Signals: Why Stablecoins are Here to Stay Post-Terra

The downfall of the LUNA cryptocurrency and its TerraUSD stablecoin (UST) made international news as onlookers sought to make sense of how a so-called stablecoin ecosystem could yield such instability. Luna boasted $40 billion in market cap at its peak but fell to next to nothing in value after UST de-pegged from the dollar, all despite a nearly $3 billion bail-out attempt by LUNA’s backers.

The collapse of LUNA has brought negative attention to the cryptocurrency space, which already is misunderstood by many in the public as being unaccountable and unstable, but crypto experts argue that the episode highlights issues with algorithmic stablecoins rather than stablecoins in general. Tether co-founder Reeve Collins recommended to Decrypt that “holders of algorithmic stablecoins start to move their money into asset backed coins like Tether,” a reserve-backed stablecoin, which a spokesperson for Circle reiterated by detailing how Circle’s similarly reserve-backed stablecoin, UST,  is “backed by cash and short-term U.S. government obligations.”

To understand their views, it is important to highlight how an uncollateralized, algorithmic stablecoin like UST differs from collateralized algorithmic stablecoins like DAI, as well as reserve-backed stablecoins like USDC or institutional stablecoins.

These other stablecoins present promising opportunities for bridging centralized and decentralized finance and making transactions more efficient, among many more use cases.

Before continuing, it's important to detail what stablecoins are and how they differ from traditional cryptocurrencies.

The first cryptocurrency, Bitcoin, was created as a peer-to-peer online payments system which wouldn’t rely on financial institutions. Bitcoin is scarce and can’t be limitlessly created, and isn’t managed by a central institution which can inflate its value.

Since its creation, thousands of cryptocurrencies have been created, each with its own utilities, but one of the most interesting creations is the stablecoin. This class of cryptocurrencies seeks to maintain a peg to some value, and the most prominent stablecoins maintain a peg to the U.S. dollar in a reversal of Bitcoin’s independence from fiat currency pricing.

Stablecoins’ utility is in the name: stability. Their price stability makes them suitable for transactions or transfers where users wish to send precise amounts of a dollar-denominated currency. In addition, because they run on blockchains, they offer faster transaction speeds and can be used outside of the traditional banking system.

As the Federal Reserve details in a recent whitepaper, stablecoins also present use cases including cross-border payments, market making, collateralized lending, derivatives, and asset management.

For retail investors, stablecoins also present the opportunity to earn superior yield on cash through decentralized finance protocols. Investors can earn interest on their stablecoins by participating in liquidity pools like Uniswap, by staking their coins to proof-of-stake ledgers, or by lending out their coins.

Stablecoins also offer exciting opportunities for the unbanked, especially those in less developed nations, to have access to financial systems with just an internet connection. Through stablecoins, anyone in the world can save or transact in coins pegged to more stable international currencies, avoiding the risk of local currency fluctuations devaluing their wealth. Organizations also use stablecoins to send funds directly to suppliers, peers, and aid recipients in these countries without potentially-corrupt or compromised financial intermediaries holding up funds.

The three types of stabloins in circulation are public reserve-backed, public algorithmic, and private institutional stablecoins.

Reserve-backed stablecoins are backed by cash deposits, treasury bills, or commercial paper, or a combination of the three. The most widely-used examples of these public stablecoins are Tether and USDC.

Algorithmic stablecoins are coins not backed by cash reserves but maintain their peg, or attempt to, through smart contracts or algorithms. The most prominent example is DAI, which uses a smart contract to ensure collateralization against different cryptocurrencies like Ethereum and USDC, to maintain its dollar peg. Another newsworthy, aforementioned algorithmic stablecoin is UST which maintained its peg algorithmically but wasn't collateralized, which experts like Ryan Clements, assistant professor at the University of Calgary Faculty of Law, argue caused its downfall.

Institutional stablecoins, or private stablecoins, are used by institutions for internal transactions, managing liquidity, and transacting between accounts within a private network. A key example of this stablecoin type is the JPM coin, which was created by JPMorgan for internal liquidity and same-day repo settlements.

