Algorithmic stablecoins in check after UST collapse

Charlie Taylor

On Monday, the US Federal Reserve (Fed) published a report that identified three assets with funding risks: specific money market funds, some bond funds and stablecoins. The stablecoin sector, according to the US central bank, “continues to be exposed to liquidity risks” and is “vulnerable to runs [bancárias]”. That same day, Terra ecosystem stablecoin UST lost more than 30% of its value during a bank run accelerated by low liquidity on the flagship Anchor lending protocol. On Wednesday (11), the stablecoin had moved further away from its backing, while LUNA, Terra’s native token, had basically lost all of its value. Other decentralized stablecoins, including neutrino (USDN), frax (FRAX), celo dollar (CUSD) and sUDS (SUSD), all dipped below $9.98 at one point as users’ trust was being put to the test. The natural question is: Is this the end of algorithmic stablecoins?

Alternative ballasts

First-generation stablecoins like Tether and Circle maintain their value through the assets that are in the bank. Every time someone buys 1 USDT or USDC for $1, Tether or Circle takes that dollar and stores it so holders can always redeem what they have. At least, that’s the idea. In fact, several other “cash equivalents” and/or debt instruments may be backing the currencies in circulation. UST, like other algorithmic stablecoins (or “somethings”), works differently. It maintains a backing against the US dollar through its relationship with another asset. In the case of Terra, to issue 100 UST, it was necessary to “burn” (or remove from circulation) US$ 100 in LUNA, which had an oscillating value. To issue $100 in LUNA, you would have to destroy 100 UST. The proposed mechanism was clever. If the value of the UST on the open market started to fall, it would still be possible to redeem it for the full amount in LUNA. For example, if UST were trading at $0.95 each, it would still be possible to get $1 in LUNA. The arbitrage opportunity would theoretically keep the price stable. But that doesn’t work anymore, as LUNA is not worth the same as before. At the time when people could still change UST by LUNA, the price had already dropped even further.

Without future

“I honestly don’t believe there is a future for agorithmic stablecoins,” Justin Rice, vice president of ecosystems at the Stellar Development Foundation (or SDF), told Decrypt. The payments-focused Stellar blockchain supports a variety of stablecoins, including USDC. “What we’re seeing now — and this isn’t the first time — is an optimistic balancing act unfolding because of natural human responses to market conditions,” he explained. According to Rice, algorithmic stablecoins have lost their backing before, but never as much as UST, which had a capitalization of $18 billion. In April, neutrino (USDN), an algorithmic stablecoin linked to the WAVES blockchain, also lost its backing. Like Terra, it faced accusations that its token economy was a mere Ponzi scheme that relied on the belief that the network’s native token would only continue to rise in price over the long term. It is still trying to get back to its parity with the dollar. This week, problems in the market are holding up your progress. Nik Kunkel, former head of backend services at Maker, who created the decentralized, over-collateralized stablecoin DAI, suggested that stablecoins don’t fail because they are algorithmic, but because there isn’t enough backing. “Partial collateralized stablecoins have failed time and time again,” Kunkel told Decrypt. “They cannot solve the fundamental problem of bank runs when the ballast is under pressure.” Rohan Grey, a law professor at Willamette University who has helped draft legislation that could require stablecoin issuers to obtain a bank license, told Decrypt that this can happen when things are not going well in the market. “Stablecoins [algorítmicas] are even more dependent purely on collateral pricing theories than brokered stablecoins,” which include centralized ones such as USDT and USDC. “So, in that sense, I think they are much more vulnerable to pro-cyclical market volatility.” Brokered stablecoins, he says, “at least have an institutional governance entity with its own equity that can back it up in a crisis” — despite the fact that he and Kunkel share a concern that stablecoins are at the mercy of a central authority that can act accordingly. dishonest. Centralized stablecoins faced similar tests. USDT dealt with this kind of crisis in 2017, when its price reached $0.91, according to CoinMarketCap. It survived, but it took three weeks to get back to $1. It is now the top stablecoin by market cap — and the third-largest crypto asset on the market, followed by bitcoin (BTC) and ether (ETH).

external intervention

UST can do the same thing, but not alone. “It’s challenging for algorithmic stablecoins to hold their weight when things fluctuate,” Rice said, “and you have to rely on outside interventions to fix things.” Do Kwon, creator of Terra, and the Luna Foundation Guard (or LFG) realized they would need outside intervention. In a series of tweets published Wednesday, Kwon said that Terra was searching for “exogenous capital” in combination with implementing changes to the protocol to help get the network back on track. He stated that the reconstruction process would involve the use of a guarantee mechanism. In other words, it would be something that would ballast the value of Terra instead of LUNA. Terra had already advanced on this, having acquired more than $3 billion worth of bitcoin (BTC), avalanche (AVAX), terra (LUNA) and terrausd (UST) to use as a reserve in case of market turmoil. But with UST equivalent to six times that amount last week, it wasn’t a sufficient guarantee. These reserves have already been emptied. Marek Olszewski, co-founder of Celo, tweeted that Terra’s reserve system was the right move, but that something could be “even more stable with an even more diverse basket of assets.” Celo’s algorithmic stablecoin is backed by CELO, BTC, ETH, DAI and carbon credit tokens. However, it had also dropped to $0.96 before returning to $0.99. This looks like a great learning opportunity for the entire crypto ecosystem. Getting everything right in the protocols takes a lot of iteration and learning, and algorithmic stablecoins are no different. And most importantly: The recent event shows how important it is to back these types of stablecoins with various assets. The initiative to partially back UST with BTC just before this event was well thought out and undoubtedly helped to avoid further loss of backing.

According to Rice and Kunkel, there are no shortcuts for decentralized stablecoins, which want to avoid government currencies and have long sought a way to do so without getting full guarantees. While Rice claimed that stablecoin projects can maintain user trust through fiat (fiat currency) guarantees and external certificates, Kunkel turned to blockchain public ledger transparency. “An ideal stablecoin needs to be over-secured and decentralized,” he explained. “Over-assurance to give stablecoin users confidence that it will retain its value. Decentralization so anyone can see the blockchain bookings in real time and verify for themselves that the protocol is solvent.” Terra users can see for themselves that the protocol is not solvent. Now, all they need is trust. *Translated by Daniela Pereira do Nascimento with permission from Decrypt.co.

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