Stablecoins Are In a War for Dominance And It’s Getting Ugly

Major cryptocurrencies like Bitcoin and Ethereum can sometimes go up or down in double-digit percentages in a single day. As a result, most people associate cryptocurrencies with volatility. But there are also some cryptocurrencies that try to achieve the exact opposite: so-called stablecoins that are ideally pegged to fiat currencies like the U.S. dollar on a 1:1 basis at all times.

Stablecoins come in handy when the crypto market goes down, because traders can seek refuge in them. They are also instrumental in one of the core functions of decentralized finance, or DeFi, which is lending and borrowing. 

There are many stablecoins today, and they’re gaining favorable attention from regulators and politicians. The competition has led to a knives-out war between upstart projects against legacy stablecoins like DAI, the stablecoin issued by MakerDAO that pioneered the DeFi borrowing and lending market in 2017.

“By my hand $DAI will die,” Do Kwon, founder and CEO of Terraform Labs, declared on March 23

Terraform Labs is the firm behind the Terra blockchain and its native stablecoin UST (not to be confused with USDT, or Tether, a separate stablecoin). As part of the plan to kill off DAI, Kwon wants to make UST the new king of the stablecoins. It’s a plausible scenario, since he and his allies hold a significant amount of tokens with which to pay off users in Curve, a DeFi protocol that largely determines the fate of stablecoins due to its prominence in the ecosystem. In a move reminiscent of hostile takeovers in the corporate world, they plan to aggressively wage a battle in what crypto people call the “Curve Wars.”   

“The biggest battle in crypto this year will likely be in the stablecoin arena. The winners from the stablecoin wars will be ones that have the best stability mechanisms as well as pay out the highest interest rate/yield,” Sam Kazemian, founder of Frax Finance behind stablecoin FRAX, told Motherboard.

And on April 1, Kwon unveiled his playbook: team up with Frax and others to target DAI on Curve, which is the go-to decentralized protocol for stablecoin swaps on the Ethereum network and DeFi’s fiercest battleground thanks to its deep user-provided liquidity, or availability of funds. In return, users receive a yield in tokens as profit. 

On Curve, stablecoin projects like Do Kwon’s UST have to fight dearly to have a share of that deep liquidity, which is needed to keep their coins near the promised peg of $1. As part of the Curve Wars, projects with liquidity pools spend tens of millions of dollars every month to pay off Curve users to vote to channel more rewards known as “emissions” to their liquidity pools. Pools with more emissions are more attractive to users, giving the stablecoin an advantage. It’s a bizarre and convoluted strategy, but it somehow works. FRAX and UST are the top “bribers,” as the practice is widely called.

Until now, DAI has never had to engage in the Curve Wars as it’s always enjoyed a privileged position in a liquidity pool known as the 3pool, together with well-established stablecoins USDT and USDC. 

“Goal is to starve the 3pool,” Kwon tweeted. “Shan’t be long.” To kill the 3pool, Kwon is planning to set up a direct competitor, the 4pool, which will consist of USDC, USDT, UST, and FRAX. 

Kwon and his allies have a sizable arsenal to deploy. The group controls more than 12 percent of all CVX, which are governance tokens conferring voting power in a separate but interlinked project called Convex Finance. CVX tokens have become common currency in the Curve Wars, and are typically used in influencing pool rewards. Furthermore, the 4pool allies have the financial capacity to “bribe” token-holding users with similar influence to vote in favor of their pool. 

“Curve wars are over, all emissions are going to the 4pool,” Kwon said in a tweet announcing 4pool.

Curve’s pool optimization researcher, who goes by the pseudonym nagaking, told Motherboard that “3pool originated when DAI had few competitors as the first widely adopted DeFi-native, crypto-backed stablecoin,” and so the lack of the competition at the time meant “there was no need for pool-specific liquidity incentives: the product essentially sold itself.”

But the competition has intensified since then, with the anti-DAI front saying the free ride must end—one way or another.

“Now that there are a number of competitors, who often pay for liquidity through various incentives, this ‘first mover’s advantage’ has been called into question,” nagaking told Motherboard.

“If Maker wishes to ensure Dai maintains its role within Curve, they need to fight to win incentives for their [liquidity providers] on Curve. As of now, I haven’t seen any indication of appetite from Maker to join the Curve Wars,” Jason Hitchcock, founder and general partner of crypto fund 4 Moons, told Motherboard.

Part of the rift can also be explained by the polarization between two stablecoin camps: those who think stablecoins need to be overcollateralized (when there’s more assets in the stablecoin issuer’s reserves than the value of their stablecoin) or those who think stablecoins can be undercollateralized (when there’s fewer assets). 

