How Stablecoins Are Driving Decentralized Finance on Ethereum
This is part of a series of articles from ConsenSys Codefi’s Q4 2020 Ethereum DeFi Report. Download the full report to learn more about token standards for assets and payments, NFT marketplaces, social and community tokens, DAOs, flash loans, wrapped Bitcoin and Filecoin, lending projects and more.
When ConsenSys first wrote about stablecoins in 2019, the sector was taking off with over 200 different stablecoins issued by companies around the world, nearly half of which were issued on Ethereum. Today, 74% of all stablecoins are issued on Ethereum and worth about $20 billion as of January 1, 2021. As ERC-20 tokens, stablecoins have the benefits of other Ethereum tokens: they are efficient to produce and manage issuance; they have global reach making it easy to transact across borders; they are fully auditable; and importantly for decentralized finance, they are interoperable with the rest of Ethereum.
Introduced as a means to represent a more familiar unit of account (dollars), stablecoins have helped decrease volatility of overall crypto markets, since traders don’t have to exit exchanges and transfer fiat to when hedging against price declines. Stablecoins also strengthen the bridge between traditional finance and crypto markets since activities like borrowing, lending, derivatives need a stable and reliable base value. Stablecoins are increasingly serving as an option for avoiding inflationary fiat currencies. For example, individuals in Brazil are turning to USD denominated stablecoins as an alternative to the Brazilian real, which hit a record low against the USD this year. The swift rise of stablecoins has also compelled governments around the world to explore the ways in which Central Banks could issue their own currencies on smart contract platforms like Ethereum.
The three largest stablecoins, USDT, USDC, and DAI have seen such a rise in use in 2020 that they are now responsible for more trade volume on Ethereum than the asset that pays for computation — ether (ETH) — itself. The annual transaction volume for ETH this year was $385 billion, but Tether’s USDT token settled $580 billion on Ethereum, Circle’s USDC stablecoin settled $239 billion on Ethereum, and MakerDAO’s DAI stablecoin settled $98 billion. All told, nearly $1.6 trillion USD in stablecoins and ETH transacted on Ethereum in 2020.
How to get a stablecoin with MetaMask
If the best way to understand something is to experience it, the best way to start your DeFi journey is by downloading MetaMask, available as a browser extension or on mobile. You’ve now equipped yourself with a key vault that only you can access, a secure login, a wallet to view your tokens, and a way to exchange tokens or access the decentralized web. Think of it as a way of managing your money, digital assets, unique art and identity as you use various decentralized finance applications.
Before you can get a stablecoin, you first need to add some ETH to your MetaMask wallet in order to pay for transactions, like exchanging tokens, on the Ethereum network. You can buy ETH directly on MetaMask or from an exchange like Coinbase. After you acquire ETH you can then swap that ETH for a stablecoin like DAI, USDC, or USDT.
Select the amount of ETH you would like to convert into a USD-denominated stablecoin, like DAI in this example. You will see an estimate, but when you select “Get quotes” MetaMask checks 7 different decentralized exchanges and Automated Market Makers (AMMs) to offer you the best trade for the lowest fees.
If you are satisfied with the rate, click “swap,” and DAI will be added to your MetaMask account. Here’s a video of the process.
Your new balance of USD-denominated ETH can be used on any Ethereum financial application you grant permission. Swapping ETH for a stablecoin is a way to hedge against volatility, or you can lock it in a high interest account like Aave (the current APY is 5.38%)
Different types of stablecoins
In 2020, stablecoins are one of the best examples of what programmable money can look like, simply because of the different design decisions of how they can be issued or how they retain parity with the U.S. dollar.
Most stablecoins are supported by the liabilities of the traditional banking system, such as Circle’s USDC where each crypto dollar is backed by a US dollar held in reserve. Since both of these stablecoins are issued by a centralized entity, they can also be seized, or a user could be denied access.
The most common types of synthetic stablecoins, such as DAI, are overcollateralized by other cryptocurrencies, such as ETH, USDC, and BAT. Newer models of synthetic stablecoins, such as Ampleforth’s AMPL, use variable supply, meaning that an oracle monitors the supply and demand and “rebases” to meet a target peg.
One of the newest developments in Q4 of 2020 were the increasing number of interest-bearing stablecoins, such as yUSD (Yearn.finance). Whenever someone deposits a stablecoin as collateral in a borrowing and lending platform like Compound or Yearn, they receive a token which represents the deposit position. For example, if you were to deposit 100 USDC into a Aave lending pool, you will get 100 aUSDC in return, which increases as you earn lending fees akin to a dividend- or coupon-issuing financial instrument. What’s unique is that even as aUSDC compounds overtime, it is just like other ERC-20 tokens: it can be traded, or used as collateral for other liquidity pools. Even more advanced yield-generating stablecoins, such as Yearn’s yUSD, yDAI, and yUSDT, are programmed to find the greatest return of investment from various lending and borrowing protocols, such as Aave, Compound and dydx.
As the different types of stablecoins offered proliferates, one way to understand their tradeoffs is through the inverse correlation of their complexity and how decentralized they are based on the collateralized assets (or none at all) that help them maintain a stable peg to the USD.
How do governments see stablecoins?
As stablecoins have risen in prominence, they’ve also become increasingly the subject of legal discussion. On November 19, 2020, several U.S. lawmakers introduced the STABLE Act, which if passed, would require stablecoin issuers to obtain a federal banking charter and also be required to obtain the approval of both the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) six months prior to issuance. While the congressional calendar ran out of time to pass the bill in 2020, it could be reintroduced in 2021.
In contrast to the STABLE Act, The US Office of the Comptroller of Currency (OCC) issued a letter clarifying that national banks and federal savings associations are allowed to operate blockchain nodes and use stablecoins for payments. Former Comptroller of the Currency, Brian P. Brooks, wrote, “Our letter removes any legal uncertainty about the authority of banks to connect to blockchains as validator nodes and thereby transact stablecoin payments on behalf of customers who are increasingly demanding the speed, efficiency, interoperability, and low cost associated with these products.”
Toward the end of the year, the European Central Bank wrote that widely adopted stablecoins, “could threaten financial stability and monetary sovereignty.” While it is still unclear how privately-issued stablecoins will be treated by governments around the globe, increasingly regulators are studying how to make sure stablecoins take place within a more regulated environment, while also researching how Central Banks could issue their own form of programmable digital currencies.