Article by BanklessAfrica Cover Art by Chameleon

Stablecoins are cryptoassets which generally track the value of a specific fiat currency, such as the U.S. dollar, the Euro, or the South African rand, making stablecoins a subclass of synthetic assets. Stablecoins are hosted on one or more smart contract platforms, and are classified as tokens rather than blockchain-native coins. Of the many different types of stablecoins on the market, most are pegged to the U.S. dollar. Generally speaking, they can be categorized as centralized or decentralized, depending on how the stablecoins are collateralized. 

While exchange-listed stablecoins are still subject to supply and demand, there are built-in stability mechanisms to ensure that the trading value of a stablecoin does not deviate too far from the valuation of the fiat currency to which it is pegged. Recent events have demonstrated that the design of these mechanisms is a critical factor in the longevity — dare we say the stability — of a stablecoin. Various types of stability mechanisms have their own advantages and disadvantages.

Unlike volatile cryptocurrencies, such as bitcoin or Ether, stablecoins offer low-risk access to various opportunities in the Web3 economy. This makes them particularly useful in developing countries, where the population is generally more risk-averse to speculative investments.

Blockchain technology and decentralized finance can provide basic financial inclusion to individuals and businesses that are unable to obtain a bank account. Financial services that can be replaced by decentralized technologies include sending and receiving remittances, borrowing and lending, as well as interest-bearing savings accounts. These real use cases make stablecoins a vital tool that Africans are adopting with increasing speed.

In this report we shed light on the relatively fast adoption of fiat-pegged stablecoins and give a market overview. We also examine the FEI stablecoin and the method used to maintain its peg.

A fiat currency is defined as money that is issued by a central bank and declared legal tender in at least one country. The reason why fiat currencies hold a market value is a collective ongoing trust that the currency can be used to purchase goods and services. While the central bank can back up this trust by holding precious metals or other fiat currencies in reserve, it does not guarantee that currency units can be redeemed for any of the reserves.

Stablecoins use different mechanisms to peg their trading value to the value of a specific fiat currency. They can be classified depending on the pegging mechanisms used.

While the primary mechanism that pegs all stablecoins to a fiat currency is trust, that trust needs to be established through at least one other mechanism. In general, we can categorize these stabilization mechanisms as outlined below:

Like in fiat currency systems, the most important factor that helps a stablecoin maintain its value is trust. As long as there is confidence that a stablecoin can be exchanged for at least its peg value, there will always be arbitrage traders willing to buy a stablecoin that drops too far below its peg and sell it on an exchange where the trading price is higher, or trigger any of the stablecoin’s stability mechanisms and redeem it for its peg value. Thus, a stablecoin can only become de-pegged if traders lose this confidence.

The oldest method to create a stablecoin is to back it with fiat deposits. For this purpose, a centralized custodian issues one token for each unit of fiat currency deposited. Essentially, these are tokenized certificates, which can be redeemed for one unit of fiat currency.

The obvious disadvantage of this method is that it requires a centralized entity who is trusted to be able to redeem the certificates at any time. Most centralized stablecoins do not have a one-to-one backing with cash, but only rely on a fractional reserve with cash, while keeping yield-bearing assets, such as commercial paper, as reserves. In the case of a bank run, centralized stablecoins at therefore at risk of losing their peg.

An advantage of this method is that the issuer can replace tokens that are inadvertently lost, providing an additional layer of security. For example, Tether replaces tokens if a user can prove that they were sent to an address where the tokens are permanently locked. Commonly, this happens by mistake when inexperienced users send funds directly to a DeFi smart contract without using the protocol’s frontend.

One approach to create a decentralized stablecoin is to use crypto deposits in order to peg the price of the stablecoin to that of a fiat currency. Typically, this invokes a lending economy, where users can take out loans in a DeFi protocol’s stablecoin, as long as the loan is overcollateralized by that user’s crypto deposit.

While this is an easy and tested method to create decentralized stablecoins, one disadvantage is the relatively low utility of overcollateralized loans to most DeFi users, which results in a lack of scalability. Also, borrowers are at risk of getting their collateral liquidated if it decreases too much in value. In the event of mass liquidations, this can result in a de-pegging event or protocol failure.

More advanced techniques involve expanding and contracting the supply of the stablecoins to even out any differences between stablecoin value and peg value. If the stablecoin trades for a higher price than the peg, more tokens need to be minted to decrease the price. However If the trading price is lower than the peg, the protocol buys back stablecoins and burns them, reducing the supply to create upward price pressure. This creates what is commonly called an algorithmic stablecoin. Recently, the model of uncollateralized seigniorage stablecoins has been called into question with the sudden fall of Terra’s popular UST coin.

