Author: Gordon Liao, Austin Bennett Source: Stanford Blockchain Translation: Shan Oppa, Golden Finance

Stability in the best and worst of times

With the new federation in place, the cryptocurrency market is more optimistic than ever. As of this writing, Bitcoin prices are heading towards $100,000 per coin, with the mainstream cryptocurrency up more than 50% in a week. Despite this, the prices of some of the top cryptocurrencies have remained stable – and that’s exactly a good thing.

While speculation surrounding the value of cryptocurrencies can bring vitality to the market, the attendant volatility has become a major obstacle to the popularity of cryptocurrencies. Cryptocurrencies trade very quickly, but when a trading pair moves more than 1% in an hour, the trading medium becomes less stable. What users want is decentralization, but they are not willing to pay the price for possible default risks. Stablecoins may be able to solve this problem – providing a sense of order in an uncertain market.

A stablecoin is a cryptocurrency that attempts to peg its value to some underlying asset, which can be a fiat currency (such as the U.S. dollar) or is a commodity (such as gold). By anchoring value to another asset, these tokens remove the incentive to speculate on their value, thus stabilizing transactions. Using stablecoins is similar to depositing assets into a blockchain bank: users can enjoy fast, decentralized financial infrastructure while retaining the asset’s store-of-value function through a convertible digital representation.

What makes stablecoins "stable"? How do stablecoins hold their value? To what extent should we use stablecoins?

To learn more about these issues, I spoke with Dr. Gordon Liao, chief economist at Circle, one of the major stablecoin providers. Understand the operating mechanism and significance behind stablecoins.

All dollars may be equal, but their stablecoins are not

While the U.S. Treasury Department reports that the use of stablecoins has increased significantly in recent years, their use in It has been in the cryptocurrency market for many years. Due to their low price volatility, stablecoins such as Tether, USDC, and Dai have become popular choices for cryptocurrency trading on and off exchanges. The goal of these stablecoins is to peg their value to $1, but the mechanisms to achieve this are very different.

Depending on their design, some stablecoins prioritize decentralization, while others place more emphasis on compliance. Although they are all anchored to the same asset, the process for obtaining these tokens is different, and some even require different kinds of assets to mint. Clearly, designing a stablecoin is no easy task. However, Dr. Gordon Liao, chief economist at Circle, said a lot of progress has been made in this area.

He mentioned that the research on asset-backed stablecoins has been very in-depth, so the related risks are relatively controllable. In particular, he emphasized that the assets supporting stablecoins must be highly liquid, while ensuring that these assets are independently stored to protect the interests of stablecoin holders. Additionally, providers will need to manage issues beyond stablecoins, such as credit, market and operational risks. With these complex issues in mind, Dr. Liao’s team recently released the Token Capital Adequacy Framework to integrate these complex metrics into a unified standard. He hopes to use this to promote the establishment of industry standards so that users can choose suppliers more wisely.

Stability under different circumstances

Take Circle as an example. The company values ​​transparency and stability. Unlike its peers, Circle discloses the composition of its reserve assets and provides daily third-party audit reports of Circle’s reserve funds. Dr. Liao further explained that due to the existence of these reserves, users can always redeem USDC for the equivalent value of fiat currency in the long term. The assets supporting USDC are stored independently, which provides strong protection for stablecoin users.

In the short term, the spot price of USDC may deviate slightly from $1. This is because tokens such as USDC are traded on secondary markets, and short-term inefficiencies in trading pairs can cause the price to deviate slightly from its USD peg. Dr. Liao gave an example, such as when the price of Bitcoin plummets, traders will transfer funds to USDC as a "safer asset." This operation could artificially push the value of USDC to just above $1, but then the price would quickly return to the anchor value.

However, Circle itself does not experience a large number of secondary market exchanges between fiat currencies and USDC. According to Dr. Liao, about 95% of USDC redemptions are completed in the primary market, that is, users redeem directly through Circle as the issuer. This trend has not changed even during certain uncertain events, such as the collapse of Silicon Valley Bank. silicon valleyDuring the bank collapse, USDC redemptions reached billions of dollars. So, while USDC’s spot price sometimes differs slightly, that doesn’t mean USDC has lost its anchor. This is usually just a matter of temporary inefficiency in the market.

On the other hand, events like the collapse of Silicon Valley Bank may show that stablecoin asset transparency can sometimes be a double-edged sword. While transparency is a highly desirable feature of a stablecoin, especially behind a company with a multi-billion dollar market capitalization, disclosing the exact location of the assets could spark panic in the market. Still, it’s hard to find cryptocurrency advocates who support withholding financial information as the best means of financial security. Blockchain is built on “truth”; even if the truth sometimes brings some pain, keeping the public fully informed of the issue is always the best option.

Stablecoins and Decentralized Finance

In addition to serving as a store of value, stablecoins have already found their way into powering decentralized finance (DeFi) applications. important uses. In fact, MakerDAO was one of the first important DeFi protocols, a decentralized stablecoin provider that minted the popular U.S. dollar stablecoin Dai through Ethereum lock-up. Although Circle is a centralized financial institution, Dr. Liao still recognizes the importance of the DeFi ecosystem, calling it the core of the blockchain and Web3 space.

