Holding Steady: The Rise of Stablecoins

Zhao B&W
Michael Zhao
Last Update 03/17/2023

In 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 reasoned 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 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 Hayek may have envisioned: a denationalized currency that isn’t directly subject to control of a centralized entity, with a value determined by supply and demand. Though, critics note that Bitcoin’s volatile nature makes Bitcoin less than ideal in supporting a user’s daily purchasing power.

Instead, we might argue that Hayek’s vision aligns closer to that of stablecoins.

The Holy Grail

Stablecoins 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 fixed 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 million dollars to a staggering $60 billion. For an idea of the damage that can result, you can visit Grayscale Research’s analysis of the collapse of the Terra/Luna ecosystem.

So, why do stablecoins’ value continue to grow?

Since inception, stablecoins have been one of the few token categories that have maintained market 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 aren’t like most cryptocurrencies. The relatively steady market capitalization 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.

Figure 1: Stablecoin Market Capitalization vs Bitcoin and Ethereum Market Capitalization

Source: Coinmetrics, Grayscale Research, “Stablecoins” Market Cap comprises of USDT, USDC, BUSD, DAI, GUSD, HUSD, PAX, SAI, TUSD, and USDK, data as of 3/9/23

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 their larger cryptocurrency counterparts.

Figure 2: Stablecoin Market Cap as a % of BTC + ETH Market Cap

Source: Coinmetrics, Grayscale Research, “Stablecoins” Market Cap comprises of USDT, USDC, BUSD, DAI, GUSD, HUSD, PAX, SAI, TUSD, and USDK, data as of 3/9/23

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 trade volume (Figure 3). Increasingly, users seemed more incentivized holding stablecoins – especially since stablecoins occasionally offered competitive yields relative to traditional USD deposits.

Figure 3: Stablecoin Market Cap vs BTC/ETH trading volume

Source: Coingecko, Grayscale Research, as of 3/11/2023

Stablecoin pairs have become a backbone of cryptocurrency trading: since late 2022, ~90% of bitcoin trading volume has become denominated in stablecoins (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.

Figure 4: Market Share of BTC Trade Volume

Source: Kaiko, as of January 2023

But stablecoins 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 staggering year-over-year inflation rates of 114% and 79%, respectively. That 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 against 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).

Figure 5: Share of <$1K crypto transaction volume made up of stablecoins

Source: Chainalysis, Grayscale Research, data measured from July 2021 – June 2022

Next, we’ll take a quick tour of the three primary designs for stablecoins, and explore some of the current challenges facing them. Then, we’ll consider the likely trajectory of stablecoins over the near term.

Stablecoin Designs

When the first stablecoins were issued in 2014, experimentation with various designs happened almost immediately. In this section, we’ll 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-backed stablecoins are the easiest to understand, because they are backed 1-to-1 with traditional assets, like cash, cash equivalents, treasuries, etc. Although there have been transparency concerns associated with difficult-to-audit bank accounts, the 90%+ of the stablecoin market cap is currently comprised of asset-backed stablecoins such as USDT, Binance USD (BUSD), and USDC (Figure 6).

Figure 6: Stablecoin Market Share

Source: Coinmetrics, Grayscale Research, as of 3/2/2023

Tether’s USDT and Circle’s USDC

Tether’s 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 structure allows Tether to exercise control over which addresses can transact with USDT and which entities can exchange USDT for fiat currency.
Circle’s 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 Tether’s 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 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 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

Figure 7: USDT and USDC reserves breakdown

Source: Grayscale Research, Tether (as of 12/31/2022), Centre (as of 3/2/2023)

Despite their popularity, asset-backed stablecoins are not immune to centralization risk — as we clearly saw in early March 2023. On March 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 collateralized 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 stablecoins have to contend.


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 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 the collateralization ratio back to 150% (Figure 8).

MakerDAO’s DAI

Figure 8: Example of how DAI’s collateralization works

Source: hackernoon.com, @kermankohli, Figure is for illustrative purposes only

Rune Christensen founded MakerDAO in March 2015, with the initial goal of creating a stablecoin 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 sophisticated 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 2023.

DAI’s 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. The Stability Fee represents the interest rate charged to the borrower for taking out a DAI loan, which helps to regulate DAI’s 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 Stability Fee, making it more expensive for users to borrow DAI, and incentivises them to pay back their DAI loans.

2. 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 DAI’s supply increases, MakerDAO could increase its Savings Rate to increase DAI demand.

DAI’s 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 (LINK), 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 ETH’s price action (Figure 9).