It should be noted that an algorithmic stablecoin still requires active participation by arbitrage traders and economic incentives to ensure this participation. In 2019, the Ampleforth (AMPL) token launched on the Ethereum blockchain; it purely relies on expanding and contracting the supply for all holders of the token. While AMPL does usually hover around its peg value of 1 USD, it becomes de-pegged too often to be classified as a stablecoin.

Next to the stablecoin itself, decentralized protocols usually also issue a utility token, whose primary function is governance voting. This utility token can be used as an emergency stability mechanism by diluting the token supply in case of a de-pegging event or protocol failure.

For example, Maker DAO needed to invoke this emergency mechanism during the March 2020 market collapse. The Terra ecosystem was entirely based on this stability mechanic, using the LUNA governance token to absorb any excess stablecoins that were traded below peg.

A variation of this stability mechanism can be a staking option that rewards holders of the utility token for putting their token at risk of being slashed if an emergency occurs. This decreases the risk of suffering a token dilution for non-staking holders.

With a current market cap of over 72 billion USD, Tether (USDT) is the most widely used stablecoin on the market. It is also the most commonly traded cryptocurrency with its trading volume even surpassing bitcoin (BTC). This is because many centralized exchanges use market pairs denominated in USDT, which are more popular for altcoin trading than BTC-denominated markets. USDT is issued by Tether Limited, a subsidiary of Bitfinex, and is hosted on the Ethereum, Tron, Solana, Omni, Avalanche, Algorand, EOS, Liquid, and SLP blockchains.

Lately, USD Coin (USDC) has closed in with a market cap of 54 billion USD. USDC is issued by Circle, which is partnered with Coinbase and Visa. The third largest stablecoin is Binance USD (BUSD) with a market cap just below 18 billion USD. BUSD deposits are custodied by Paxos.

USDT, USDC, and BUSD are centralized stablecoins, which means that there are concerns about regulation and the USD backing of the tokens. Stablecoin issuers primarily make money by mixing yield-bearing assets like commercial paper and treasury bills into their reserves, which means that there is a looming risk of getting de-pegged in the event of a bank run.

In the past, Tether was especially known for poor transparency concerning its reserves, but started posting regular independent audits in 2021. It claims to have an 84% backing in cash equivalents, but of this, only 14% is actual cash, with commercial paper making up the majority of “cash equivalents”. There also is a disclaimer stating that Tether is allowed to delay cash deposits in case of difficult market conditions that limit liquidity.

Before May 2022, Terra USD (UST) had grown to become the leading decentralized stablecoin, and was on pace to flip BUSD in terms of market cap. However, UST dramatically broke its peg in early May 2022, and does not look likely to recover.

Currently the largest non-centralized stablecoin is DAI, which is issued by MakerDAO. While having the first mover advantage — DAI has a lot of popularity and liquidity both in centralized and decentralized exchanges — it still relies on overcollateralized loans, which makes it less capital-efficient and scalable as algorithmic stablecoins, such as FEI or FRAX. Interestingly, in order to acquire capital to mint DAI, MakerDAO has resorted to taking in large amounts of USDC collateral, making a portion of DAI’s backing centralized.

* in million USD. Data as at May 31, 2022. Source: CoinGecko: Stablecoins by Market Capitalization. Neutrino USD (USDN) has been excluded from the list due to suspected market manipulation.

Fei Protocol uses direct incentives as its primary mechanism to maintain its peg. If the protocol’s FEI stablecoin trades below peg on the Uniswap ETH/FEI pool, users who buy FEI in order to raise the price are rewarded with an additional mint of FEI. On the other hand, users who sell their FEI get a proportion of their FEI slashed, based on the price deviation from peg. If FEI trades above peg, arbitrage traders can supply ETH to the protocol in order to mint more FEI and sell them on Uniswap.

FEI were initially issued by selling them along a bonding curve at a price below 1 USD until the price of FEI on Uniswap reached 1 USD. Further issuance is done solely at this price and is only profitable for arbitrage traders if they can sell FEI at a higher price.

In contrast to other stablecoin protocols, FEI cannot be sold directly to the protocol, leaving users with only the option to sell the token on a secondary market. Instead of total value locked (TVL), Fei uses protocol controlled value (PCV), since this money can never be redeemed by any user and is owned by the protocol and under control of the protocol’s decentralized governance.

This serves two purposes: first of all, the collected ETH are staked as ETH/FEI liquidity on Uniswap, creating deep liquidity for the FEI token. Secondly, the ETH/FEI liquidity can be used as another stabilization mechanism. In case FEI loses its peg, any user can call a smart contract function to automatically pull the liquidity, restore the peg, and resupply the liquidity.

