SharkTeam: Analyzing the Security and Regulation of Stablecoins from On-Chain Data

1. Overview of Stablecoins

As is well known, the prices of cryptocurrencies are extremely volatile. To establish a reasonable price measurement standard in the cryptocurrency market and lay the foundation for the liquidity of various cryptocurrencies, stablecoins have emerged. Their design goal is to maintain a stable value by pegging to stable assets such as the US dollar. Therefore, the value of stablecoins typically maintains a fixed exchange rate of 1:1 with the US dollar, euro, renminbi, or other assets (such as gold).

In addition to their value-pegging characteristics, stablecoins also play an important role as a means of payment, allowing users to make payments and transfers conveniently. Due to the relatively stable value of stablecoins, users find it easier to conduct commercial transactions and payments. As the base currency for OTC, DeFi, and CeFi, stablecoins provide users with more financial services and product options.

Based on the mechanisms and issuance methods behind stablecoins, they can be divided into the following four categories:

(1) Centralized Stablecoins Based on Fiat Reserves

The value of this type of stablecoin maintains a fixed exchange rate of 1:1 with fiat currencies (such as the US dollar, euro, etc.). Issuers typically hold an equivalent amount of fiat reserves in bank accounts to ensure the value of the stablecoin. For example, Tether (USDT) and USDC (USD Coin) are representatives issued by centralized institutions, with USDT having the highest liquidity and a market capitalization exceeding $92 billion.

(2) Decentralized Stablecoins Based on Crypto Asset Collateral

This type of stablecoin is decentralized and employs innovative solutions built on blockchain protocols, making it more secure and transparent. Also known as collateralized stablecoins, their asset backing usually comes from other cryptocurrencies, such as Ethereum or Bitcoin, to maintain their value stability. MakerDAO's DAI is a typical example, generated through an over-collateralization mechanism and is popular among DeFi protocols.

(3) Decentralized Algorithmic Stablecoins

This is one type of decentralized stablecoin, whose value is automatically adjusted by algorithms without the need for collateral, using market demand and supply to maintain a fixed price. Ampleforth is an algorithmic stablecoin that employs an elastic supply mechanism to automatically adjust the supply based on market demand.

(4) Stablecoins Based on Hybrid Mechanisms

This type of stablecoin combines the characteristics of the above different mechanisms to provide a more stable value. For example, Frax combines algorithmic and fiat reserves, using a hybrid stablecoin mechanism, with part of the fiat reserves supporting the other part managed by algorithms to maintain price stability.

In summary:

Centralized stablecoins solve the problem of value anchoring for virtual assets, linking digital assets with physical assets (such as the US dollar or gold) to stabilize their value while addressing the access issues of virtual assets in a regulatory environment, providing users with a more reliable way to store and trade digital assets. However, they often rely on the issuance and management of centralized institutions, which poses financial audit risks and regulatory risks for the issuers.

The decentralized characteristics of decentralized stablecoins provide a more free and transparent way for the development of the cryptocurrency market, using transparent and verifiable smart contract code to establish market trust, but they also face challenges such as hacking attacks and governance risks.

2. On-Chain Data Analysis

Since Tether launched the first stablecoin USDT in 2014, various types of stablecoins have emerged in the market, such as USDC, DAI, BUSD, etc. The total market capitalization of stablecoins has gradually increased since 2018, rapidly rising from mid-2020 until it peaked at $18.265 billion on April 7, 2022. However, the market trend subsequently declined, and as of now (December 28, 2023), the total market capitalization has fallen back to $12.877 billion.

