Lesson No. 5: Stablecoins
What are they and how do they work?
Welcome back, readers! Last week, we covered different token standards on the Ethereum network before diving into NFTs and their real-world applications. Today, we’re going to cover:
Introduction to stablecoins
Types of stablecoins
1. Introduction to stablecoins
As the name suggests, stablecoins are a type of cryptocurrency that aims to preserve a “stable" price. They offer stability and protection by allowing the “liquidation” of tokens for digital dollars when markets are volatile. Additionally, they provide the benefits of blockchain technology, such as security and transparency.
A stablecoin’s stability is ensured by being “pegged” to a fixed external asset, like an algorithm, fiat currency such as the US dollar (USD), or a commodity such as gold. The “peg” refers to the stablecoin’s value as tied to– or backed by– the external asset. The company or entity issuing the stablecoin typically sets up a reserve of external assets equal to the amount of stablecoin in circulation. The stablecoin and the reserve move in unison, and as a result, the price of the stablecoin fluctuates very little. For example, Circle and Coinbase established the stablecoin USD Coin (USDC) in 2018, and it has barely strayed from its $1 value since.
Stablecoins that are pegged to fiat currencies act as a bridge between the crypto market and traditional financial markets. As a result, stablecoins play an essential role in the DeFi ecosystem because they provide an anchor of stability when payments are transacted. Stablecoins are also used in blockchain-based lending platforms to pay for goods and services.
Despite their name, there are several risk factors associated with stablecoins. The most concerning is the risk of reserve, meaning a stablecoin issuer may not have the reserve necessary to maintain the peg or it may otherwise refuse to redeem the token.
2. Types of stablecoins
Stablecoins are pegged by different assets which means they use different methods to hold their values steady. There are several ways to classify stablecoins; here we will follow Deutsche Bank’s model distinguishing them based on whether they are collateralized (fiat or asset-backed) or on-chain (backed by decentralized transactions occurring on the blockchain). This leads to three types: (1) off-chain collateralized, (2) on-chain collateralized, and (3) uncollateralized stablecoins.
These centralized stablecoins are pegged by assets not on the blockchain (off-chain) and are governed by either a company, bank, or government. The most popular stablecoins are fiat-backed, meaning they are backed 1-to-1 by an underlying government-issued currency, such as the USD. The issuer or a third-party financial institution holds the collateral in reserve, and may be subject to regulatory disclosure requirements concerning the nature of the reserve assets.
Tether (USDT) and USDC are both fiat-backed stablecoins pegged to the USD. So what makes them different? Both were launched by different companies: USDT (Coinbase and Circle) and USDC (Hong-Kong based Tether Limited). This means they have different auditing requirements. USDT is audited monthly by an auditing firm and releases complete reports on its reserve. Conversely, USDT has been criticized for irregular and incomplete audits. Nonetheless, both are leading fiat-backed stablecoins.
Other off-chain collateralized subtypes include commodity-backed stablecoins, which are pegged to physical assets like gold, oil, or real estate. An inherent drawback to off-chain stablecoins is centralization risks such as lack of transparency and security, or hyperinflation.
These decentralized stablecoins are collateralized by one or more cryptocurrencies. You may be wondering why there are crypto-backed stablecoins if the main reason for the creation of stablecoins is to have a stable and less volatile cryptocurrency. Remember the irregular auditing and reserve risks associated with off-chain collateralized stablecoins? Well, blockchain technology minimizes these risks. Transactions are more transparent, intermediaries are removed, and holders can check the coin’s collateral holdings. To ensure a stable price, these crypto-backed stablecoins are over-collateralized–meaning for every crypto-backed stablecoin there’s collateral in excess of the value locked in their reserves (usually two times market value).
These decentralized stablecoins have no reserves at all. Instead, they use an algorithm that automatically controls the token supply and keeps the coin's value from drastically fluctuating. This model is known as seigniorage shares. These stablecoins need sufficient demand to maintain their value.
So, how do these work? Consider this example: imagine you create a new coin and peg it to the USD; each new coin equals $1. If the price of your coin goes above $1, this means demand for your new coin is too high. The algorithm will mint (create) more coins to increase supply until it meets demand and the price comes back down to $1. If the price of your coin falls below $1, this means there are too many coins in circulation, and demand is lower than supply. The algorithm will purchase the coin and burn them (permanently remove coins from circulation) to reduce supply until it meets demand and the price goes back up to $1.
