I wanted to flesh out some of my ideas about stablecoins, primarily to clear my thoughts and solidify my understanding of them. I always find this helps when having clouded thoughts around a particular issue and have found it to be the greatest alpha tool anyone in this space can harness. Sit down and write, it helps.
Stablecoins and more recently not-so-stablecoins, are one of the biggest opportunities in this space, it doesn’t take a genius to work that out. That being said, they haven’t had the greatest time throughout crypto history.
Even throughout 2014-2017, there were a series of what can only be described as experiments such as NuBits, CoinOUSD and BitUSD that all fell by the wayside due to their underlying tech. Without going too deep into the history of these OG stablecoin projects, they all failed in one way or another during highly volatile times.
Fun fact: Charles Hoskinson was a founder of BitUSD which was a crypto-back stablecoin… Which tokens backed it you ask? BitShares (BTS) of course… sound familiar?
Skip forward a few years and we are still seeing “stablecoin” projects follow the same demise as their forefathers. Now, I am not knocking those who have the decentralised ethos at heart and are trying every which way to crack the code of a truly decentralised, permissionless and secure stablecoin. I think it is vital that we push on and try to find the secret sauce. Is it achievable? Maybe…
So, Why Do Some Stablecoins Fail?
To answer this question we need to understand the different types of stablecoins and their underlying mechanisms that are supposed to, you know… keep them stable.
First, what is a stablecoin? – Stablecoins are crypto-assets that reflect the price of a real-world currency i.e. the US dollar, EURO, Japanese Yen, Pound etc. In an ideal world, these stablecoins keep parity with their real-world counterparts USDC should hold the value of $1, GYEN should hold the value of the Yen and the GBPT (Tether’s new GBP product) should, you guessed it… hold the value of the Pound.
Holding their respective values is known as maintaining the peg. “USDC is pegged to the dollar” for example. That is simple enough to understand.
Different Types of Stablecoins –
Now, we can plot specific types of stablecoins based on their decentralisation and their collateral backing. See below:
As you can see from my beautiful image that I spent way too long making, the centralised stablecoins such as USDC, GYEN, GBPT, ZUSD etc. tend to come with 1:1 backing of cash or cash equivalents.
Being a centralised authority that issues stablecoins through minting, understandably comes with its regulatory scrutiny due to a very obvious attack surface for the powers that be. This is why you will tend to find the vast majority of centralised stablecoins will come fully collateralised… the “USDT?” in the under-collateralised, yet centralised camp is a little bit tongue in cheek, it’s a crypto-mystery as old as time itself.
Algorithmic Stablecoins: Will we ever learn?
Despite the majority of banking systems throughout the world working on a fractional reserves basis, this doesn’t mean that we should replicate systems that we have seen crumble before.
A run on the banks is rare, but not uncommon. When depositors come asking for their hard-earned savings it is usually not an issue. When they all come at the same time is when we begin to see even the most trusted institutions begin to fail.
There is an excellently written blog post from GMO-Trust; a Japanese Yen (GYEN) and USD (ZUSD) stablecoin provider, which outlines the similarities between previous depression-era bank runs and the LUNA/UST downfall. You can read it HERE.
It has been said that the Terra/UST fiasco was DeFi’s first run on the “bank”. This is not technically true. There have been many an algo-stable that have entered my wallet over the years that promised ridiculous gains (usually through a seigniorage model), yes I am talking about you Basis Cash, D-Dollar, Iron Finance and many others that didn’t last long enough to register into my brain.
Another fun fact: Do Kwon was allegedly behind the failed Basis Cash experiment before starting LUNA and UST.
Algorithmic stablecoins will vary in their method of defending the peg. In general, they will all attempt to maintain their peg through code as opposed to being fully/over collateralised by other assets.
Yes, it is as stupid as it sounds and has resulted in death, 100% of the time. I do hope we one day achieve such stability in an algorithmic stablecoin. This hope though is up there with seeing someone defeat the final boss on Takeshi’s Castle.
The root of the problem was in fact that the code did its job… unfortunately.