One advantage of this stabilization method is that it is more capital efficient, since it does not require full collateralization similar to fractional reserve banking. The flipside of such an undercollateralized stablecoin is the risk of a bank run, which can lead to a major de-pegging event. Such a bank run occurred shortly after FEI launched on Uniswap, crashing the price to as low as 0.136 USD.

Ironically, the direct incentives played a key role in the de-pegging event, since traders who sold FEI on Uniswap received less than they expected due to the penalty mechanism, triggering a panic sale. Ava Labs founder Emin Gün Sirer noted in this Twitter post that the penalty mechanism also decreased the buying pressure, which exacerbated the problem. Also, the reweighting mechanism of the smart contract that holds the collateral owned by Fei seemed to make matters even worse, as it created a favorable moment to sell FEI each time it was called.

It took about six weeks until the FEI peg was restored. Since May 2021, FEI has been remarkably stable though, trading within a 0.02 USD error margin.

According to Chainalysis, Africa is the smallest economic region for cryptocurrency, having received $105.6 billion worth of cryptocurrency between July 2020 and June 2021. Despite that, it is the third-fastest growing region in the world. Cryptocurrency transactions make up 7% of the total retail transaction value, which is the largest percentage across all regions studied. Furthermore, the Chainalysis data suggests a tendency towards grassroots adoption, rather than institutional adoption.

Chainalysis also notes that Adedeji Owonibi, CEO of the Nigerian blockchain consultancy company Convexity, sees that young middle class Nigerians increasingly adopt stablecoins, since they are less inflationary than the Naira. Speculative cryptoassets only seem to be interesting for wealthier Africans.

It is estimated that Africa is inhabited by 1.34 billion people, which is 17.2% of the world population. Africa has both the youngest and the fastest growing population in the world, with a fertility rate of 4.4 and a median age of 20 years.

The median age ranges between 15 (Niger) to 37 years (Mauritius). The percentage of the population living in urban areas ranges from 14% (Burundi) to 87% in Gabon and Western Sahara. As of 2022, the median income in African countries ranges from 395 USD (Congo) to 3,832 USD (Mauritius).

While Africa, especially the sub-Saharan region, is the least developed continent, there is a strong heterogeneity between countries. For example, primary education is near-universal in Namibia, Mozambique, Malawi, Madagascar, and Lesotho. Lower secondary education is near-universal in Zimbabwe and Rwanda. Eswatini (84%), South Africa (79%), and the Seychelles (86%) have the highest rate of upper secondary education.

Projected inflation rates remain high in Africa with Sudan (41.8%), Zimbabwe (30.7%), South Sudan (24.0%), and Zambia (19.2%) topping the list. In Mali, Senegal, Gabon, Benin, Djibouti, Guinea-Bissau, Cabo Verde, Morocco, and the Comoros, inflation is expected to stay contained at or below 2%.

Aside from currency devaluation, corruption can lead to a failing fiat currency. As of 2021, more than two thirds of all African countries score a Corruption Perception Index (CPI) of less than 50, with lower scores denoting more corruption. The global average CPI is 43. Sub-Saharan Africa is the most corrupt region worldwide with an average CPI of 32. The lowest scores are recorded in South Sudan (11), Somalia (13), and Equatorial Guinea (17).

Other socio-economic factors that may drive stablecoin adoption are a young population, urbanization, education, Internet availability, and reliance on remittances. Taking all factors into account, we estimate that stablecoins will have the largest impact in Sao Tome, Burundi, Sierra Leone, Guinea, Madagascar, Uganda, Tanzania, Congo, Rwanda, and Malawi.

One major challenge for stablecoin adoption in Africa is the high transaction fees on Ethereum, which make the leading smart contract platform an unviable solution for middle-class Africans. The leading stablecoins, most notably the decentralized ones, may not be available on all alternative low-fee blockchains with sufficient liquidity.

Also, there is a lack of infrastructure for converting cryptoassets into fiat currency. Crypto ATMs are not available in most African countries and where they are available, they usually don’t accept stablecoins. Centralized exchanges, if they are legally allowed to operate, require a bank account for converting stablecoins into fiat. Therefore, unbanked stablecoin owners either require merchants to accept whatever stablecoin they hold as payments, or must rely on OTC traders, which usually operate in an unregulated space. In some instances, mobile payment gateways that accept stablecoins, such as Cashapp, Venmo, or PayPal, can be used to issue payments.

As with all cryptoassets, there are some risks attached to stablecoins. Primarily, there is a risk of theft or loss if the private key gets lost or falls into the wrong hands. De-pegging events such as the recent Terra crash add another risk factor. Finally, there are smart contract risks attached to using stablecoins for investments in DeFi protocols.