SharkTeam: Analyzing the Security and Regulation of Stablecoins from On-Chain Data

Figure: Stablecoin Market Cap (February 1, 2018 - December 28, 2023)

SharkTeam: Analyzing the Security and Regulation of Stablecoins from On-Chain Data

Figure: Top Stablecoins Market Cap (January 1, 2018 - December 28, 2023)

In terms of market share, USDT has consistently held a leading position. Since early 2020, the top five stablecoins by market capitalization have been USDT, USDC, BUSD, DAI, and TrueUSD. However, by June 2023, due to sanctions on Binance, the market capitalization of BUSD significantly declined, gradually losing its position among the top five. Meanwhile, First Digital USD, launched on June 1, 2023, rapidly grew, surpassing BUSD in market capitalization by December 14, becoming the fifth-largest stablecoin. The following are statistics on market capitalization, trading volume, supply, and user numbers for the top five stablecoins:

SharkTeam: Analyzing the Security and Regulation of Stablecoins from On-Chain Data

Figure: TOP 5 Stablecoin's Market Cap, Volume, and Circulating Supply. Data as of December 28, 2023

SharkTeam: Analyzing the Security and Regulation of Stablecoins from On-Chain Data

Figure: USDT Trading Volume, Transaction Count, and User Count in the Last 30 Days, data as of December 28, 2023

SharkTeam: Analyzing the Security and Regulation of Stablecoins from On-Chain Data

Figure: USDC Trading Volume, Transaction Count, and User Count in the Last 30 Days, data as of December 28, 2023

SharkTeam: Analyzing the Security and Regulation of Stablecoins from On-Chain Data

Figure: DAI Trading Volume, Transaction Count, and User Count in the Last 30 Days, data as of December 28, 2023

3. Security and Risks of Algorithmic Stablecoins

Algorithmic stablecoins adopt a mechanism similar to shadow banking. Unlike traditional stablecoins, algorithmic stablecoins do not require centralized institutions to maintain their stability but instead adjust market supply and demand through algorithms to ensure that prices remain within a certain range. However, this form of currency also faces a series of challenges, including insufficient market liquidity and risks from black swan events. The value of algorithmic stablecoins is not entirely supported by external reserves but is adjusted through algorithm-based market mechanisms to maintain price stability.

In recent years, algorithmic stablecoins have frequently collapsed due to death spiral issues, primarily reflected in the following aspects:

(1) Supply and Demand Imbalance

When market demand for algorithmic stablecoins decreases, their price may fall below the target value, leading the issuer to need to destroy or repurchase part of the circulating supply to restore balance. This may further undermine market confidence and demand, creating a vicious cycle, 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, there may be governance risks, such as code defects, hacking attacks, and price manipulation.

(3) Legal Regulation

Due to the lack of physical assets as collateral or anchors for algorithmic stablecoins, they face more legal regulatory challenges and uncertainties. It is expected that more countries or regions will restrict or prohibit the use of algorithmic stablecoins in the future.

(4) Case Study: Luna/UST Collapse

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

The core design idea of the Terra ecosystem revolves around how to expand the use cases and payment needs of the stablecoin UST. The operation of UST employs a dual-token design: Luna serves as the governance, staking, and validation token, while UST is the native stablecoin pegged to the US dollar. Simply put, every time one UST is minted, an equivalent value of Luna must be burned, and Luna helps maintain the peg of UST to the US dollar through an arbitrage mechanism: if the price of UST is > $1, there is an opportunity to burn Luna, mint UST, and take the pegged difference as profit; if UST is < $1, one can burn UST for Luna to restore the peg, purchasing 1 UST at a price below $1 and obtaining Luna worth $1, then selling Luna for profit.

Anchor Protocol (hereinafter referred to as Anchor) is a DeFi platform launched by Terra in March 2021, essentially a lending platform similar to Compound. However, Anchor is unique due to its extremely high APY (Annual Percentage Yield), consistently maintained around 20%. Under the stimulus of high annualized returns, the demand for UST surged, which is also the core of UST's business. In the Terra ecosystem, Anchor plays the role of a "state-owned bank," promising a super high interest rate of 20% on demand deposits to attract public deposits (in the form of UST).

