Unstable Stablecoins

INTRODUCTION

As the name suggests, the term ‘stablecoin’ pays homage to what’s written on the tin – a coin that is intended to be just that – stable. If we dig just a little bit deeper, we can say that stablecoins are a form of digital currency with their value pegged to some underlying external asset class, such as fiat currency, commodity, or some other financial asset such as gold. In fact, the premise of stablecoins is that they offer the utility of cryptocurrencies given that they can be traded on and across blockchains, however, they offer the inherent stability offered by being pegged to an underlying asset.

In a cryptocurrency world troubled with sometimes unfavorable volatility, uncharacteristic of typical financial markets, stability can be regarded as a far-fetched notion, however, stablecoins provide comfort which would otherwise be difficult to accomplish. They offer an opportunity to bridge the gap between fiat currencies and cryptocurrencies by acting as price-stable digital assets that on the one hand behave like fiat currencies, yet on the other hand permit the utility offered by cryptocurrencies. Their underlying feature is that they can act as a novel solution to crypto volatility by providing this price stability, but the open question that’s being circulated around the cryptocurrency ecosystem is whether their stability is perpetual, and what happens when they become unstable. Thankfully to some, and unthankfully to others, there are a few cases in point that we can look, at to analyze the true impact of unstable stablecoins.

The need for Stablecoin

Stablecoins form a cornerstone of the cryptocurrency market. Users typically park their funds into one of many coins that maintain their peg accordingly. However, the choice of which one to use for this particular exercise can often boil down to the fundamental functionalities of the stablecoin in question, and how that specific stablecoin “works” in actuality. The nature and birth of stablecoins are very much linked to how these coins came into play. In fact, as with any emerging asset class, cryptocurrencies’ susceptibility to market forces gave rise to a need to deploy a more sophisticated protection mechanism that surpasses the ingenuity of stop-loss orders or other similar techniques, which are typically akin to the traditional trading world. As a result, price stability was built directly into the assets themselves in the form of these wonderful stablecoins.

Types of Stablecoins

Stablecoins are typically categorized into one of four underlying collateral structures; fiat-backed, cryptocurrency-backed, commodity-backed, or algorithmic. It’s time to briefly cover each in turn.

 Fiat-Collateralized Stablecoins

The most popular and most secure is that of fiat-collateralized stablecoins that are backed (or “collateralized”) one-for-one with the underlying fiat currency in question, for example, the United States Dollar, Great British Pound, or similar. Why are they the most secure I hear you ask? Well, the purchaser of the stablecoin can redeem their stablecoin position for hard-earned fiat cash easily, given that the stablecoin issuer has the underlying currency held in its reserves, thus maintaining the value and stability of the coin. You only need to think of Binance’s BUSD, Tether’s USDT, or Circle’s USDC stablecoins to appreciate the popularity of these coins as a tradable pair against “non-stablecoin” cryptos.

Take a look at USDC’s collateralized constituents which are extremely liquid holdings:

 Crypto-Collateralized Stablecoins

It’s written on the label… Crypto-collateralized stablecoins are simply backed by other cryptocurrencies. However, as the cryptocurrency held in reserve is potentially prone to all-familiar crypto market price volatility, this category of stablecoin requires ‘over-collateralization’. In other words, the value of the cryptocurrency held as collateral has to be greater than the value of the stablecoin issued. Take the example of MakerDAO's DAI stablecoin, which is pegged to the US Dollar, but collateralized by Ethereum (as well as a basket of other cryptocurrencies). Together the cryptocurrencies held in reserve have a total value that is often worth 150 – 200% of the DAI stablecoin in circulation.

 Algorithmic Stablecoins

Next on the list is the more unconventional, questionable, yet highly creative algorithmic stablecoin category. Contrary to the previous two classifications, these stablecoins may or may not hold any assets in reserve. Algorithmic stablecoins have come in many variations and permutations of former algorithmic coins, however, some have hit the headlines more than others. We might even say that the algorithmic stablecoin type, is largely responsible for the regulatory radar and negative light that has put increasing pressure on stablecoins as a whole. But why is this and what caused this shift in “stability”?