In many countries around the globe, there is still a lack of regulatory clarity surrounding cryptoassets. Stablecoins in particular have received increased regulatory scrutiny in the past few years, which brings both benefits and risks. While this enhances consumer protection and introduces transparency standards for centralized stablecoins, both centralized and decentralized stablecoin issuers may be unable to legally continue their operations in certain countries.

The majority of African governments have been slow in addressing cryptoassets in their regulations. This means that crypto companies such as exchanges typically operate in a legal gray area when they are either based in Africa, or offer services to Africans. Peer-to-peer trading platforms like Paxful and Remitano, as well as informal trading groups on social messengers like Whatsapp and Telegram, are methods of choice to circumvent these regulatory problems.

Some countries, including Morocco, Tunisia, Algeria, and Egypt have an outright ban on crypto companies or restrict the usage of cryptoassets. Also, the practice of implicitly banning cryptoassets through indirect laws is most prevalent in Africa.

Image credit: Statista

Stablecoins take a focal position in the growing crypto economy, with trade settlement and DeFi the most important applications. In the following section, we discuss three functions that are of chief importance for African users, remittances, borrowing and lending, and savings.

African countries are among the largest recipients of remittances worldwide. With 33 billion USD in 2021, Egypt accounted for 54% of all remittances among developing countries of the region. Measured by the percentage of their GDP, Lebanon (34.8%), the Gambia (33.8%), Lesotho (23.5%), West Bank and Gaza (16.7%), Cabo Verde (15.6%), the Comoros (12.3%), Liberia (10.0%), and Senegal (9.5%) all had substantial remittance activity.

It is estimated that nearly half of the adult population in sub-Saharan Africa either send or receive remittances, however the centralized services that facilitate these payments remain costly, especially when e-banking is not available. In Q4 2021, sub-Saharan Africa was the most expensive region to send remittances to, with an average transaction cost of 7.8% on a 200 USD transaction. Globally, the average was 6%.

By 2030, the UN’s Sustainable Development Goals aim to achieve transaction costs for remittances below 3%. Blockchain technology, especially stablecoins that are hosted on alternative L1 and L2 blockchains, are well-suited for reaching this goal, as transaction costs typically amount to only a few cents and, in some instances, only a fraction of a cent, regardless of the amount sent.

Furthermore, some African countries, such as Nigeria, restrict remittance payments. These restrictions can be effectively circumvented with cryptoassets.

One common application of stablecoins is their usage in DeFi lending. Currently, most borrowers who use DeFi platforms are interested in entering some kind of leveraged position on their crypto holdings, by using them as collateral and borrowing stablecoins.

We estimate that this use case is of little value for African consumers, unless they are willing to take the risk of investing in a volatile cryptocurrency, in addition to the smart contract risks posed by DeFi applications. What could become an interesting use case for Africans in the future is using illiquid assets as collateral.

Some novel DeFi lending platforms make first approaches to this with NFTs as collateral. In the next step, this could be expanded to tokenized assets, such as real estate, vehicles, or capital goods, which can facilitate lending for unbanked individuals and SMEs.

One of the pioneer projects in this field is Centrifuge’s Tinlake protocol, which allows selected owners of real-world assets, such as trade invoices or residential real-estate loans, to use these assets as collateral. It will take several more years until this option becomes available on a large scale and in a permissionless fashion.

While it still remains difficult for the average African to obtain access to a bank account, blockchain technology has the potential to make bank accounts obsolete. Stablecoins can provide a way to escape inflationary fiat currencies prevalent in many African countries.

DeFi services such as yield farming protocols typically provide a yield that surpasses the interest rate of traditional savings accounts. However, more developments in decentralized insurance are needed, in order to allow DeFi users to eliminate the smart contract risk attached to DeFi applications.

BanklessAfrica conducted a group interview with three Web3 users from Ghana and Kenya. All of them self-identify as experienced users who have been around the Web3 ecosystem for more than three years.

[Note: the group interview was conducted prior to the UST failure which occurred in May 2022]

We found that price stability is seen as the most important criterion when it comes to choosing a stablecoin. While the participants reported using mainly USDT for the purpose of fiat on- and off-ramping, the participants were not very concerned about Tether’s centralization. The ability to maintain its peg was of more importance than decentralization, regardless of the concerns about regulations or the assets that are backing this stablecoin.

There was an agreement that USDT has a first-mover advantage and this network effect favors its use. The liquidity of USDT is an attractive feature that is used in P2P services of exchanges like Binance to facilitate fiat-to-crypto or crypto-to-fiat movements.