SharkTeam: Analyzing the Security and Regulation of Stablecoins from On-Chain Data

Income and Expenditure Model: Outgoing Exceeds Income, Laying Hidden Dangers:

Anchor's main income comes from borrowing interest + PoS rewards from collateral (currently bLUNA and bETH) + liquidation penalties; its main expenditure is approximately 20% annualized deposit interest. Anchor also provides high ANC token subsidies to borrowers, and to maintain the price of ANC tokens, Anchor faces additional costs for maintaining the price of ANC tokens, i.e., addressing the selling pressure on ANC tokens.

This is the income and expenditure model of UST and Luna. Based on the current scale of UST and Luna, an additional operating cost of around $1 billion is needed each year, which Anchor alone clearly cannot bear. Therefore, in February 2022, as Anchor's reserve pool was about to be exhausted, LFG announced a grant of 450 million UST to Anchor to replenish its reserve pool. This confirms one point: Anchor, unlike other lending protocols, is essentially a component of the Terra planned economy, and its current business operation is not aimed at pursuing profit but is a scenario-based product subsidized by Terra officials to support the expansion of UST's scale.

Emergence of the Death Spiral:

From the above analysis, it can be seen that Terra's complete logic is: creating scenarios through Anchor to shape the demand for stablecoins; demand drives the minting scale of UST, attracting users to enter; users continuously enter, creating data performance for the ecosystem (TVL, number of addresses, number of projects, etc.) and gradually pushing up the price of Luna; project parties or foundations cash out funds through Luna and provide subsidies to maintain high annualized returns, thus creating a cycle.

If the above cycle is stable, UST is the engine of Luna, and Luna is the stabilizer of UST. As more Web3 projects and users flow in, the two interact positively, forming a positive spiral when the trend is favorable.

However, when the market capitalization of Luna relative to stablecoins decreases and trading depth diminishes, collateral will become insufficient, increasing the risk of stablecoin de-pegging, and the cost of maintaining consensus will rise, leading to a death spiral. For example, when the overall market declines, Luna cannot escape, or when someone can attack the price of Luna, the death spiral will occur.

SharkTeam: Analyzing the Security and Regulation of Stablecoins from On-Chain Data

How High is the Threshold for the Emergence of the Death Spiral, and How Great is the Risk?
Project parties are certainly aware of the importance of maintaining the cycle and subsidy sources and are taking measures to increase production reserves. Anchor is adding new collateral assets: bLuna, bETH, wasAVAX, bATOM, which will also help increase Anchor's profits. Introducing dynamic rates for Anchor, according to proposals, the pegged yield will decrease at a rate of 1.5% per month, with a minimum APY set at 15%, to be reached within three months. However, if Anchor's APY falls below what people expect, demand for UST and Luna will decrease, leading to a smaller demand for UST, resulting in more Luna being minted, causing Luna's price to drop.

Therefore, the emergence of the death spiral may stem from an overall market downturn, a decline in Anchor's APY, or targeted attacks on Luna's price. Currently, it seems that the emergence of the Terra death spiral is almost inevitable.

4. Analysis of Black and Gray Industries

"Black and gray industries" typically refer to illegal, and even socially harmful, industrial chains. These industrial chains often violate legal regulations and involve fraud, illegal trading, smuggling, and other activities. In recent years, an increasing number of "black and gray industries" have utilized cryptocurrencies, especially stablecoins like USDT, for illegal fundraising or money laundering, and the emergence of black U has severely disrupted the safe development of the stablecoin ecosystem. This mainly includes the following aspects:

(1) Online Gambling
Online gambling is a branch of black and gray industries with severe social harm. It involves the operation of online gambling platforms, network technology, payment systems, advertising promotion, and other links. Black and gray industries create seemingly legal gambling websites or applications to attract players to register and participate in gambling activities, promoting their gambling platforms through various means, including malicious advertising and spam, to expand their user base. Cryptocurrencies are commonly used as a payment method because they provide a relatively anonymous way to pay, making online gambling harder to trace. Criminals in the black and gray industries create or purchase virtual identities before engaging in illegal activities, which in the case of cryptocurrencies means blockchain addresses, and the funds transacted through gambling platforms may be used for money laundering, concealing illegal gains.

