UST: does this mark the end of the algorithmic stablecoin?

UST: does this mark the end of the algorithmic stablecoin?

UST: does this mark the end of the algorithmic stablecoin?

The stablecoin landscape has been booming up until now, with close to 100 projects being listed on Coinmarketcap. Especially popular as of late are algorithmic stablecoins, which rely on ecosystem activity to keep the price pegged to a fiat currency of choice, rather than the traditional route of being backed by a reserve.  

But with Terra UST’s recent issues, and the launch of a similar algorithmic stablecoin in Tron’s USDD, people are beginning to question how stable these stablecoins actually are.

Here we’ll take a look at why stablecoins are a popular area of development and some of the strategies and problems in making a value-pegged token, before diving into the leading algorithmic stablecoin offerings on the market today.

    What are Stablecoins?

    Stablecoins are a plug-and-play crypto for the global economy, enabling peer-to-peer international transfers without the volatility usual to crypto assets.

    Payment processors make about 1 trillion dollars a year middle-manning these types of payments, according to William Quigley, founder of stablecoin issuer Tether (USDT).

    That’s a lot of additional capital that businesses and individuals alike would save by switching from legacy payment methods, part of which is up for grabs to the stablecoin issuers vying for dominance in this space.

    From the January 2022 Federal Reserve study "Stablecoins: Growth Potential and Impact on Banking"

    Each stablecoin in crypto has different platforms and exchanges that they can be used and traded on, and differing strategies for maintaining their pegged value.

    Different types of stablecoin

    There are 4 main types of stablecoin:

    ·      Fiat-backed – The issuer holds a 1:1 reserve of the pegged fiat currency, or equivalent value in marketable assets. The most notable fiat-backed stablecoin is Tether USDT, which is the largest stablecoin in the crypto space and makes up over half of all of Bitcoin’s trading volume. This strategy is the most centralized because the reserve relies on banks and centralized markets.

    ·      Commodity-backed – These stablecoins are pegged to the value of an underlying commodity, with popular options using gold, like PAXG. These stablecoins are less centralized as the reserve is not controlled by a government, but the issuing company can be a single point of failure.

    ·     Crypto-backed – These coins use smart contracts to mint stablecoins when users deposit enough crypto collateral. Though these projects are even less centralized, they are subject to the price fluctuations of crypto markets and require overcollateralization to mint new stablecoins. For example, one popular crypto-backed stablecoin Maker-DAI requires users to have collateral valued between 101% and 175% of the DAI they wish to mint.

    ·      Algorithmic –  With algorithmic stablecoins, the issuer plays with the balance of a native token and a paired stablecoin. An algorithm is used to adjust the trading pair’s supply in circulation and incentivize traders with arbitrage opportunities. You can think of the algorithm like a thermostat trying to maintain a constant temperature in a house. If it’s a hot day outside, the thermostat runs the AC to remove energy from the air. Conversely if it’s a cold day outside, the thermostat will run the furnace to add energy to the air. Notable players in this space are Terra, Tron, and Near. These stableoins are the most decentralized as the supply is controlled by a DAO’s smart contracts.

    Top algorithmic stablecoins

    There are three main protocols that have created algorithmic stablecoins:

    Terra and UST

    The Terra blockchain was built to be a price-stable global payments platform with censorship resistance like Bitcoin. LUNA is Terra’s native token that’s paired to maintain the prices of  7 stablecoins, of which UST has become the most widely used. Using their bridge protocol, LUNA and UST are available on 11 blockchains, including Ethereum. LUNA holders are incentivized to exchange LUNA for stablecoins at profitable rates, adjusted by the algorithm, to expand or contract supply as demand for each stablecoin changes. The Luna Foundation accumulated $1.6 billion in BTC as a reserve to back Terra’s stablecoins, but the recent selling of BTC reserves seems only to have exacerbated the crypto-wide market crash, rather than having any success in stabilizing the price of UST and LUNA.  