3. Terra-Luna crash
The Terra-Luna crash in May of this year sent shockwaves around not just the crypto world but the traditional financial sector as well. Few projects have grown so quickly and plummeted even more rapidly. Since the crash, lawmakers around the world have shown an increased urgency when it comes to regulating stablecoins, especially algorithmic ones. While we cannot say with certainty whether the crash was caused by a single actor or a team, we do know the design of the ecosystem was fallible to begin with. Let’s begin by explaining a few important terms and concepts:
Terra - Terra is the name of the blockchain network developed by Terraform Labs, a South Korean company co-founded by Do Kwon.
TerraUSD (UST) - UST is an algorithmic stablecoin pegged to LUNA, a native token of the Terra blockchain network. As a stablecoin, UST was designed to maintain a value of $1.
LUNA - In addition to being Terra’s native token, LUNA was created to help UST maintain its $1 value. Furthermore, LUNA was supposed to serve as a shock absorber in case UST lost its peg rapidly.
Arbitrage - Arbitrage is an investment strategy whereby an investor takes advantage of small price differences of assets in different markets. For example, a share of TESLA may be worth $1 on the New York Stock Exchange (NYSE) but $1.01 on the London Stock Exchange (LSE). An investor would buy TESLA on the NYSE and sell it on the LSE to make a profit.
Supply, Demand, and Price - Basic economic principles state that when the supply of something increases, the price decreases and vice-versa. The opposite is true for demand; when demand increases, price increases and vice-versa.
To understand the crash of the Terra-Luna ecosystem, you need to understand how it was built in the first place. There are two basic layers involved.
The first and most basic layer is how UST maintained its $1 value. By applying arbitrage and basic economic principles, Do Kwon and his co-founders created a system where one token of UST could always be exchanged for $1 of LUNA and vice-versa. If the price of UST went above $1, anyone could burn (destroy) $1 of LUNA in exchange for one UST. Given the price of UST is higher than $1 at that moment, the individual is able to make a small profit. More importantly, the increase in supply of UST eventually brings its price back to $1. Similarly, if the price for UST went below $1, anyone could burn one token of UST for $1 of LUNA. Once again, the individual is able to make a profit because UST is priced below $1, and the decrease in supply of UST takes its price back up to $1.
The second layer involves a DeFi protocol on the Terra blockchain network called Anchor. Anchor, in an attempt to act like a conventional savings bank, offered 20% returns on UST. This is an extremely high rate of return and it incentivized people to spend billions of dollars to buy UST so they could put it in Anchor and earn interest. Where did Anchor get this money from? Initially, the Luna Foundation Guard (LFG), an organization devoted to improving the Terra network. LFG supplied Anchor with the necessary funds so it could attract more users with the eventual goal of having the ecosystem sustain itself.
Things were going even better than Do Kwon and Terraform Labs could’ve imagined. LUNA’s price skyrocketed to over $110 at one point. Billions of dollars were put into the Terra network. UST was available to buy and sell on multiple crypto exchanges, helping it amass a market cap of $15 billion. Unfortunately, it was all about to come crashing down.
To make understanding the crash simpler, let's divide it into different stages from the attacker‘s point of view:
Plan: Cause a “death spiral” by reducing and maintaining UST’s price at less than $1.
Action: “Drain'' (basically steal) $250 million worth of UST from Curve, a DeFi protocol on the Ethereum network, and sell it at a price increasingly below $1 on Binance, a cryptocurrency exchange. This reduced the price of UST to around 90 cents.
Spiral: In order to raise the price back up, UST can be burned in exchange for LUNA. The problem with that is if UST’s price stays below $1, more and more LUNA needs to be minted, causing LUNA’s price to plummet. As LUNA’s price continues to decrease, more LUNA has to be minted to try and help UST reach its $1 peg. Eventually, LUNA’s price is so low this is no longer possible.
Death: As UST’s price stayed below $1, people continued to sell, causing its price to drop further. As more LUNA was minted and its price dropped, people sold their LUNA causing its price to drop further. In less than a week, LUNA lost 99% of its value, falling from around $100 to less than $1. UST is now permanently less than $1.
Stablecoins are a type of cryptocurrency aiming to preserve a “stable” price and therefore serve as a bridge between crypto and traditional markets
Stablecoins maintain their value by being “pegged” to an external asset–they can be pegged to fiat currencies, commodities, or even algorithms
Off-chain collateralized, on-chain collateralized, and uncollateralized are three different types of stablecoins
TerraUSD (UST) is an algorithmic stablecoin pegged to LUNA, a native token of the Terra network
After soaring to incredible heights, the Terra-Luna ecosystem came crashing down in May of this year, causing concern among regulators about the dangers of algorithmic stablecoins.