The economy always runs in cycles. When the economy grows, people make profits with their transactions, and more and more people join this economy. However, when the economy is declining, it gets hard for people to generate profit, leading individuals to start leaving for more stable economies.
The same is true for the cryptocurrency market. When there is a market crash, people start to leave, and the only way to achieve stability is to convert their assets to fiat currency which can take days. This process causes their assets to lose more value.
Stablecoins solve this problem. With Stablecoins, people can convert their assets to stable coins to rectify more losses. Different players in the market are providing stable coin services, and they want the market to adapt their solutions. Some provide a centralized solution with some transparency issues, and some provide a decentralized solution. The decade of effort in these solutions gives birth to the stable coin trilemma, meaning that your solution must be centralized to maintain maximum capital efficiency. Algorithmic coins are trying to solve this trilemma, and some of them, like terraUST, and IRON, crash on their way.
Table of Contents
What are Stablecoins?
Stablecoins are a type of cryptocurrency whose per-token values are kept equal (or “pegged”) to the value of another asset – such as a FIAT currency, precious metal, or security.
Why need Stablecoins?
People are more comfortable with those economies that are more stable. If an economy is highly volatile, people will not be willing to adopt that economy and avoid investing in it. To gain more reach among the audience, we have to provide stability in our ecosystem so people can trust and be ready to invest in them.
In the case of crypto coins, if we take bitcoin as an example, its highly volatile daily price fluctuates by thousands of dollars. Building an economy on it is highly risky. On the other hand, Stablecoins solve high volatility issues in crypto-economics. People can park their assets in stablecoins in bearish markets to save themselves from bearish market trends. Using a Stablecoin community can allow P2P transactions without losing value. Thus, Stablecoin tether has the third-largest market cap.
Stablecoin Trilemma
The most common stablecoin type is centralized stablecoins, led by Tether, the balance sheet of which includes commercial paper and less liquid assets. Decentralized (over-collateralized) stablecoins are led by MakerDAO’s DAI. In this design, individuals issue DAI tokens through over-collateralized positions in which they deposit cryptocurrency collateral (typically, ETH). While decentralized, they are less capital-efficient than their centralized counterparts (Kozhan and Viswanath-Natraj 2021). The third type is algorithmic stablecoins, led by TerraUSD, typically under-collateralized. While this is a more capital-efficient design, it has the drawback that they are prone to speculative attacks and can trade at a large discount. Terra is trying to solve the trilemma stabilizing algorithmic stable coin peg.
Asset Collateralized Stable Coins
Asset Collateralized Stablecoins typically derive their peg from an underlying reserve (or “collateral”) of assets, including FIAT currency, precious metals, securities, bonds, treasuries, and cash equivalents. For example, the popular stablecoin USDC is pegged 1-to-1 to the U.S. Dollar and is backed by collateral made up of cash, cash equivalents, and short-duration U.S. Treasuries. This means that the value of a single USDC token will always equal USD 1 and that USD 1 total worth of cash, cash equivalents, and short-duration U.S. Treasuries are kept saved for every single USDC token in circulation.
Tether
Tether Limited is the company that issues Tether on different blockchains. It is the largest stablecoin by market cap (approx. 73 Billion) and is one of the most tradable crypto assets.
Properties
Price pegged with the US Dollar: If you give the company one dollar, they will mint one Tether token, and give it to you. If you return that Tether, they will burn it and refund you with an equal amount of money. This way, the dollars we give them and the Tether token that they mint will always remain equal. They make it possible to convert fiat currency to digital currency and enter the world of cryptocurrency.
100% Backed: In October 2014 when Tether released its first token, it claimed:
Every tether is always backed 1-to-1 by traditional currency held in our reserves. So 1 USDT is always equivalent to 1 USD.
Strengths
Catastrophic drop: Whether you hold Tether or not, if Tether loses its price, the whole crypto market will be affected. Tether is a token mostly present on the Ethereum network. Large exchanges like GEMINI and Binance hold a lot of Tether and some of the decentralized apps also use them like curve finance and Aave. There is a theory that because Tether is so big, with a market capitalization of roughly $60 billion, it will drag down the entire crypto market if it fails.
Since Tether, liquidity pools have been used in a variety of decentralized applications as well as basic building blocks for Dapps. In theory, if Tether prices pump or dump, these pools become extremely vulnerable to attack via flash loans. If one part of the pool changes its price, the other part of the pool also gets affected. In fact, in a lot of cases, they rely on the fact that Tether stays at $1. That is also one of the reasons that regulators are trying to investigate it.
