency whose price is pegged to another asset. Usually it’s the US dollar, though it can also be the Euro, gold, or even a major crypto asset like Bitcoin. A peg doesn’t mean a strict 1:1 parity: it’s normal for a stablecoin to trade within a narrow range (e.g. $0.99-1.01).

Centralized stablecoins

Centralized stablecoins are issued and controlled by a specific company: Tether for USDT, Circle for USDC, Binance for BUSD, etc. Normally one stablecoin is minted when a customer deposits the  equivalent asset ($1) with  the issuer. This way, the stablecoins in circulation should always be backed by liquid fiat reserves.

For example, a company can open an account with Circle, deposit USD in it, and receive an equivalent amount of freshly minted USDC. When you simply buy USDC on an exchange for USDT, APT, BTC, etc., no minting happens.

Note that reserves don’t always have to be in the peg asset. A US-pegged stablecoin can hold part of its reserves in euros, British pounds, gold, Bitcoin, or even credit liabilities. It depends on regulations in the issuer’s jurisdiction. For example, Facebook’s now-defunct Libra stablecoin was initially supposed to be backed by a basket of currencies: USD, EUR, GBP, JPY, and SGD (the Singaporean dollar).

Ideally, the issuer should publish audit reports showing the state of the reserve vault. Circle does it monthly for USDC. Without an audit, it’s hard to be sure that the stablecoins are securely backed.

Decentralized stablecoins

The main difference with decentralized stablecoins is that they aren’t backed by fiat reserves. Instead, their issuance is governed by a smart contract. The issuer can’t just decide to mint tokens: something has to trigger the contract.

Also, a truly decentralized stablecoin is governed by its community of holders. Any change in the protocol has to be approved by them and can’t be simply be enacted by the team  (though they count as holders and have voting rights).

Decentralized stablecoins fall into three main categories:

1) Collateralized:- Stablecoins are minted when collateral (another cryptocurrency) is deposited in the contract. A user can withdraw their collateral by burning stablecoins. In other words, the stablecoin’s supply is regulated by the flow of reserves.

For example, DAI (created by MakerDAO) is issued when users deposit USDC, USDT, DAI, ETH, or AAVE. It’s fully automated: the team of MakerDAO can’t just make new DAI appear unless more collateral is added.

‍2)Algorithmic: Instead of maintaining reserves, these stablecoins use algorithms which regulate the supply automatically based on supply and demand conditions. The algorithm will let users buy stablecoins at a discount when the price is below $1, or let them sell at a premium when the price is above $1. This arbitrage should restore the peg, in theory. .

3) Mixed: They use a combination of collateral and algorthmic controls to maintain the peg.

How do stablecoins maintain peg?

A stablecoin is only stable as long as it maintains parity (1:1) with the base asset. For this to work,  the market has to trust  it.

For centralized stablecoins, this means that the market trusts the issuer has  appropriate reserves and can honor requests to redeem the stablecoin for fiat. For decentralized stablecoins, the market should trust that their smart contracts are secure and that the pegging algorithms can withstand selling pressure and various types of attacks and market manipulations.

When that trust is lost, l lots of people will sell  the stablecoin or attempt to redeem it at the same time, leading to a run. In this case, any stablecoin can depeg . Sometimes it is caused by FUD (fear, uncertainty, and doubt) that spreads through the media, or even is planted intentionally  by a competitor or short-seller. In other cases, a sell-off is triggered by market manipulation, as happened with UST (see below), or a smart contract exploit.

Ultimately, the only thing that keeps  a stablecoin stable is the market’s belief that it will stay stable. In the rest of the article, we’ll look at what can cause stablecoin FUD or depegging – and ways to protect oneself from this risk.

Centralized stablecoins risks

When holding centralized stablecoins, once faces two key types of risks:

Counterparty risk: the risk that the stablecoin issuer won’t meet its contractual obligations as a result of error or malicious behavior.