UST is an undercollateralized “algorithmic” stablecoin and is propped up by a price stabilizing algorithm and another cryptocurrency, LUNA. Traders can sell 1 UST for $1 worth of LUNA and vice versa, which is especially lucrative when UST goes below or above $1. DAI, meanwhile, is overcollateralized mostly by Ethereum and USDC, another stablecoin.

“Some people think that a stablecoin needs to be overcollateralized in order for it to be stable and retain its value during times of high market volatility,” Tyler Reynolds, a web3 investor and former Google payments team manager, told Motherboard. “That camp’s belief is that the only liquidity you can rely on during times of extreme market volatility is the collateral backing the stablecoin that’s sold off during liquidation. They believe that any amount of undercollateralization will cause token holders to mass exit during times of volatility and cause the peg to break.”

But, said Reynolds, overcollateralization is no guarantee that the stablecoin will remain stable even during calm periods: DAI, for example, was often off-peg from 2018 to 2019. It’s not a sure thing that the liquidations will go smoothly during volatile times either, he said, highlighting that the MakerDAO liquidations—loss of collateralized assets due to price changes—went awry on the Black Thursday of March 12, 2020, when the crypto market crashed by 50%. The system even let someone buy $6 million worth of Ethereum for just 1 DAI ($1).

But the Maker Mafia, as MakerDAO members are known, has been unfazed by the war cries so far, and perhaps for good reason.

“Typically, Curve pools are important for stablecoins in that they provide low slippage liquidity to enforce a peg. However, Dai is unique. Dai has the most onchain liquidity of any stablecoin,” Nik Kunkel, head of oracles (bridges connecting blockchains to the real world) at MakerDAO, told Motherboard. 

Kunkel explained that “The Peg Stability Module” (PSM), an in-house mechanism similar to a Curve liquidity pool, has $5.3 billion of Dai liquidity redeemable 1:1 for stablecoins USDC and USDP with no fees. The PSM has over 3.5 times more liquidity than 3pool, so “removal of Dai from 3pool would have little effect on its peg and Dai would still remain the most liquid stablecoin,” he said.

Doo Wan Nam, Asia business development lead at MakerDAO, believes there’s bias in free-rider accusations towards DAI

“When there’s demand for stablecoins, especially due to DeFi, we see many stablecoins including USDC, USDT, and Dai growing. USDC and USDT didn’t use incentive programs or yield farms and grew due to increasing demands. The same case for Dai. And I haven’t heard accusations that USDC and USDT are free-riding,” he told Motherboard.

Kwon’s beef with Dai goes back a while. In January, the co-founder of MakerDAO called UST a “Ponzi.”

“Look, UST and MIM are solid ponzis and I respect that,” tweeted Rune Christensen, co-founder of MakerDAO, on January 4. “You can make good money off them for sure. But they are not built for resilience and they are going to 0 once the market turns for real.”

“Now stop trying to scam users looking for actual stability into being ur exit liquidity,” he said. 

These accusations are due to the fact that UST relies on arbitrage trades against LUNA. To support UST’s peg, Do Kwon also has plans to buy up $10 billion worth of Bitcoin. A Terra-linked foundation called LFG (Luna Foundation Guard) has already bought $1.6 billion worth of Bitcoin, according to the latest update from April 6, and has since expanded to another cryptocurrency.

“FRAX and UST rely on arbitrageurs to keep their coins at $1, which can be bad as the market is not always so rational or efficient,” pseudonymous stablecoin trader YettyWapp told Motherboard. “As a yield farmer, I am all for higher yield and welcome the 4pool. But I also understand the risks. I would never put all my money into an algo stablecoin.”

Amid all of this market froth, some stablecoins aren’t always so stable. On April 4, algorithmic stablecoin USDN depegged from $1, currently trading around $0.8.

“The USDN depeg is what could potentially happen with FRAX and UST, where your $1 is now worth .75 cents,” YettyWapp said, saying that he believes other tokens are safer. “This has never happened with USDC, USDT and DAI as they are backed by a physical dollar or ETH as collateral.”

“No decentralized stablecoin is too big to fail,” said Kazemian of Frax Protocol, ruling out suggestions of a systemic risk from dethroning overcollateralized Dai and replacing it with undercollateralized algorithmic stablecoins.

“In fact, the three top decentralized stablecoins (UST, DAI, FRAX) combined are still smaller than Tether’s [UST] market cap. The big decentralized three stablecoins have a long way to go before ‘systemic’ enters the conversation at all.”

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