UST (Terra Stablecoin) is created by taking LUNA and burning it. The dollar value of LUNA would then mint a dollar equivalent of UST… i.e. if 1 LUNA was worth $100, then you could mint $100 by burning your 1LUNA token, simple enough.
So, in practice as the supply and market cap of UST grows, more LUNA is burnt reducing the supply and increasing the pumpanomics… Everyone is happy because number-go-up.
Naturally, when you have an ego-inflated cult leader at the helm, the natural progression to increase said ponzinomics were sure to play out. Let’s increase the demand for UST, this leads to more LUNA being burnt, supply shocks happen on LUNA and the price increases as a consequence. It is all so clear in hindsight…
The same is true in reverse though… before we get into this, let’s take a look at the social/expected routes for maintaining the peg of UST.
So, the infographic above does a great job at showing the simple mechanism by which UST maintains its peg. The issue is that it relies 100% on arbitrage. If UST was above peg (let’s say UST is $1.1) people are incentivised to buy $1 worth of LUNA, burn it to mint UST i.e $1.10 and then take the UST and sell it for $1.10 of whatever other asset you wish… you could in theory buy more LUNA with this and repeat until the price of UST is brought back to $1…
The same is true for the reverse process. If UST was below peg let’s say $0.95, you could then buy UST at a discount, burn it for $1 worth of LUNA and then sell the LUNA and pocket the difference…
Sounds simple, doesn’t it?
There were a whole bunch of issues that arose in early May. The key driving force for UST demand came from the Anchor protocol which was an extremely high 20% savings account which allowed users to deposit UST into their vault and earn very lucrative returns.
When in doubt, follow the yield…
The “yield” was supposed to come from borrowing and lending fees generated from the Anchor protocol itself but it took around 30 seconds for anyone that bothered to look to realise that the borrowing/lending deposits were way off for the amount required to maintain such a high “stablecoin” yield.
Following that, some opportunistic whale games that took advantage of depleted liquidity before the new UST Curve pool led to a liquidity crisis and consequently, UST lost its peg through a lot of market selling on centralised exchanges and whatever other liquidity pool users could find.
Liquidity was a key factor in maintaining that arbitrage potential and thus defending the UST peg; once that dried up this further exacerbated the de-pegging of UST.
Whilst all of the above was happening, LUNA had been losing steam through wider market downturns and natural speculation of its corresponding UST losing its peg. The death spiral commenced. Code is law and all that.
As liquidity dried up, users were forced to redeem to offload their UST. If UST was at $0.80 for example, then they could redeem $1 worth of LUNA. The problem was people were also off-loading LUNA. The consequence was more LUNA began being minted and sold, driving the price down further and further. Each time the price depreciated, a larger amount of LUNA was being minted per each UST redemption. The result is the rapid depreciation in the price of UST and also the huge supply increase in an ever-decreasing asset price of LUNA. Then the chain was halted.
UST could have probably gone on for an awful lot longer if the demand for stablecoin yield was not so high, a downstream effect of turbulent market conditions and people wanting a stable and reliable yield…
The moral of the story is that without the complete reassurance and backing of underlying assets not tied to the performance of one another, LUNA and UST were naturally destined to fail, like all those that came before them.
I know a lot of people who lost the bulk of their savings and portfolio through this mess and feel awful for all those affected. This will inevitably lead to regulation surrounding such stablecoin products in the future and I can’t say I am surprised. Not that I am crying out for regulation like Mark Cuban following another Algo-stable episode: Iron Finance, but there are better alternatives IMO.
TLDR of algorithmic and under collateralised stablecoins: They get an F- from me. They are fun for a few days and with pocket change at risk but they have caused a lot of pain and suffering to people who were sold the dream unknowingly. They have also sped up the rate of regulation in the crypto space and hopefully won’t cause an overreaching knee-jerk reaction from those upstairs.
Disclaimer: I was unaffected by the LUNA/UST situation but played the Ponzi games in DeFi summer, the BSC cycle and a few others too.