The Terra Network’s UST differed from eminent stablecoins like USDC, Tether, and DAI, because of how it kept its dollar peg through a smart contract algorithm without collateralization. Instead UST maintained its dollar peg through arbitrage.

According to Fortune, “for every UST token minted, the equivalent of $1 in Luna was destroyed—and vice versa. Whenever the price of UST dropped below $1, traders were encouraged to burn UST for Luna, which would decrease the supply of UST and theoretically push its price up to equilibrium. Whenever UST was valued at more than $1, traders could take advantage of the price difference to mint UST and burn Luna, which would increase the supply of UST and push the price back down to $1.”

UST lost its peg after its founders suddenly removed $150 million in liquidity from the ecosystem, prompting major investors to dump hundreds of millions of UST and regular investors to  sell off LUNA en masse, further crippling prices.

UST isn’t the first algorithmic stablecoin to lose its peg and death spiral. Iron Finance suffered a similar fate in June 2021 after its TITAN token became overvalued. Interestingly Coindesk found that Basis Cash, a stablecoin that reached $174 million in peak total value locked (TVL) despite never achieving a dollar peg, shared a co-founder with UST. It’s believed that the co-founder, Do Kwon, treated Basis Cash as a pilot program for the Terra Network.

Non-collateralized algorithmic stablecoins’ string of failures seems to show that collateralization is needed for long-term stability and success.

Given the failure of non-collateralized stablecoins, it’s worthwhile to consider if the king of algorithmic stablecoins, DAI, may meet a similar fate to UST.

As mentioned, the key difference between DAI and other algorithmic stablecoins like UST is its over-collateralization using coins like USDC and Ethereum. In order to get DAI, individuals must deposit $150 worth of Ethereum coin to receive $100 of DAI. If the value of their collateral drops, they must add more collateral or have their position liquidated.

As Bloomberg notes, DAI’s overcollateralization has enabled it to survive a number of crypto bear markets and seemingly placed it on far better footing than UST.

The largest stablecoins by market capitalization are Tether and USDC. Both are maintained by centralized organizations who back their coins with reserves, made up of cash, treasuries, or commercial paper.

USDC’s reserves are in cash and short-dated U.S. treasuries and are attested monthly by Grant Thornton, a leading American accounting firm.

Tether, meanwhile, relies on a number of assets to back its coins 1-to-1 including with commercial paper (short-term, unsecured debt issued by companies). Tether has not yet produced audits for its reserves so less information is available about the make-up of this stablecoin’s backing.

In mid-May, Tether’s stablecoin slipped below its intended $1 peg over UST, sparking concern about its stability. Despite this slippage and lack of disclosure, Tether is still the leading stablecoin by market capitalization and has thrived since its 2014 launch, through numerous crypto bear markets.

Tether would enjoy even higher public confidence if it were to disclose audits and reduced holdings of potentially risky commercial paper as reserves.

While uncollateralized, algorithmic stablecoins like UST will likely pop up in the future, many investors will be more wary to put their funds into stablecoin projects without cash reserves, even if they’re promised unsustainable yield on investment, as UST did.

In light of the UST meltdown, potential stablecoin users may look to reserve-backed stablecoins like USDC which provide ample evidence of their reserves with audits or attestations by outside agencies. And for potential users who favor algorithmic stablecoin systems, collateralized stablecoins with track records of success like DAI may provide more long-term stability.

The stablecoin space offers much promise from price stability to quick, borderless transactions but until regulators step in, investors and users should practice prudence when choosing coins to convert their dollars into. Cryptocurrency insiders should also use their influence to promote sustainable practices and call out potential risk, especially when considering how gimmicks like high yield on stablecoins can be enticing to unsophisticated investors.

Outside of public stablecoins, institutional stablecoins will likely continue to grow in utilization and hopefully will lead to more convenience and efficiency in financial management.

While painful, industry slip-ups like the Terra meltdown will help weed out unsustainably structured stablecoins and direct the industry towards a more transparent, stable future.