Unfortunately, similar to the broader cryptocurrency market, the DeFi ecosystem has suffered from its history of volatility. For example, the shocking collapse of the algorithmic USD stablecoin UST was managed by the Terra blockchain. The value of UST relies in part on its governance token, LUNA, rather than equivalent fiat currency reserves. Due to the symbiotic relationship between these two coins, billions of dollars in value were destroyed when they suddenly collapsed at the same time. Therefore, Dr. Liao believes, “We hope that the most secure value storage and unit of account will become the cornerstone of DeFi.” By this standard, USDC is undoubtedly a strong contender to support the ecosystem.

At the same time, DeFi advocates may argue that there are inherent contradictions in using a centralized stablecoin like USDC to power DeFi infrastructure. If we really want to embody the idea of ​​decentralized finance, perhaps we need to adopt stablecoins that run through DAO governance, such as MakerDAO’s Dai. However, according to this argument, it is also reasonable to think that underpinning the global DeFi system with currency-linked stablecoins is also centralized - but this does not preventStop the US dollar from becoming the gold standard for stablecoins.

Dr. Liao has a different view on the true meaning of DeFi: “Overall, DeFi is not necessarily about decentralized governance or decentralized permission management , but about the ability to decentralize balance sheets.” Analyzing the failures of the traditional financial system, he explained, “The biggest innovation is that you can spread risk to more participants that would otherwise not be available. Technology of Engagement ”

He took market making as an example, pointing out that historically it required "highly complex technology and highly complex capital" to participate, thus forming a highly concentrated market structure dominated by high-frequency trading companies. Dr. Liao said, "The difference with DeFi is that you can use technology to bring more participants on board, not just professional companies but ordinary capital owners."

Decentralized exchanges (DEXs) are perhaps the best example of this collective impact. In addition to being a hub for meme coins, DEXs democratize traditional order books in a fast and easy-to-use way. As a teaching assistant in the Stanford Graduate School of Business’ Pathfinder course (BUSGEN 102), I’ve seen this firsthand. Students with absolutely no experience suddenly became traders and liquidity providers for our fictional “red coins” and “blue coins” on the Uniswap Sepolia testnet. They no longer need to rely on centralized exchanges to trade – instead they can trade directly with each other.

When DeFi provides this level of access, the issue of stablecoin centralization may seem trivial. After all, if our goal is to truly achieve a decentralized financial infrastructure, then we should be able to work with all stablecoins without any barriers – whether USDC, Tether or Dai – while also recognizing that DeFi protocols may Make the same choice. There may not be a “one-size-fits-all” stablecoin for every scenario, but other options will always be available through exchange.

Modern Stablecoin

Considering the different preferences within the crypto community, Circle has also taken important steps to enable USDC to be interoperable across multiple blockchains. Operability. Dr. Liao mentioned a software feature from Circle that allows users to burn USDC tokens on one chain while minting an equal amount of tokens on another chain. He claimed that this functionality is more seamless compared to traditional methods of transferring assets between blockchains using bridge protocols, which tend to have many vulnerabilities. Dr. Liao also admitted,While Circle’s trust-based intermediary is centralized, as DeFi continues to expand, the need for such platforms will grow to prevent the space from becoming too fragmented.

Finding the right level of centralization (if any) in the blockchain has also attracted a lot of regulatory interest. In addition to the lawsuit, it is also experimenting with a controversial new stablecoin, namely central bank digital currencies (CBDCs). Typically issued by a central bank, this type of cryptocurrency can be considered a stablecoin representation of a currency. Blockchain-based implementations offer significant advantages in terms of efficiency compared to traditional banking systems; but at the same time, the very transparency that makes crypto projects successful may also be what makes them potentially dangerous.

While a CBDC may utilize blockchain technology, the current implementation differs significantly from the stablecoin structure we know today. Perhaps the best-known example of a CBDC is e-CNY, a stablecoin pegged to the Chinese yuan and led by the People’s Bank of China. The token is being tested in 29 pilot areas as of July 2024, and users will need to provide personally identifiable information to access the token. However, due to lackluster response, the push for adoption became more aggressive, with some cities even making it mandatory for public sector employees to receive their salaries in the token.

Dr. Liao pointed out that areas where CBDC has entered trial operation tend to have stronger controls. In fact, Royal Bank of Canada recently confirmed to CBC that they have shifted their focus on CBDC development, while Federal Reserve Chairman Jerome Powell has also claimed that the creation of a USD CBDC would require congressional approval. However, we may first see a USD stablecoin in Wyoming backed by Wyoming Token, which is scheduled to launch in 2025. No matter who the token provider is, Dr. Liao emphasized that high standards of reserve support are still necessary.

Whether operated by institutions, private companies, or smart contracts, the future of stablecoins remains an exciting prospect. Building on real-world assets in the blockchain space may just be the key to bridging the gap between traditional banking institutions and the future of decentralized finance; but at the same time, we must remain vigilant to ensure that this balance is not lost. . If stablecoin infrastructure lacks sufficient decentralization, we risk losing Satoshi Nakamoto’s vision—and the blockchain could degenerate into the centralized institutions it was originally trying to circumvent. However, without the backing of a robust stablecoin, our tokens could be worthless—with no backing value and no one to hold accountable, and it could all spiral out of control.