Collateralised Debt Positions (CDPs) –
This one is pretty straightforward and doesn’t take a lot of explaining. Collateralised debt positions (CDPs) or in ape-speak, stablecoins backed by crypto have been relatively successful if we take the biggest two in the marketplace.
DAI is a dollar-pegged stablecoin which is over-collateralized by a basket of different assets including ETH, WBTC and stablecoins… users can deposit their assets into a smart contract (vault) and then mint DAI.
Due to the over collateralisation, users can only mint less DAI (in dollar terms) than their posted collateral. This does mean that you are at risk of liquidation if your loan-to-value (LTV) decreases close to your borrowed amount.
The system relies heavily on its liquidation engine in times of market stress and volatility. At a fundamental level, the oracles that feed price data into the liquidation contracts are extremely important.
The eagle-eyed amongst you will have noticed that some of DAI’s collateral is in fact, other stablecoins… It isn’t a small number either. Around 65% of DAIs collateral is USDC which is kind of hilarious. So, how decentralised is it? That is for you to make your own decision.
Magic Internet Money (MIM), is another CDP product from Abracadabra Money. MIM is backed by interest-bearing assets as opposed to native assets. Users can deposit the likes of stETH, LP tokens and even yvDAI (yearn-vault DAI) and borrow MIM against their collateral.
Both DAI and MIM have come under their own tests to defend their peg through liquidations and arbitrage opportunities but have (until now) held up pretty well compared to their under-collateralised counterparts.
There are questions regarding the scalability of these stablecoins, however, as they can reach maximum saturation. For example, each cauldron (deposit vault) on Abracadabra has a maximum amount of MIM available. I assume this is the maximum safe amount of assets that could be liquidated at any one time and their risk limit on bad debt that could slosh around in the system.
Interestingly enough, the AAVE community has recently proposed a new CDP stablecoin called GHO which can be minted following a deposit of collateral into one of their lending vaults.
This kind of threw me when I first read it but it makes sense given the amount of TVL in their protocol.
AAVE appears to be playing the regulatory game rather well too, with their AAVE Arc which is a private fully KYC/AML institutional-grade protocol for those who have been properly vetted. I think we will see a lot more of this separation between retail and institutional/private protocols for those who are willing to be fully vetted.
So, these get a big tick in my book although, during uncertain times, I’d always opt for the next type of stablecoin: collateralised and centralised stablecoins.
I don’t get the stigma around centralised stablecoins if I am honest. I understand the transparency of Tether needs to be increased, that is an issue. I also get that Circle and USDC have a lot of people second guessing with their close ties to Coinbase and regulators.
Both have their fair share of wallets that have been blacklisted over the years too which goes completely against everything this space stands for and is just as good as a depegging from a more risky type of stablecoin IMO, despite the risk of that being extremely low unless you are acting pretty suspect. Still, the fact it can happen is not exactly reassuring. This also makes me question the selling point of DAI.
So where does this leave us for the future of stablecoins in crypto and DeFi?
Naturally, the early iterations of any new technology bear the brunt of battle testing, scalability and regulation. Ideally, projects that can learn from the mistakes of those that have gone before them, will have a greater starting point. Yes, the first mover advantage is huge, people like what they know. Everyone still using Metamask despite it being a terrible product is a testament to that.
There are certainly going to be huge developments in the non-USD stablecoin markets. A lot of other leading global currencies are beginning to gain some traction which has almost certainly been ignited by the current global macro situation.
Ironically, those worldwide who trade in crypto would naturally be sat in USD-denominated stablecoins throughout the past few months which would have protected those in Europe and other parts of the world from further losses against the dollar. It will probably be a lot of people’s greatest trade this year without them even realising.
This obviously won’t always be the case. Markets are highly dynamic and the option to trade in and out of liquid stablecoins of other currencies will begin to increase in demand, I am certain of that.
GMO-Trust, a vast multinational, is beginning to make moves with their Japanese Yen Stablecoin GYEN whilst also offering a ZUSD product too. We have spoken with their team on numerous occasions over the past month or so and they are ready to break into the DeFi space.