Figure 9: DAI’s price vs ETH’s price

Source: Coingecko, Grayscale Research, as of 3/9/2023

Despite having a cumulative collateralization ratio of 150% as of March 2023, crypto-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 DAI’s underlying assets, had an adverse impact on the value of DAI. As USDC temporarily 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.


Algorithmic stablecoins are not backed by any assets or cryptocurrencies, but are instead pegged through a seigniorage algorithm that incentivizes arbitrage. Seigniorage — 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 stablecoin’s value by tweaking its supply in response to demand.

In essence, a seigniorage mechanism operates by adjusting the supply of a stablecoin contingent on its current market value. If the stablecoin’s 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. 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 the market, thus reducing the number of tokens in circulation and, correspondingly, theoretically increasing the price to bring the stablecoin’s value back up to its intended level (Figure 10). Ultimately, the peg is maintained via arbitrage opportunities instead of collateralization.

Figure 10: Theoretical example of how an algorithmic stablecoin burns supply to return to peg

Source: Grayscale Research, For illustrative purposes only

Terra Luna

The now infamous Terra network was launched in January 2018, and Terra’s stablecoin, UST, was launched in 2020. UST aimed to maintain its 1:1 parity with the U.S. dollar through a dynamic relationship with Terra’s native cryptocurrency, Luna.

At the heart of this Luna-UST relationship was an arbitrage opportunity that arose 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 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 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.

Source: The Tie Research

Ultimately, a combination of market and mechanistic forces ended the Terra project. UST’s price cratered in May 2022 when a combination of UST capital flight, a liquidity pool imbalance, and an exodus of users on a Terra DeFi protocol dramatically decreased UST’s price (Figure 11). 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 $1 worth of Luna for a modest profit, and subsequently sold their Luna holdings. This activity created selling pressure on both UST and Luna, as we discussed in one of our previous market bytes.

Figure 11: UST Price

Source: Coingecko

The Trilemma

Each 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 current 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 stability and capital efficiency, with a 1:1 collateralization, but each has centralized control that poses a dependency risk, as we saw with USDC’s exposure to Silicon Valley Bank.
  • Crypto-collateralized stablecoins, like DAI, offer stability and decentralization, but they require a higher collateralization ratio for minting, making them less capital efficient than other options.
  • 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 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 Developments

Creating a stablecoin that solves “the 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 Solutions

There are more than a few notable projects that are experimenting with various stablecoin mechanisms.

Frax Finance’s 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 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 the 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. MakerDAO, for instance, has invested over $600 million worth of DAI into various RWAs, such as treasuries, real estate loans, and structured credit investments (Figure 12). Although RWAs only account for 13% of MakerDAO’s total assets, they contribute more than 50% of the protocol’s annual revenue11. The growth in RWAs signifies a growing trend of integration between the traditional financial 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.

Figure 12: MakerDAO’s RWA holdings

Source: Dune, @SebVentures, as of 3/9/2023, holdings subject to change

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, UXD’s stablecoin 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 Solana 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 remains stable despite any underlying changes to the asset price. While it’s still too early to tell if this design is sustainable, the novel experimentation contributes to advancing the technology.

Regulatory Scrutiny

Recent regulatory focus seems to be on centralized stablecoins. For example, the New York Department 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 Binance, and had reached a market cap of $23bn in November 2022. The NYDFS claimed Paxos “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, alleging 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 13). While this doesn’t directly impact other centralized stablecoins, it exposes the extent to which centralized stablecoin issuers are subject to the actions of regulatory bodies.

Figure 13: BUSD Market Capitalization during NYDFS and SEC actions

Source: Coingecko, Grayscale Research

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 with the traditional banking system. Silvergate’s SEN and Signature’s 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 users 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 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 that they would issue a CBDC in the next 10 years. In the future, competition from CBDCs could impact 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.


Stablecoins offer some refuge in a world of crypto volatility. However, optimizing their design is 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 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 term 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.

1. Measures the relationship between the changes of two or more financial variables over time

2. “Burning” in the context of cryptocurrency typically refers to when a user takes a specified amount of cryptocurrency out of the circulating supply

3. Every Ethereum block has a base fee. When the block is mined this base fee is “burned”, removing it from 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 USDC

5. As of 3/7/2023 according to ultrasound.money

6. As of February 2023

7. As of February 2023

8. As of February 2023

9. 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 bank’s solvency or ability to meet its financial obligations.

10. A black swan event refers to a rare and unexpected occurrence that has a significant impact on society or the economy

11. As of 3/7/23 based on https://makerburn.com/#/rundown

12. A “Wells Notice” is a correspondence that 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 Coingecko



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