The participants mentioned using other stablecoins, such as UST, USDC, Paxos, DAI, FEI, xDAI, and Celo Dollar (cUSD) for different use cases. These are used in DeFi platforms and participants decide which to use depending on the chain or if a certain protocol offers a more attractive yield on a particular stablecoin. None of the participants mentioned holding any stablecoin for a long time or having used them for payments or remittances.

Even though Africans in general have less access to traditional banking services, there is an option of accessing some services using a digital wallet on their phones. Our participants mentioned M-Pesa and Mobile Money to move fiat to local crypto exchanges or P2P services to purchase crypto, which they then moved to self-custodied mobile wallets.

None of the participants mentioned any restrictions or special laws concerning digital assets. There is some concern about future tax regulations, or the government taking a harsher stance on digital assets in the future though. Reasons for this might include the creation of a Central Bank Digital Currency, or the desire to control access to cryptoassets. The government could impose restrictions through taxation or by adding restrictions directly to mobile wallets.

Participant 1: Chemist living in Ghana. Has been around crypto since 2017 but stayed out during the bear market and recently joined the ecosystem again after discovering Bankless and the bDAO. Key quote:

The government doesn’t actually stop Bitcoin. You are free to engage in Bitcoin but the government has realized that this has been used in a lot of online transactions so they got to approve a law that taxes you directly in your mobile wallet. I think they are trying to get attention to also position their CBDC, but you are free to use crypto.

Participant 2: 38-year-old male from Kenya. Economist with more than ten years of banking and finance experience. Discovered crypto in 2014 and has been stepping in and out from time to time, but got more active since 2018. Key quote:

If I don’t have crypto, I go to my local payment agent called M-Pesa. I go to the P2Ps to get like 1,000 or 2,000 USD in stablecoins and I use M-Pesa to send the money to that guy on the other end. The other guy can be in Paxful, Binance, Bybit, etc. When they approve to send the stablecoins I send them the local money through M-Pesa and in 5 to 10 minutes I get the crypto in my Paxful Wallet and then I send that to [my own wallet] through the mainnet.

Participant 3: Male resident of Ghana. Discovered Bitcoin and used it for transactions, after PayPal was blocked in the country, and has been interested in the crypto ecosystem since. Key Quote:

I don’t think USDC is an improvement on USDT. They both have their own entities underlying the stablecoin but I think the reason USDT dominates is because of the network effect. So USDT is like the Bitcoin of the stablecoin ecosystem. It got pegged with all of the cryptos in the market.

Stablecoins are being adopted quickly by middle-class Africans, both banked and unbanked, for the purpose of remittance payments, DeFi, and inflation evasion. The largest stablecoins by market cap remain USDT and USDC, since decentralized stablecoins are capital inefficient due to the requirement of overcollateralization.

Algorithmic stablecoins promise a way to create highly liquid, capital efficient USD-pegged tokens without sacrificing decentralization. However, most uncollateralized or heavily undercollateralized seigniorage stablecoins have failed, with Terra’s ecosystem being the latest, and most impactful. So far, however, fractionally collateralized FEI and FRAX have weathered bear markets and avoided death spirals, and future algorithmic stablecoins are likely to resemble these two models.

From a group interview with three experienced Web3 users in Africa, we learned that USDT is their stablecoin of choice due to its liquidity. While decentralization was of lower relevance than decentralization for our interview participants, they reported using other stablecoins for DeFi investments.

African users generally rely on mobile devices for interaction with Web3 protocols and cryptoassets. Our interview participants reported using M-Pesa and Mobile Money for fiat movements and P2P exchanges for on- and off-ramping.

Taken all together, stablecoins and Africa are on the Rise. 

As an international media node of BanklessDAO, the BanklessAfrica team seeks to drive the adoption of trustless, decentralized money systems and blockchain technology with the aim to promote capacity building, economic empowerment and financial sovereignty in Africa.

Author Bio

This is a collaborative effort between BanklessAfrica, BanklessDAO Research Guild, and BanklessDAO Writers Guild.

BanklessAfrica is an International Media Node that seeks to educate, onboard and inform everyday Africans about bitcoin, DeFi, DAOs and Web3.

BanklessPublishing is the publishing arm of BanklessDAO. Top-shelf educational Web3 content.

BanklessDAO is an education and media engine dedicated to helping individuals achieve financial independence.

This post does not contain financial advice, only educational information. By reading this article, you agree and affirm the above, as well as that you are not being solicited to make a financial decision, and that you in no way are receiving any fiduciary projection, promise, or tacit inference of your ability to achieve financial gains.

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