Third party risk: the risk that the issuer won’t meet its obligations as a result of actions by the government, an attack by criminals/hackers, etc.

Let’s see how these risks played out for several centralized stablecoins:

USDCL: Inaccessible reserves due to banking crisis: USDC

Circle held $43.5 billion in reserves for the minted USDC as of March 9, 2023. Where is all that money stored?  The answer is short-term US Treasury bonds ($32.4bn) in accounts with around 10 banks ($11.1bn).

But what happens if one of those banks collapses and can’t return Circle’s money? That’s what happened with Silicon Valley Bank (SVB), where Circle had $3.3 billion in reserves. On March 9, it was announced that the Federal Deposit Insurance Corporation  (the major American banking regulator) took control of SVB after the bank urgently needed $2.25 billion to continue operations after losing $1.8 billion on security sales.

As anxious depositors lined up in front of SVB’s offices, Circle urgently requested withdrawals, but the bank couldn’t process them. After Circle tweeted about it on March 11, investors feared Circle could not recover the reserves  and started selling USDC en masse.  Within hours, the price of USDC fell to $0.88.

Two days later, reports surfaced that SVB depositors would get their money back, and USDC quickly recovered to $0.95. When the US financial regulators confirmed the news, the stablecoin regained its peg. On March 12, Circle even minted 407 million more USDC, indicating that investors were again willing to deposit money with the issuer. Market trust in USDC was restored.

By the way, some traders earned a lot of money on the depegging. They bet on Circle being able to resolve the problem by  buying cheap USDC at $0.88, then sold it for $1 once it repegged. Among these smart traders, according to Lookonchain, was a wallet connected to Tron CEO Justin Sun, whichmade $3.3 million in profits.

Tether: Unaudited reserves lead to FUD

The story of Tether’s unaudited, undisclosed reserves was the mother of all stablecoin FUDs. In 2021 the Attorney General of New York State found that Tether had misrepresented USDT as being fully backed by USD reserves. In reality, the reserves included vast amounts of unsecured credit liabilities and other assets that weren’t dollars. They were held not by banks, but by various unregulated third parties, often without any officially signed agreements.

In fact, over the course of 26 months between 2016-2018, there were just 27 days when Tether held enough USD reserves to back every USDT token. What’s more, Tether had claimed that it would undergo regular audits – but in reality it conducted just one, on a date chosen in advance. Just before that audit, Bitfinex exchange (which has the same owners as Tether) transferred $382 million to Tether so that it could meet the audit requirements.

Tether removed the claim of being 100% backed by “traditional currency” and the mention of “professional audits”. Credit: Forbes.com

It was also uncovered that Tether and Bitfinex regularly mixed their funds together. When Bitfinex had liquidity issues, Tether loaned $850 million from its reserves. In October 2021, the Commodity and Futures Trading Commission (CFTC) ordered Tether to pay $41.5 million in fines.

When the news of unbacked USDT first came out in October 2018, USDT depegged and fellto $0.92 but quickly recovered. There were also isolated episodes when the stablecoin traded above or below peg on specific exchanges for a short time – for example, at $0.57 on Bittrex on May 12, 2022.

Nevertheless, despite  the FUD waves after 2018, USDT by and large maintained its peg. The company has introduced transparent quarterly audits and eliminated commercial paper (unsecured corporate bonds) from its reserves. USDT is now backed by US Treasury bonds, dollars in cash and deposits, money market funds, and other reliable and liquid instruments. It even reported $960 million in excess reserves.

Many in the market still predict that Tether will go down some day, but so far the controversial stablecoin has weathered every storm.

Frozen accounts: Circle blocks 75,000 USDC in Tornado Cash wallets

When using centralized stablecoins, you also face the risk of your funds getting blocked due to regulatory actions. In August 2022, the US Treasury sanctioned the crypto mixer Tornado Cash, and Circle immediately proceeded to blacklist its wallets. At least 75,000 USDC was blocked as a result. This meant that whoever held USDC on the mixer platform couldn’t access their funds anymore.