Problems
Bank Run: In theory, the number of dollars equals the number of tether tokens in circulation. Tether market cap is 60 Billion dollars, so they hold 60 Billion dollars in their bank account. But it’s not. There is very strong evidence against the company that they create the tokens and transfer them to wallets. If all the people give back their tether and ask for their dollars back, the company cannot give them their dollars back.
The intrinsic value of tether is not much, but it has a perceived value that we get our dollar back, but if that’s not the case, we are at risk. It’s just like the crash that happened in 1930 when all the people at the same time demanded their money from the bank, and the bank simply replied, “we don’t have enough to give everyone their money.”
Never Fully Audited: In 2017, Tether mentioned that its holdings are published daily and subject to frequent professional audits. They were once scheduled for an audit with Friedman LLP. However, Tether bailed out in the middle of the audit after being asked a lot of questions. Instead of answering them, Tether forced the audit to stop.
It’s been nearly half a decade, and the company still has not had a single audit conducted.
Transparency issues: Tether Limited is also not located in the US, so they could not be forced for the audit. They purposefully set themselves on the British island. The New York Attorney General Leticia James did some investigation. Due to that investigation, you cannot buy tether in New york. They said it’s to protect their citizens. Tether declared:
Bitfinix and Tether recklessly and unlawfully covered-up massive financial losses to keep their scheme going and protect their bottom lines. Tether’s claim that its virtual currency was fully backed by U.S. dollars at all times was a lie. These companies obscured the true risk investors faced and were operated by unlicensed and unregulated individuals and entities dealing in the darkest corners of the financial system.
From June to September 2017, there was never more than $61.5 million backing Tether, even as more than 442 million coins were in circulation at one point. Only 14% of the total supply is backed by fiat dollars. Tether was also forced to change its statement on the website that every tether was not backed by every US.
USDT Recent Events
USDT De-peg to 90 cents: USDT’s most recent attestation revealed that they had a few billion dollars (about $5 billion) in digital assets on their balance sheet, with intron being one of the largest locations. Digital assets in their balance sheet will affect the market’s willingness to accept USDT for the stability of Tether price as a stablecoin, considering the market’s bearish behavior these days and the USDT de-peg to 90 cents recent event.
10 million dollar withdrawal: Tether is in danger of collapsing because for the first time there is an unprecedented run on their reserves. Over the course of 14 days, $10 billion was redeemed, accounting for more than 10% of their total supply. This is the way we find out tether is not fully backed, people keep on asking for their money until they say we have no money left.
CoinDesk’s Campaign: One method to discover the truth is to obtain a record of their reserves, which is what CoinDesk attempted to do. Tether refused to share the material, claiming that doing so would expose proprietary business information. As a result, Tether filed a lawsuit against CoinDesk.
Crypto Solution on Centralized Stable coins
Some solutions came into the market against centralized stablecoins like DAI and SUSD. Other cryptocurrency assets back them up. You can use platforms like MakerDAO or the Oasis App to lock the assets like Ether and other crypto-assets to generate this type of cryptocurrency. They are meant to be at dollars and backed by more dollars worth of crypto.
The crypto stays there 2-3 times higher than the number of tokens in circulation, and it’s over-collateralized. They are meant to be over-collateralized, and there is proof that all the funds are found in these vaults.
Algorithmic Stable Coins
Algorithmic stablecoins are crypto token that uses price stabilization algorithms to keep the value of an asset, usually at $1. Simply algorithmic stablecoins are backed by computer code.
Algorithmic stablecoins have huge potential. To understand why all you have to do is understand the US dollar. The US dollar was once a stablecoin tied to gold, then slowly, the dollar established itself as an asset during the second world war and eventually left the gold standard completely. Because the American economy got so big, so fast during and after the world war, it required more gold backing, but the supply of gold material couldn’t keep up. The American economy needed to scale up so fast and with more flexibility than the gold standard could afford.
Similarly, a stablecoin economy can eventually outgrow the dollar economy in the long run. Dollar-backing stablecoin is a good start and works for now. The end goal is to leave the dollar standard and aim for maximum capital efficiency. So, to have an algorithmic stablecoin that could scale to whatever size or speed the economy needs would be fascinating. It would take us decades to achieve that goal.
