I. Overview of Stablecoins

As is well known, the price of cryptocurrencies is highly volatile. To establish a reasonable standard of price measurement in the cryptocurrency market and lay the foundation for the liquidity of various cryptocurrencies, stablecoins were introduced. Their design goal is to maintain a stable value by pegging to stable assets such as the US dollar. Therefore, the value of stablecoins is usually maintained at a 1:1 fixed exchange rate with the US dollar, euro, renminbi, or other assets (like gold).

Besides their value-pegging characteristics, stablecoins also play an important role as a medium of payment, enabling users to conveniently make payments and transfers. Due to the relative stability of their value, users find it easier to conduct commercial transactions and payments. As the base currency in OTC, DeFi, and CeFi, stablecoins offer users a wider range of financial services and product choices.

Stablecoins can be classified into four categories based on their mechanisms and issuance methods:

1. Fiat-collateralized centralized stablecoins: These stablecoins maintain a 1:1 fixed exchange rate with fiat currencies (such as the US dollar, euro, etc.). Issuers usually hold an equivalent amount of fiat currency reserves in bank accounts to ensure the value of the stablecoin. For example, Tether (USDT) and USDC (USD Coin) are representative centralized institution-issued stablecoins, with USDT being the most liquid and having a market cap exceeding 92 billion US dollars.

2. Crypto-collateralized decentralized stablecoins: These are decentralized and built on blockchain protocols, offering more security and transparency. Also known as collateralized stablecoins, their asset backing typically comes from other cryptocurrencies, like Ethereum or Bitcoin, to maintain value stability. MakerDAO’s DAI is a classic example, generated through an over-collateralization mechanism and popular in DeFi protocols.

3. Decentralized algorithmic stablecoins: One of the decentralized stablecoin types, their value is automatically adjusted by algorithms without any collateral, using market demand and supply to maintain a fixed price. Ampleforth is an algorithm-based stablecoin that uses an elastic supply mechanism, automatically adjusting supply based on market demand.

4. Hybrid mechanism-based stablecoins: This type of stablecoin combines features of the different mechanisms mentioned above to provide a more stable value. For example, Frax combines algorithm and fiat reserves, using a hybrid stablecoin mechanism, supported partly by fiat reserves and partly managed by algorithms to maintain price stability.

Overall:

Centralized stablecoins address the issue of value anchoring for virtual assets, linking digital assets with physical assets (like the US dollar or gold), stabilizing their value, and resolving the access and regulatory issues of virtual assets in a regulatory environment, providing users with a more reliable digital asset storage and trading method. However, they often rely on centralized institutions for issuance and management, posing financial audit risks and regulatory risks for issuers.

Decentralized stablecoins, with their decentralized characteristics, provide a more free and transparent way for the development of the cryptocurrency market. They establish market trust using transparent, verifiable smart contract codes but also face challenges like hacker attacks and governance risks.

II. Analysis of On-Chain Data

Since Tether launched the first stablecoin, USDT, in 2014, various types of stablecoins such as USDC, DAI, and BUSD have emerged in the market. The total market cap of stablecoins began to grow steadily from 2018, surged rapidly from mid-2020, and reached its peak on April 7, 2022, with a total market value of 182.65 billion US dollars. However, the market trend has since declined, and as of December 28, 2023, the total market cap has fallen back to 128.77 billion US dollars.

Figure: Stablecoin Market Cap (2018.2.1 – 2023.12.28)

Figure: Top Stablecoins Market Cap (2018.1.1 – 2023.12.28)

In terms of market share, USDT has consistently held a leading position. Since the beginning of 2020, the top five stablecoins by market cap have been USDT, USDC, BUSD, DAI, and TrueUSD. However, by June 2023, due to sanctions against Binance, the market value of BUSD significantly decreased, causing it to gradually lose its position in the top five. Meanwhile, First Digital USD, launched on June 1, 2023, experienced rapid growth and, by December 14, its market cap exceeded that of BUSD, making it the fifth-largest stablecoin. Below are the market cap, trading volume, supply, and user base statistics for the top five stablecoins:

图：TOP 5 Stablecoin’s Market Cap、Volume and Circulating Supply. Data as of 2023/12/28

Figure: USDT trading volume, number of transactions, and number of users in the past 30 days, data as of 2023/12/28

Figure: USDC trading volume, number of transactions, and number of users in the past 30 days, data as of 2023/12/28

Figure: DAI transaction volume, number of transactions, and number of users in the past 30 days, data as of 2023/12/28

III. The Safety and Risks of Algorithmic Stablecoins

Algorithmic stablecoins adopt a mechanism similar to shadow banking. Unlike traditional stablecoins, they do not require a centralized institution to maintain their stability. Instead, they use algorithms to adjust the market’s supply and demand to ensure that the price stays within a certain range. However, this form of currency also faces a series of challenges, including insufficient market liquidity and black swan events. The value of algorithmic stablecoins is not fully supported by external reserves but is regulated through an algorithm-based market mechanism to maintain price stability.