To blacklist an address, Circle needs to call a special function in the smart contract, after which the owner of the wallet where the USDC is held can’t transfer it anywhere anymore. Back in 2020, Circle blocked 100,000 USDC in an Ethereum address upon a request from the law enforcement, though the details weren’t revealed.

This situation falls into the third party risk category, though the third party’s actions don’t damage the issuer as much as you, the user. A platform where you keep stablecoins can be sanctioned, whether or not you did anything  wrong.

Regulatory issues: BUSD can’t be issued anymore but doesn’t depeg

Binance’s BUSD is the third-largest stablecoin (after USDT and USDC), but it is no longer issued by Binance. Rather, the issuer is Pax Trust Co, a US-regulated company that’s also behind Paxos Dollar (USDP) and Paxos Gold (PAXG). Paxos provides custodial services for BUSD and publishes monthly reserve audits.

On February 13, 2023 Bloomberg reported that the New York State regulator had ordered Paxos to stop minting BUSD. Paxos clarified that the SEC had issued it a warning (a Wells notice), threatening legal action because it considered BUSD an unregistered security.

Binance and Paxos assured users that the funds were safe, but the news still caused a wave of FUD, with media headlines like “Crypto market crash imminent?” The market cap of BUSD fell 50% from $16 billion to $8 billion as depositors redeemed BUSD for USD or Paxos’ USDP.

Binance CEO CZ admitted that the market cap of BUSD would continue to decrease but stressed that it wasn’t Binance that issued it and that Paxos would continue to service the product.. Indeed, amid all the anxiety, BUSD didn’t depeg.

As in the case of USDC, this story shows that you should think twice before panic-selling stablecoins. Even when they depeg, they often bounce back. Algorithmic stablecoins, however, are a different matter.

Decentralized stablecoin risks

When dealing with decentralized stablecoins, you have to hope that the smart contract doesn’t contain vulnerabilities and that the pegging algorithm can withstand massive outflows of liquidity. Unfortunately, such algorithms are hard to stress-test in real market conditions.

Third-party risk is an important factor here, as hackers scrutinize token contracts for vulnerabilities. Further, an entity with a lot of capital can exploit a stablecoin’s business logic for its profit. Decentralized stablecoins are more vulnerable to such attacks than centralized stablecoins as the teams who create them normally have either the control over the contract or the necessary resources to restore the peg.

Of course, there is a risk that the creators themselves can use the stablecoin to make a profit and destabilize it in the process, a form of counterparty risk.

Market manipulation: Terra UST

Remember when UST had a market cap of $18 billion and LUNA traded at $100? But in just 10 days in May 2022 it collapsed to $0.15, triggering the deepest phase of the 2021-2023 bear market.

UST wasn’t backed by any collateral. Instead, whenever a user burned $1 worth of LUNA, 1 UST was minted. The idea was that if the price of UST fell below $1, arbitrage traders would buy it on exchanges and redeem (burn) it for $1 worth of LUNA via the algorithm, making a small profit. It would decrease the supply and bring UST back to peg. This is how many algo stablecoins work.

So how did UST lose almost all of its value, then? We’ve written a very detailed article on how it unfolded, but here’s the gist. Note that this is a theory and not proven fact, but evidence is strong.