    Tron and USDD

    Tron’s algorithmic USDD, live as of May 5, is the newest stablecoin that aims to be regulation-resistant through decentralization. USDD uses the same algorithmic method as Terra’s UST, except with its native TRX token as the trading partner for USDD. Also like UST, USDD is backed by a mix of decentralized currencies in reserve should the algorithmic incentives fail. Tron’s founder, Justin Sun, has said that “[kicking] off in May, I think we’re probably going to have $1 billion put into the reserve.” However, crypto news publisher The Block has been unable to verify if that reserve indeed exists. Launching on BitTorrent network’s cross-chain protocol, USDD will be accessible on Ethereum and BNB Chain. Investors may be wary of holding USDD after the UST collapse.

    Near and USN

    Near Protocol’s decentralized stablecoin USN went live in late April. It too uses the same arbitrage incentive structure to keep its pegged value with the trading pair as NEAR:USN. Although it has reserves designed to back the coin during market volatility, the reserves are made up of NEAR and USDT, and how much will be allocated to the reserves is still undecided. Near hosts protocols such as Aurigami, Bastion, Burrow and Ref Finance who have decided to use USN. As of May 12, NEAR do not seem to have publicly commented on the UST collapse, but it’s likely that NEAR developers are re-assessing the security of their ecosystem behind closed doors.

    Academic push-back against algorithmic stablecoins

    Calling Luna’s UST “unstable”, starting May 8th would be an understatement. The stablecoin has since dropped to as low as $0.19 on FTX. Rather than being stabilized by the arbitrage incentive, UST’s price woes were made worse as floods of LUNA entered the market.

    The Luna Foundation Guard stepped in with BTC reserves mentioned earlier and staved off a collapse. While UST is trading at around $0.63, LUNA is down to $0.019 at the time of writing (05.12.2022) after having started the week at roughly $64. That’s a shocking loss of 99%.

    Bulls are seeing the potential for a rally, but the value of LUNA now relies heavily on faith being restored in UST.

    In a paper titled “Built to Fail”, Ryan Clements, assistant professor of Business Law at the University of Calgary, disputes the foundations of how algorithmic stablecoins are designed to work. He posits that algorithmic stablecoins can only function when three specific conditions are true at all times:

    1.     Baseline demand for the trading pair of tokens works as a support level.

    2.     There’s a population of willing arbitrageurs that act as price stabilizers.

    3.     The market is trading with highly accurate information.

    Clements warns that these conditions break down in times of market volatility, as seen in action this past weekend. Other commentators on crypto Twitter also pointed out that they had accurately “called” what they referred to as Terra’s “death spiraling Luna” model.

    The future of Stablecoins from here

    If institutional investors at Fireblocks are an indicator, stablecoin adoption should still grow in the coming years as more financial institutions start offering cryptocurrency custody and DeFi access.

    Fireblocks CEO Michael Shaulov saw institutional investors surge at a chance to participate in DeFi using the Terra blockchain, saying that $500 million moved into UST in its first week of availability with $250 million of that entering in the first 72 hours.

    But it’s clear that more rigorous testing should be done before billions of dollars of value is deployed into experimental protocols.

    When asked about the stablecoin landscape he said “… the model around stablecoins and specifically what Terra is doing is somewhat experimental. If you’re asking me if there is a place for this innovation around stablecoins, I think that the answer to that is yes.”

    It will be interesting to see whether Terra can survive this serious setback, and whether projects like Tron and Near will adapt their stablecoin model in the face of recent events. Terra validators earlier decided to halt activity on the blockchain and apply a patch that reduces the risk of a (now financially feasible) 51% attack.

    Others on Twitter have shared stories about how they have lost their life savings in Terra's ecosystem. For now, at least, it looks as though reserve-backed stablecoins will inspire the most confidence in retail and institutional investors.

    This content is for informational purposes only and is not investment advice. You should consult a qualified licensed advisor before engaging in any transaction.

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