In recent years, algorithmic stablecoins have often collapsed due to the “death spiral” issue, mainly manifested in the following aspects:

1. Supply and Demand Imbalance: When the market demand for algorithmic stablecoins decreases, their price may fall below the target value, forcing the issuer to destroy or repurchase part of the circulation to restore balance. This can further reduce market confidence and demand, forming a vicious run, with the Luna/UST collapse being the most typical example.

2. Governance Risks: Since the operation of algorithmic stablecoins relies on smart contracts and community consensus, they may face governance risks such as code defects, hacking attacks, and price manipulation.

3. Legal and Regulatory Challenges: Since algorithmic stablecoins do not have physical assets as collateral or anchoring, they face more legal and regulatory challenges and uncertainties. More countries and regions are expected to restrict or ban the use of algorithmic stablecoins in the future.

4. Case Study: The Collapse of Luna/UST

   • Business Model: Algorithmic Stablecoin (UST/Luna) and High Interest Rates (Anchor Protocol):

     The core design philosophy of the Terra ecosystem revolves around expanding the use cases and payment demand for the stablecoin UST. UST operates with a dual Token design, Luna: a token for governance, staking, and validation, and UST: a native dollar-pegged stablecoin. Simply put, whenever a UST is minted, an equivalent value of Luna must be burned. Luna helps maintain the peg of UST to the dollar through an arbitrage mechanism: if the price of UST is > $1, there is an opportunity to destroy Luna, mint UST, and take the difference as profit. If UST is < $1, Luna can be burned to restore the peg, buying 1 UST for less than 1 dollar and obtaining 1 dollar’s worth of Luna, then selling Luna for a profit.

   • Anchor Protocol: Launched in March 2021 by Terra, Anchor is fundamentally a lending platform, similar to Compound. However, what sets Anchor apart is its extremely high APY (Annual Percentage Yield), consistently around 20%. Driven by the high annual yield, the demand for UST skyrocketed, which was also the core of UST’s business. In the Terra ecosystem, Anchor, acting as a ‘state bank’, offered an exceptionally high 20% interest rate on demand deposits (in the form of UST), thereby attracting public deposits.

Revenue and Expenditure Model: Deficit Leading to Hidden Risks:

The primary income of the Anchor Protocol comes from loan interest + PoS rewards from the collateral (currently bLUNA and bETH) + liquidation penalties. Anchor’s main expenses are approximately 20% annual interest on deposits. Anchor also provides high ANC token subsidies to borrowers, and to maintain the price of ANC tokens, Anchor faces additional costs in managing the selling pressure of ANC tokens.

This is the revenue and expenditure model for UST and Luna. Based on the current scale of UST and Luna, there is an operational cost of about one billion US dollars per year. Anchor itself obviously cannot bear this expense alone. Therefore, in February 2022, when Anchor’s reserve pool was about to be depleted, LFG announced an allocation of 450 million UST to Anchor to replenish its reserves. This confirms that Anchor, unlike other lending protocols, is essentially a part of Terra’s planned economy. Its current business operation is not for profit but a scenario-based product subsidized by Terra’s official funding for the expansion of UST.

The Genesis of the Death Spiral:

From the above analysis, it’s evident that Terra’s complete logic is: create scenarios through Anchor to shape the demand for stablecoins; this demand drives the minting scale of UST, attracting users; continuous user influx boosts the ecosystem’s data (TVL, address count, project number, etc.) and gradually raises Luna’s price; the project team or foundation cashes out Luna for funding and provides subsidies to maintain high annual yields, thus forming a cycle.

If this cycle is stable, UST is the engine for Luna, and Luna is the stabilizer for UST. As more Web3 projects and users join, the mutual interaction leads to a positive spiral when the trend is good.

However, when Luna’s market value relative to the stablecoin decreases or its trading depth diminishes, the collateral becomes insufficient, increasing the risk of stablecoin depegging and making the cost of maintaining consensus higher, leading to a death spiral. For instance, when there is a general market downturn, and Luna is not spared, or when someone can strike Luna’s price, a death spiral occurs.