• An entity with huge amounts of capital shorted BTC at $42k for $4 billion. The entity needed the price of Bitcoin to go down. Meanwhile, Luna Foundation Guard (LFG), a fund created by Terra Labs, accumulated over $3.5 billion in BTC and AVAX as reserves to help protect the UST peg.
• At some point, LFG withdrew a lot of UST liquidity from one pool in Curve to move it to another. With less liquidity in the original pool, the price became more volatile – that’s when the short-selling entity began selling huge amounts of UST on Curve and Binance.
• This sell pressure caused UST to depeg, and LFG had to start spending its BTC reserves to buy UST and bring it back to peg. The attacker kept selling and the media was swamped with FUD about UST and LUNA. Other users started withdrawing UST from Anchor and other protocols, while the price of UST kept going down. Investors began selling Bitcoin and other coins.
• Eventually BTC dropped to $30k, and the short-seller closed their position with a profit of $800 million, according to @OnChainWizard. LFG’s BTC reserves weren’t enough to save UST. As of March 2023, the former stablecoin trades at just $0.02

This is an example of both third-party risk (the mysterious short-trading entity using a gap in liquidity to impact the price) and counterparty risk: Terra Labs CEO Do Kwon failed to acknowledge the vulnerabilities, even though many analysts warned him.

Using market psychology: USDD (Tron)

USDD, the biggest native stablecoin on the Tron blockchain, is a decentralized asset that is personally endorsed by Tron founder Justin Sun. It was launched in May 2022 by Tron DAO, Tron’s community governance network. The main incentive to hold USDD is earning up to 69% APY in farms on the Sun DeFi platform – another of Justin Sun’s projects.

USDD’s value is maintained through a combination of overcollateralization (172% of the market cap in March 2023) and an arbitrage algorithm. The latter is called the Peg Stability Module (PSM) and allows you to swap USDD for other stables at a 1:1 ratio with zero fees.

The first USDD depeg in June 2022 was very interesting, as it was apparently triggered by a small group of users who wanted to short TRX – and used market psychology to do it.

As explained by Tron DAO, the short-sellers correctly presumed that the market believed the relationship between TRX and USDD to be the same as between LUNA and UST. The depeg of UST pushed the supply of LUNA up and the price down, which made the depeg worse, and so forth in a spiral. The actual relationship between TRX and USDD is different, but if USDD was to depeg, many would expect TRX to dump.

The short-sellers borrowed large amounts of USDD on-chain through JustLend and sold it on centralized exchanges, triggering a minor depeg. They also opened short TRX positions. The depeg caused a panic and massive sell-offs on both USDD and TRX, the price of which dropped 40% in 3 days.

In response, Justin Sun injected $700 million into the stablecoin’s reserve, and the peg was restored. This story is a reminder that cunning players can use fear and confusion in the markets to their advantage.

Another lesson is that a formally decentralized stablecoin can depend strongly on the actions and statements of the personalities behind it. In total, USDD depegged 3 times in 2022, but every time Justin Sun (via Tron DAO) deployed more capital to push the price back up. One could argue that the market trusts USDD to the extent to which it trusts Justin Sun and his immense financial resources.

Reserve risks: DAI

MakerDAO’s DAI relies on overcollateralization rather than an arbitrage algorithm. However, over 50% of the collateral is held in USDC.

MakerDAO has a Peg Stability Module (PSM) where users can swap USDC for DAI at a 1:1 ratio. When USDC depegged, users rushed to swap it through the PSM, as it earned them a small profit. As a result, DAI itself went as low as $0.89 for a short time.

In response, Maker Governance passed a set of emergency measures to reduce the exposure to USDC, in particular:

• a 1% fee for swapping USDC for DAI in the PSM;
• cutting the amount of DAI that could be minted daily in the PSM using USDC as collateral from 950M to 250M.

The measures worked, and DAI repegged. Some users called upon the DAO to stop relying on USDC altogether. However, on March 23, 79% of the DAO members voted for USDC to remain the main reserve asset. The fee for USDC-DAI swaps in the PSM went back to 0% and the daily minting limit went up from 250M DAI to 400M DAI.

Still, users should keep in mind that collateralized decentralized stablecoins can be affected by the volatility of their reserve assets. This falls under third-party risks.

Using USD on the blockchain - the technical challenge

Recently on Twitter a user asked: why can’t we create a decentralized stablecoin with dollar reserves stored on-chain? The idea would be that $1 is added to the market cap when someone deposits $1.