The most interesting part is the algorithm that helps stabilize the token price. It’s similar to how our central banks use monetary policies to leverage interest rates, buying and selling government bonds to stabilize the price. The mechanism that stablecoins use to stabilize the price is:
REBASE (Supply elastic token)
SEIGNIORAGE (BASIS)
ESD
Terra
UST is a stablecoin (supposedly “stable” value where 1 UST = 1 USD) not backed by assets but pegged via market incentives. UST has mechanisms where 1 USD of the LUNA token could be burned (destroyed or converted) to mint 1 UST and vice versa (burn 1 UST for 1 USD of Luna). If UST went down to $0.90, arbitrageurs could:
1) Buy 100 UST with 90 USD in an exchange
2) Burn 100 UST to mint $100 worth of LUNA tokens on the Terra Protocol
3) Sell $100 worth of LUNA tokens on an exchange – profiting $10.
But since this would reduce the supply of UST (UST was destroyed to mint LUNA), the reduction in supply would effectively start bringing the price back to $1 as more people take advantage of the opportunity.
Risks
Let’s say there is a continuance drop in UST demand – e.g., people are scared UST will not regain its peg. People will either sell UST on the exchange or keep burning UST for LUNA, and since more LUNA tokens are minted, there is more supply in the market, causing downward pressure on the price of the LUNA token – causing the token to crash too. As people keep selling both UST and LUNA, they keep falling in price. Token then enters the death spiral. This is an inherent risk in the Terra/Luna ecosystem.
There is less risk when the markets are good and there is a sustained demand for UST. However, it becomes unsustainable when people start questioning UST, and the demand fades.
Algorithmic Stable Coin Crash
LFG: Luna Foundation Guard(LFG) is a Singapore non-profit company that coordinates Terra development. However, LFG also played another important role: for UST to maintain its peg at all costs. LFG is famous for buying millions of dollars of BTC, which is used to protect UST pegs. The reason why this BTC treasury came into existence is because of the UST peg save on three different occasions:
First: in December of 2020, UST remains de-peg for a complete day.
Second: Last May, when the crypto crash UST was below its peg for almost a week. This de-peg made the Terra team think about how they could protect the UST peg and set BTC as the ideal backing for UST during times of volatility.
Third: UST again de-peg in January, caused by another protocol called abracadabra, whose degenbox mechanism can crash the whole UST Luna ecosystem even with a slight variation from the peg. Realizing that many ways can crash the terra ecosystem, LFG incorporated to defend peg using BTC.
LFG Reserves At the time of Crash
LFG made all of its crypto wallet addresses public to see the accumulation in real-time. A few days before the crash, LFG reserves were
80,394.BTC
39,914 BNB
26,281,671 USDT
1,973,554 AVAX
23,555,590 USDC
697,344 UST
1,691,261 LUNA
A few days after the crash, LFG reserves were:
313 BTC
39,914 BNB
1,973,554 AVAX
1,847,079,725 UST
222,713,007 LUNA
They dumped 99% of the BTC to guard the UST peg.
Terra Crash
On 7th May 2022, Terra team drew a massive amount of UST from one of the pools on curve finance. For context, curve finance is a decentralized exchange for stable coin, and the terra team withdrew all their UST in preparation for something called ‘four pool.’ Do Kwon, the founder of Terra, chose the wrong time to remove the liquidity. Liquidity in this pool is not enough to handle the peg in case of a large trade. UST is at 20 Billion dollars, and the liquidity in this pool is just 700-800 Million dollars. Liquidity must be between 5-8 Billion dollars to perform this migration.
All you need to know is that when the Terra team withdrew UST, an unknown whale swap of 85M UST with 85M USDC on curve financing occurred, causing the UST to fall slightly below the peg. At the same time, another 200 M dollars of UST was sold on Binance. It was enough to push the UST price slightly below the peg.
Crypto crash is also happening these days due to which other strong holders like institutions also start selling UST for other stable coins, which increases the selling pressure and the price starts falling a lot. Some of the market participants are also starting to burn UST to mint LUNA for a quick profit and sell LUNA before it loses more value. This selling pressure on LUNA and more circulating supply crashed its price even further. The moment LUNA Market cap fell below UST market cap, LUNA officially entered the death spiral, and LUNA price crashed to ashes.
The Takeaway
The cryptocurrency economy is similar to the traditional economy. It may either be in a boom, increasing the value of its owners’ assets, or it might crash, causing people to seek more stable economies. Stablecoins address this issue. People may use Stablecoins to convert their valuables to stable coins and avoid further losses.