How High is the Threshold for the Occurrence of a Death Spiral and How Great is the Risk?

The project team is certainly aware of the importance of maintaining the cycle and the sources of subsidies, and is taking measures to increase reserve production. Anchor is adding new collateral assets: bLuna, bETH, wasAVAX, and bATOM, which will also help increase Anchor’s profits. The introduction of the Anchor Dynamic Rate involves a proposal where the Anchor yield rate will decrease by 1.5% per month, with the minimum APY set at 15%, to be reached within three months. However, if Anchor’s APY falls below what people expect, the demand for UST and Luna will decline. A decrease in UST demand will lead to more Luna being minted, and the price of Luna will fall.

Therefore, the emergence of a death spiral could result from three scenarios: a general downturn in market conditions, a decrease in Anchor’s APY, or targeted attacks on the price of Luna. Currently, it seems almost inevitable that Terra will experience a death spiral.

IV. Analysis of Black and Grey Market Activities Involving Cryptocurrencies

The term “black and grey market” typically refers to industries that are illegal or even harmful to society. These industry chains often violate legal regulations and involve fraud, illegal transactions, smuggling, and other activities. In recent years, an increasing number of these markets have utilized cryptocurrencies, particularly the stablecoin USDT, for illegal fundraising or money laundering, severely undermining the safe development of the stablecoin ecosystem. Key aspects include:

1. Online Gambling: Online gambling is a severely socially harmful branch of the black and grey market. It involves the operation of online gambling platforms, network technology, payment systems, advertising, etc. Black and grey markets create seemingly legitimate gambling websites or applications to attract players to register and participate in gambling activities, promoting their platforms through various means, including malicious advertising and spam emails, to expand their user base. Cryptocurrencies are a common means of payment because they provide a relatively anonymous way of transacting, making online gambling harder to trace. Criminals in the black and grey market create or purchase virtual identities – in the case of cryptocurrencies, blockchain addresses – and the transactions made through gambling platforms may be used for money laundering, concealing illegal proceeds.

Image: Analysis of the transaction graph of a specific online gambling address 1AGZws…x1cN

1. “Score Running” Platforms: “Score running” typically refers to the act of artificially improving the performance scores of software or hardware. Black and grey USDT score running scams disguise themselves as money laundering platforms but are actually investment fraud schemes. Once participants invest a significant amount of USDT, the platform refuses to return it under various pretexts.

2. Ransomware: Ransomware attacks are a severe problem in cyberspace security. They are often spread through phishing emails or malicious links, combined with social engineering attacks, luring users to click and download to infect computers. After encrypting the victim’s data, ransomware typically displays a ransom message demanding a specific amount of cryptocurrency (like Bitcoin) to be paid for the decryption key, adding anonymity to the payment. Financial institutions and other key sectors, which manage and store large amounts of critical data and services, have become primary targets for ransomware attacks. In November 2023, ICBC Financial Services (ICBCFS), a wholly-owned subsidiary of ICBC in the USA, was attacked by LockBit ransomware, causing significant adverse effects. The image below shows the on-chain transaction hash graph of a LockBit ransom collection address.

Image: On-chain transaction hash graph of a LockBit ransom collection address

1. Terrorism: Terrorists use cryptocurrencies for fundraising and money laundering to evade monitoring and legal investigation by traditional financial institutions. Their anonymity and decentralized nature make cryptocurrencies a potential tool for terrorist organizations. Fundraising, transferring funds, and cyberattacks are ways terrorist organizations might use cryptocurrencies. For instance, Ukraine has used cryptocurrencies for fundraising, and Russia has used them to evade SWIFT sanctions. In October 2023, Tether (USDT) froze 32 addresses related to terrorism and warfare in Israel and Ukraine, holding a total of 873,118.34 USDT.

2. Money Laundering: Due to the anonymity and untraceability of cryptocurrencies, they are often exploited by criminals for laundering. According to data statistics and on-chain risk labels, over half of the black U assets are related to black and grey market activities, and most are used for money laundering. Take the North Korean hacker group Lazarus Group as an example; in recent years, they have completed over 1 billion USD in asset transfers and laundering. Their laundering methods typically include:

   • Splitting funds across multiple accounts and transferring small amounts to increase tracking difficulty.