Unfortunately this isn’t possible because you can’t store fiat currency on-chain. A token is a blockchain object: a dollar isn’t. Tokens can be stored in smart contracts; but where does the $1 go exactly? Fiat money can be stored only in bank accounts, in cash in vaults, and similar.

Therefore, the only way you can turn $1 into 1 stablecoin is to deposit the dollar in a bank account or vault and mint a token. This means custody – either by a bank or another entity. You want the party that provides custody to be audited and regulated – and that leads us back to the problems of centralized stablecoins.

Can you think of a safe way to deposit cash dollars in a decentralized way to mint stablecoins? Share your ideas in the comments!

How can you protect yourself from stablecoin risks?

This is notfinancial advice, just food for thought. You should always do your own research (DYOR).

• Any stablecoin can depeg, but large centralized stablecoins statistically have an easier time repegging. Don’t forget: it’s all about market trust, and markets tend to have more trust in projects with a track record, ample reserves, and audits.
• Don’t put all your  eggs in one basket, even if a stablecoin offers very attractive DeFi yields. Some people lost millions because they put all their money in UST to earn 20% APY on Anchor.
• Don’t overreact to FUD. Crypto news often surfaces when it does because it suits someone’s interests. Do some analysis – and only then act.
• Liquidity is important. A stablecoin with lower liquidity in pools or lower market cap depegs more easily.

Stablecoins on Aptos

Aptos supports  two types of stablecoins: bridged and native.

The bridged stablecoins are USDT, USDC, and DAI, and BUSD. They originate on other blockchains and can be bridged to Aptos using LayerZero, Portal Bridge (Wormhole), and Celer cBridge (DAI and BUSD with Celer only).

On Liquidswap, the list of verified assets clearly indicates which bridge is used. The same goes for all DEXs on Aptos: for example, PancakeSwap indicates stablecoins as ceUSDT (Celer) and lzUSDT (LayerZero).

Note that there are different pools for the same stablecoin on different bridges. Sometimes, users try to redeem LP tokens issued by the LayerZero USDT-USDC pool through the Wormhole pool for the same pair and get confused when they see a 0 LP balance. Pay attention to these details.

Native Aptos stablecoin: Move Dollar

As for native stablecoins on Aptos, the best-known is Move Dollar (MOD) by Thala Protocol. Thala is a DeFi platform where you can deposit collateral in APT, USDT, etc. and mint MOD. You can also do swaps, earn farming rewards, and stake MOD in a special Stability Pool to receive rewards in THL.

Just weeks after launch, the TVL of MOD collateral reached $9.5 million. Note that as of April 2023, the lowest amount of MOD you can mint is 500 and the collateralization ratio for most vaults is 150%. This means you need to deposit at least $750 worth of collateral to open a vault.

Swapping stables on Liquidswap

On Liquidswap, we introduced special stable pools for stablecoins and other correlated assets. They use a different liquidity curve to minimize slippage and price impact for large transactions. When you swap USDT for USDC, for example, you’ll see a Stable icon indicating that a stable pool is being used.

We also recommend that you turn on front running protection when swapping stablecoins (or any other tokens). It’s a Liquidswap innovation that keeps you safe from the most common sandwich bot attacks.

In the past 12 months, we’ve seen some intense stablecoin FUD and dramatic depegs. We’ve also learned that stablecoins as an asset class aren’t inherently stable and carry serious risks. But they aren’t going anywhere, so you need to treat them with the same caution you use for any other cryptocurrency.

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About Pontem

Pontem Network is a product studio building foundational dApps for Aptos. Our products  include Pontem Wallet; Liquidswap, the first DEX (AMM) for Aptos; browser code editor Move Playground; the Move IntelliJ IDE plugin for developers; and the Solidity to Move translator ByteBabel -- the first implementation of the Ethereum Virtual Machine for Aptos.