SharkTeam: Analyzing the Security and Regulation of Stablecoins from On-Chain Data

Figure: Analysis of Transaction Patterns of a Gambling Address 1 AGZws…x 1 cN

(2) "Score Running" Platforms
"Score running" typically refers to the act of improving performance test scores of software and hardware through certain means. Black and gray USDT score running scams disguise themselves as laundering platforms, claiming to be order-taking platforms for laundering USDT funds, but in reality, these are investment scams. Once participants invest a large amount of USDT, the platform will refuse to return it for various reasons.

(3) Ransomware
Ransomware attacks are a severe issue in current cybersecurity. They typically spread through phishing emails or malicious links, combined with social engineering attacks, tricking users into clicking and downloading to infect their computers. After the victim's data is encrypted, ransomware usually displays a ransom message, demanding payment of a certain amount of ransom to obtain the decryption key. They often require payment in cryptocurrencies (such as Bitcoin) to increase the anonymity of the payment. Financial institutions and other critical sectors manage and store a large amount of sensitive data and services, making them the primary targets of ransomware attacks. In November 2023, ICBC Financial Services (ICBCFS), a wholly-owned subsidiary of the Industrial and Commercial Bank of China in the US, was attacked by the LockBit ransomware, resulting in significant adverse effects. The following is the on-chain transaction hash map of a LockBit ransom collection address.

SharkTeam: Analyzing the Security and Regulation of Stablecoins from On-Chain Data

Figure: On-Chain Transaction Hash Map of a LockBit Ransom Collection Address

(4) Terrorism
Terrorist organizations use cryptocurrencies for fundraising and money laundering to avoid monitoring and legal investigations by traditional financial institutions. Their anonymity and decentralized characteristics make them tools that some terrorist organizations may exploit. Fundraising, transferring funds, and cyberattacks are activities that terrorist organizations may utilize cryptocurrencies for. For example, Ukraine has previously used cryptocurrencies for fundraising, while Russia has used cryptocurrencies to evade SWIFT sanctions. In October 2023, Tether (USDT) froze 32 addresses related to terrorism and war in Israel and Ukraine, which collectively held 873,118.34 USDT.

(5) Money Laundering
Due to the anonymity and difficult traceability of cryptocurrencies, they are often exploited by criminals for money laundering. Data statistics and on-chain risk labels indicate that over half of black U assets are associated with black and gray industries, and the vast majority are used for money laundering. Taking the North Korean hacker group Lazarus Group as an example, they have completed over $1 billion in asset transfers and laundering in recent years, and their money laundering patterns typically include:

Multiple account splitting and small, numerous asset transfers to increase tracking difficulty.

Creating a large number of fake coin transactions to increase tracking difficulty. For instance, in the Atomic Wallet incident, 23 out of 27 intermediary addresses were fake coin transfer addresses. Recent analysis of the Stake.com incident also found similar techniques, but previous incidents like Ronin Network and Harmony did not exhibit such disruptive techniques, indicating that Lazarus's money laundering techniques are also upgrading.

Increasingly using on-chain methods (such as Tornado Cash) for mixing coins. In earlier incidents, Lazarus frequently used centralized exchanges to obtain startup funds or conduct subsequent OTC transactions, but recently they have been using centralized exchanges less and less, even avoiding them as much as possible, which may be related to recent sanction events.

SharkTeam: Analyzing the Security and Regulation of Stablecoins from On-Chain Data

Figure: Atomic Wallet Fund Transfer View

With the continuous increase in black and gray industries utilizing cryptocurrencies and other illegal activities, regulation of cryptocurrencies, especially stablecoins, is particularly important.