First, we have to look at what identifies an algorithmic stablecoin from its peers. In a nutshell, an algorithmic stablecoin has an inherent built-in mechanism that allows the stablecoin’s value to be pegged to some underlying fiat currency, by creating an algorithmic relationship between its supply and that of some other coin within the same blockchain ecosystem, by way of smart contracts. This isn’t too dissimilar from central banks that have uncollateralized fiat currency in their vaults. However, the difference here is that central banks have sophisticated monetary policies, battle-tested over decades (if not centuries), not to mention historic references to fall back on. In addition, central banks can stand behind their currency if push comes to shove… But this is not so true of the recently created algorithmic stablecoin concept, of which has yet to trek through the peaks and troughs of various economic cycles.

THE FALL OF TERRA & THE BIRTH OF THE “UNSTABLE STABLECOIN (UST)”

We only need to refer to Terra’s algorithmic stablecoin UST and its ground-shattering collapse earlier this year, to see the risk and ramifications that a non-collateralized stablecoin can have, including the wider negative knock-on impact that this can have on the wider crypto-market. The initial idea; is that if you can mint (create) $1 of UST by burning (removing) $1 of LUNA – which was Terra’s layer-1 native token – and vice versa, then you will always have a relationship that allowed arbitragers to either raise the value of UST to $1 if the stablecoin slipped below the $1 peg, or reduce it’s value back down to $1 if the reverse was true. However, on May 7th as well as the following few days, the price of UST plunged over 90% vaporizing its value/peg against the US Dollar. Similarly, LUNA fell by more than 80% overnight eroding $60 billion from the crypt market, and since inception, no other crypto ecosystem has suffered a collapse of this magnitude.

The Cause

Although this is still up for debate, the most reoccurring theme is that a handful of rogue traders sought to shake up the Terra ecosystem, by manipulating one of Curve’s liquidity pools. In layman’s terms, all that was required was a few withdrawals of $25m – $150m (see Chainalysis figure below) worth of UST from this pool (i.e. a large sequential sell-off) in noticeable chunks, to take down this former Top 10 Layer-1 blockchain… astonishing! This essentially depegged UST from the US Dollar in a few predominant moves.

What made matters worse is that Terra was offering an interest rate return of 18 – 20% on UST deposits with their [now] infamous Anchor Protocol, which was in itself, intrinsically unsustainable. You then had every Tom, Dick, and Harry worried about their hefty UST savings deposited in this protocol, withdrawing their funds (i.e. selling UST) in fear of an eventual seismic downfall – and they were right! Despite the Luna Foundation Guard’s attempts to resurrect and restore parity with the US Dollar, their efforts fell short and everything ultimately came tumbling down.

Takeaways

A collection of central bankers and financial regulators from the G20 countries – collectively known as The Financial Stability Board (FSB) – warned us that stablecoins aren’t stable. They’ve further stressed that the majority of stablecoins would struggle to maintain their value under adverse market conditions.

The research done thus far by large central banking bodies including the European Central Bank, U.S. Federal Reserve, and others, comes in light of their intention to decide whether or not to issue their own digital currencies. Furthermore, their decision to discuss this stems heavily from the collapse of Terra and their algorithmic UST stablecoin, which the Financial Stability Board cites as indicative of "the inherent difficulty of designing a robust stabilization mechanism based on an algorithm and arbitrage strategy involving assets with no inherent value." Going a step further, the board states that many stablecoins “do not have credible mechanisms to support their promise of price stability,” according to the FSB’s report.

Stablecoins are far from fool-proof, riskless digital assets, and 2022 alone has highlighted a handful of major risks and drawbacks linked to stablecoins. Although they are far more “stable” than their non-stable digital counterparts, the community must know that their relative low risk should not be considered as no-risk. We should always assess the associated counterparty risk alongside the reserve risk, that is, whether the counterparty will stay afloat and whether actual collateral is held in reserves, respectively. Yes, we 100% need stablecoins around, but we also need to question the imagination of stablecoins.

Published On: December 11, 2022Categories: Legal0 Comments

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