If you are a cryptocurrency investor, you have probably seen the recent crash of LUNA and its stablecoin, UST.
This debacle exposed a serious problem for the crypto community at large.
Which stablecoins can you trust to hold their peg to a dollar for the long haul?
If you are new to the game, or even if you are experienced, stablecoins can be confusing.
In this short article, we cover everything relevant to stablecoins in 2022 including:
- Why Stablecoins are Important In Crypto
- The Different Types of Stablecoins
- The TerraLuna (UST) Collapse
- How To Prevent the UST Collapse
Why are Stablecoins Important in Crypto?
If you follow cryptocurrency at all, then you know that volatility is part of the game. Stablecoins aim to keep their price fixed (typically to one dollar). In turn, they add stability to an often wildly dynamic market.
Since stablecoins aim to mirror fiat, they are more often used in everyday transactions. Therefore, they help bridge the gap between traditional (legacy) finance and decentralized finance (DeFi).
But if crypto is so volatile, how do stablecoins not follow the same trend? The answer depends on the type of stablecoin that we are examining.
Stay with me, we are about to get technical.
The Different Types of Stablecoins
There are primarily four different types of stablecoins: fiat-backed, commodity-backed, crypto-backed, and algorithmic.
Fiat Backed Stablecoins aim to peg the value of their coins to a fiat currency like the Dollar and Euro. This is accomplished by collateralizing these assets in a central institution and issuing an equal number of coins.
The key to this approach is that one stablecoin is always redeemable for one unit of fiat from the central institution. Of course, this approach relies on trusting a third-party institution. One of the more popular coins in this genre is USDC.
Commodity-Backed stablecoins have the backing of hard assets such as gold, oil, silver, or even real estate. Essentially, owners of these coins have ownership over the commodities that are collateralized.
One advantage of this kind of system is that it provides worldwide instant access to digital assets which track the prices of commodities. One downside to owning these stablecoins is that their price fluctuates with the asset. Another downside is trusting counterparties to honor their agreements for token redemption.
Paxos Gold (PAXG) is one such example of a commodity-backed stablecoin. One PAXG token is redeemable for 1 troy fine ounce of gold held in vaults. Paxos undergoes monthly audits to ensure that their supply of PAXG tokens matches their gold supply. As mentioned previously, the price of PAXG will be roughly pegged to gold and you on trusting a counterparty to honor their agreements.
Algorithmic (Over-collateralized) Stablecoins
Algorithmic (over-collateralized) stablecoins rely on the backing of various different cryptocurrencies. Now you may be asking yourself, how does a volatile asset like crypto produce a stable asset? The answer is over-collateralization.
For example, imagine you take $2000 worth of PLS and mint $1000 worth of stablecoin. The system is designed in such a way that your stablecoin will always be worth $1 of the underlying asset, in this case, PLS. This works well if the value of your minted stablecoin exceeds the value of your PLS. However, if the value of PLS drops below the minted stablecoin value, then a liquidation can occur.
The major advantage to algorithmic (over-collateralized) stablecoins is decentralization and censorship resistance. Collateralizing your crypto on the blockchain can remove the need to trust a middleman and remove overhead costs for storage or paying employees.
The best example of an overcollateralized, crypto-backed stablecoin is USDL of the Liquid Loans Protocol. Within the smart-contract on PulseChain, one USDL will always be redeemable for one dollars worth of PLS. The protocol ensures overcollateralization by incentivizing users to liquidate vaults for a profit (arbitrage) when their collateral levels dip below 110%.
Other examples of overcollateralized stablecoins include Dai of MakerDao and MIM of Abracadabra money.
The alternative to this style would be an undercollateralized algorithmic stablecoin. This leads us nicely into UST, which falls into this category.
The TerraLuna Collapse
On May 7 2022, Luna and TerraUSD (UST) began to collapse. Luna had a price of over a 100 dollars and crashed to below a penny in less than a few days. The main stablecoin of the ecosystem was UST, which lost its peg to a dollar and dropped to as low as 20 cents.
How could this happen? As expected in crypto, the answer is complicated on the outside, but if you take the time, understanding it becomes simple.
UST is an algorithmic stablecoin. The smart contract is designed to automatically burn Luna tokens to mint new UST tokens. Conversely, if a user wants to redeem their UST, the contract would have to mint new Luna. The problem with this approach is that if there is a high demand for UST, then the pool of UST can become greater than the asset backing it. Anchor protocol was the straw that broke the camel’s back, providing such a high demand.
Anchor protocol held the majority of UST, offering 20% returns. This provided the demand for a mad rush of users acquiring LUNA and burning it for UST. Then, all of a sudden, Anchor suggested dropping their returns to 4%. Now, the same users who just burnt their LUNA for UST are selling their UST on the market…
Massive amounts of LUNA got minted as a result of a huge bank run to try and redeem UST. Unfortunately, there was not enough value in LUNA to back the stablecoins. As a result, LUNA inflated greatly as users sold out of it and created the massive crash we see today. UST depegged because it was no longer redeemable for a $1 worth of anything. At one point, the supply of UST was 10X higher than the value of LUNA.
To make matters worse, this stablecoin model was already tried and failed. NuBits was a seigniorage model which broke in a similar fashion to UST. Users rushed to sell their NuBits in high quantities in response to optimism about the Bitcoin price. The price was unable to hold its peg due to the large selloffs. And worst of all, UST founder, Do Kwon, launched a previous stablecoin called Basis Cash, which also failed.
How To Prevent The UST Collapse
The key to preventing the UST collapse is to design overcollateralized stablecoins.
In other words, the stablecoins will ALWAYS be redeemable for $1 of the cryptocurrency that is backing them within the algorithm.
The best examples of overcollateralized, algorithmic stablecoins are:
USDL – The native stablecoin of the Liquid Loans Protocol. USDL is minted into existence at 0% interest from PulseChain tokens (PLS) which are locked up at a 110% collateral level. Meaning there will always be sufficient value backing the stablecoin.
LUSD – LUSD is the parent protocol of Liquid Loans. LUSD operates the Ethereum chain. Users locked up their ETH at a 110% collateral level and mint stablecoin at zero percent interest using that.
Dai – This stablecoins acts similarly to both USDL and LUSD, allowing users to mint stablecoin from locking up various crypto assets. The key differences are the 150% minimum collateral ratio and the interest payments on the loan.
The Bottom Line
For a stablecoin to remain stable under all market conditions, they must not have more value than the collateral backing them. If not, they run the risk of losing their peg or even going all the way to ZERO. Make sure when choosing a stablecoin that they are overcollateralized.
By Liquid Loans team
Disclaimer: None of the above is meant to be a financial advice. Never rely on a single source of information and do your own research before any investment. Don’t trust, verify!