   • Creating a large number of fake currency transactions to increase tracking difficulty. For instance, in the Atomic Wallet incident, 23 out of 27 intermediary addresses were fake currency transfer addresses. Similar techniques were found in the analysis of the Stake.com incident, but previous incidents like Ronin Network and Harmony did not have such interference technology, indicating that Lazarus’s money laundering techniques are also evolving.

   • Increasingly using on-chain methods (like Tornado Cash) for mixing coins. Earlier, Lazarus often used centralized exchanges to obtain startup funds or conduct subsequent OTC transactions, but recently they have been using centralized exchanges less frequently, even avoiding them, possibly related to recent sanction incidents.

Image: Fund transfer view of Atomic Wallet

As the utilization of cryptocurrencies in black and grey market activities and other illegal activities continues to increase, the regulation of cryptocurrencies, especially stablecoins, becomes increasingly important.

V. Regulation of Stablecoins

Centralized stablecoins are issued and managed by centralized institutions, hence these issuing organizations need to have certain strength and credibility. To ensure transparency and trustworthiness, these institutions should be registered, recorded, supervised, and audited by regulatory authorities. Furthermore, stablecoin issuers should ensure a stable exchange ratio with fiat tokens and disclose relevant information promptly. Regulatory authorities should require regular audits of stablecoin issuers to ensure the safety and adequacy of their reserve funds. At the same time, it’s important to establish risk monitoring and early warning mechanisms to timely identify and address potential risks.

Decentralized stablecoins, which use algorithms to adjust the total market currency volume and determine prices based on supply and demand, have higher transparency but also present greater regulatory challenges. Issues like vulnerability checks in algorithms, risk aversion in extreme scenarios, and how to participate in community governance become the main regulatory challenges.

In 2019, the launch plan for Libra drew global market attention to stablecoins, gradually exposing related financial risks. The “Global Stablecoins Assessment Report” released in October the same year first formally proposed the concept of global stablecoins and pointed out their potential impact on financial stability, monetary sovereignty, consumer protection, etc.

Subsequently, the G20 tasked the Financial Stability Board (FSB) to review the Libra project. In April 2020 and February 2021, the FSB published two sets of regulatory recommendations for global stablecoins. Under the FSB’s regulatory recommendations, some countries and regions have also proposed their own stablecoin regulatory policies. Some countries have been strengthening regulations on stablecoins, like the United States with its “Stablecoin Payments Act Draft,” and regulatory policies in Hong Kong and Singapore, as well as the European Union’s “Markets in Crypto-Assets Regulation” (MiCA).

In April 2023, the U.S. regulatory authorities released the “Stablecoin Payments Act Draft,” setting conditions for the issuance and requirements of payment stablecoins. It particularly emphasizes a 1:1 pegging ratio with fiat currencies or other highly liquid assets, requiring application to the Federal Reserve System Board within 90 days and subject to audits and reporting. This bill not only reflects the U.S. government’s attention to the stablecoin market but also shows its support and encouragement for crypto innovations.

In January 2023, the Hong Kong government discussed cryptocurrencies and published a summary, focusing on bringing crypto activities under regulation, defining the scope and requirements of regulation, and also outlining the principles of differentiated regulation, emphasizing communication and coordination with international organizations and other jurisdictions.

In August 2023, Singapore released the conclusions of a consultation document on the regulatory framework for stablecoins. It revised regulations on historical regulatory scope, reserve management, capital requirements, and information disclosure, establishing a final framework emphasizing differentiated regulation. It also revised the “Payment Services Act” and related regulations to strengthen coordination and communication with international regulatory bodies.

In May 2023, the EU Council, composed of ministers from the 27 EU member countries, approved the “Markets in Crypto-Assets Regulation” (MiCA), proposed by the European Commission in 2020, to be implemented in 2024. MiCA mainly covers three areas: crypto-assets issuance rules, setting various requirements for issuers; Crypto-Asset Service Providers (CASP), which need authorization from competent authorities and are subject to the “Markets in Financial Instruments Directive II” (MiFID II); and rules to prevent abuse in the crypto-assets market.

The United States currently leads in cryptocurrency regulation, with its “Stablecoin Payments Act Draft” poised to become the world’s first formal legislation specifically regulating stablecoins. Policies in other regions like Hong Kong and Singapore still need time to solidify into formal regulations. Different countries have varying approaches to stablecoin regulation, and their legislative processes are at different stages. Relevant institutions or operators should constantly assess risks, adjust their business models according to applicable laws and regulations, and comply with stablecoin-related provisions to avoid potential compliance risks.

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