We both agreed that 1:1 backing (or above) with as much transparency and as little overreach as possible could lead to the next big stablecoins being sat in everyone’s wallets. It is nice to see derivative products or synthetic assets in the DeFi landscape but if you are going to hold alternative stable currencies you ideally want to know you can redeem 1:1 if anything were to happen.
We saw this recently with the USDT FUD, which was potentially the most ridiculous thing I have seen in a while. I have a sneaking suspicion that a small portion of the people off-loading USDT was confused with UST… no I am not trying to be comical here, I heard a few stories at the time of people not knowing the difference between the two. I suppose we are still early…
Anyone who understands the 1:1 backing from legitimate off-chain stablecoin providers such as GMO, Circle, Tether, PAXOS etc. will know that a stablecoin trading below peg is the easiest arbitrage opportunity for big players that anyone could wish for.
I believe USDT actually hit $0.95 at one point which anyone with two brain cells to rub together could have taken a great 5% arbitrage right there. You can literally redeem it for dollars…
I do think the past 6-8 weeks will fast-track regulators stepping in. LUNA exposed a lot of charlatans in this space, whether that be directly or the downstream effects of the collapse showing just how little risk management was applied by the so-called “big brains” of this space.
After all, it is the retail investors who felt the real pinch of this. A lot of those affected by LUNA and the subsequent contagion will largely be okay. As we all now know a lot of their risk was limited as it was other people’s money. I’d argue a lot of retail were invested with the hard-earned cash that they spent years saving, well I know 100% this is accurate from conversations I have had with people who didn’t know where to turn.
Regulation will come but I don’t think we need to be overly concerned. It doesn’t mean you will not be able to try better yourself by investing in this space. We go through regulated rails every day without even knowing it. The issue is certainly when gatekeepers and overreaching bodies begin to dictate what users can and can’t do with their assets.
In an ideal world, the regulation initially focuses on funds and trying to prevent mass contagion as we have recently seen. The irony is that in a transparent system (which this space claims to be) we saw some of the must under-hand leveraging tactics that even the suits in Wall Street would be proud of.
The right kind of regulation can prevent this, I do have concerns that it marginalises the little guy but if people are so committed to this space we will find a way. I don’t say this to be negative, it is just highly likely. I don’t even know what it will look like if I am completely honest but I’d like to be part of the conversation.
Another great overview of the current landscape from GMO-Trust: https://medium.com/gmo-z-com-trust-company/traditional-finance-and-the-need-for-crypto-regulation-part-3-15b44dee22ac
Andre Cronje was getting at this very point in his last article a few weeks before this whole fiasco and people berated him for it. As usual, the loudest people in the room (Twitter) are usually the least informed and probably only read the click-bait headline.
“Crypto regulation, is in my opinion, simply infeasible. As public blockchains have no domain, they should be guided by Maritime law. Without geopolitical dominion, no one can lay claim to these lands.
Regulated crypto, however, is very feasible. A company issuing and managing a cryptocurrency could apply for the required licenses (if they existed) in their territory. An exchange operating in a jurisdiction could apply for an operating license (if it existed). A country wishing to regulate crypto interactions can launch their own National Blockchain.
Instead of trying to fight regulatory bodies because of crypto regulation, we should be trying to engage and educate on regulated crypto. What should a token issuance license look like? What should an exchange’s activities be expanded to?” – Andre Cronje.
DeFi allows us a lot of transparency. We have seen that with Celcius and their open positions at the risk of liquidation opting to pay down their on-chain debt before other firms. You can’t argue or bargain with a smart contract (funnily enough).
I do think we see protocols having separate contracts for institutional interests that are private and away from retail participants. This will probably come in the form of private blockchains on the likes of an Avalanche Sub-Net or a full L1 on Cosmos. The Aave Arc is a leading indicator here in my opinion.
This is what it should be, and if anything the past few weeks made me even more optimistic about this whole space, despite the overarching narrative and sentiment.
Thanks for reading 🙂
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