5. Regulation of Stablecoins

Centralized stablecoins are issued and managed by centralized institutions, so the issuing institutions need to have certain strength and credibility. To ensure transparency and credibility, issuing institutions should accept registration, filing, supervision, and auditing by regulatory authorities. In addition, stablecoin issuing institutions should ensure that the exchange rate with fiat currencies remains stable and disclose relevant information in a timely manner. Regulatory authorities should require regular audits of stablecoin issuing institutions to ensure the safety and adequacy of their reserve funds. At the same time, a risk monitoring and early warning mechanism should be established to detect and respond to potential risks in a timely manner.

Decentralized stablecoins use algorithms to adjust the total supply of currency in the market, determining prices based on supply and demand, which provides high transparency but also poses relatively greater regulatory challenges. Checking for algorithmic vulnerabilities, risk avoidance in extreme situations, and how to participate in community governance will become the main regulatory challenges.

In 2019, the issuance plan of Libra sparked global market attention towards stablecoins, and the financial risks associated with stablecoins gradually became apparent. In October of the same year, the "Global Stablecoin Assessment Report" was released, formally proposing the concept of global stablecoins for the first time and pointing out their potential impacts on financial stability, monetary sovereignty, and consumer protection.

Subsequently, the G20 entrusted the Financial Stability Board (FSB) to review the Libra project, and in April 2020 and February 2021, two regulatory recommendations regarding global stablecoins were released. Under the FSB's regulatory recommendations, some countries and regions have also proposed their own stablecoin regulatory policies, and some countries have begun to strengthen the regulation of stablecoins, such as the United States' "Stablecoin Payment Bill Draft," regulatory policies in Hong Kong and Singapore, and the European Union's "Markets in Crypto-Assets Regulation" (MiCA).

In April 2023, the US regulatory authorities released the "Stablecoin Payment Bill Draft," which stipulates the conditions for the issuance and requirements of payment stablecoins, emphasizing the need to peg to fiat currencies or other highly liquid assets at a 1:1 ratio, requiring applications for licenses to be submitted to the Federal Reserve Board within 90 days, and mandating audits and reporting. This bill also grants the Federal Reserve Board emergency intervention and penalty powers. This bill reflects the US government's emphasis on the stablecoin market and shows its support and encouragement for crypto innovation.

The Hong Kong government discussed cryptocurrencies in January 2023 and released a summary, focusing on bringing cryptocurrency activities under regulation, specifying the scope and requirements of regulation, and also elaborating on the principles of differentiated regulation while emphasizing communication and coordination with international organizations and other jurisdictions.

Singapore released a consultation document conclusion on the regulatory framework for stablecoins in August 2023. On one hand, it revised regulations regarding historical regulatory scope, reserve management, capital requirements, and information disclosure, establishing the final framework and emphasizing differentiated regulation; on the other hand, it revised the "Payment Services Act" and related regulations to strengthen coordination and communication with international regulatory authorities.

The European Council, composed of ministers from 27 EU member states, approved the "Markets in Crypto-Assets Regulation" (MiCA) in May 2023. This draft, proposed by the European Commission in 2020, will be implemented in 2024. MiCA mainly includes three areas of topics: one is the rules for the issuance of crypto assets, which impose multiple requirements on issuers of various types of crypto assets, forming a more complex set of rules for issuance, authorization, governance, and prudential requirements; the second is for crypto asset service providers (CASP), which need to obtain authorization from the competent authority and are subject to the "Markets in Financial Instruments Directive II" (MiFID II) for financial companies; the third area is rules to prevent abuse of the crypto asset market.

The United States currently maintains a leading position in cryptocurrency regulation, with its "Stablecoin Payment Bill Draft" expected to become the world's first formal legislation specifically regulating stablecoins. Other regions, such as Hong Kong and Singapore, require time to develop their policies into formal regulations. There are differences in the regulatory situations of stablecoins among countries, and the legislative processes are at different stages. Relevant institutions or operators should continuously assess risks and adjust their business models according to applicable laws and regulations to comply with stablecoin-related regulations and avoid potential compliance risks.