Recently, the crypto community was shaken by the dramatic fall of TerraUSD and LUNA. Since then, countless speculations have arisen as to why the once-dominant stablecoin fell from grace.
In light of these recent shock waves, this article will take the opportunity to go back to the basics and explain:
- What is a stablecoin?
- What are the different types of stablecoins?
- Why are some stablecoins more stable than others?
- Examine the potential causes for UST’s failure
- Explain what differentiates AstridDAO’s stablecoin: $BAI
What is a stablecoin?
A stablecoin is a cryptocurrency whose value is pegged to another asset, usually the U.S. dollar. For example, a stablecoin pegged to the U.S. dollar is presumably worth $1.
Stablecoins are essential in the “DeFi” (decentralized finance) ecosystem because they power most crypto trading volumes today and enable investors to quickly get in and out of the dollar without needing a bank to approve transactions. As of this publication, USD stablecoins represent at least $180 billion of total market value.
One might be forgiven for thinking that all stablecoins are the same. After all, stablecoins all strive for the same objective: stability.
While it is true that stablecoins look the same on the surface, nothing could be further from the truth. Although, as in the case of USD-pegged stablecoins, the (desired) result is for the stablecoin to be worth $1, the mechanisms by which such stablecoins achieve this 1:1 price parity are as diverse as the number of stablecoins themselves. And as we saw with UST’s catastrophic fall from grace, the desired result is far from guaranteed.
What are the different types of stablecoins?
Broadly speaking, stablecoins use either a collateral mechanism or an algorithmic mechanism to achieve price stability.
Note: Depending on the context, collateral can be viewed from different perspectives. At the macro level, collateral is simply the collection of assets that back the value of the stablecoin. At the micro-level, collateral refers to the assets that an individual borrower must provide to take out a loan, these assets act as a security for the debt.
In terms of collateral mechanisms, there are three primary asset classes that back stablecoins, namely, fiat (i.e., US Dollar), crypto (i.e., Bitcoin), or commodity (i.e., Gold).
The fourth is not collateral per se but rather algorithmic.
What follows is a deeper look at each mechanism.
Collateralized stablecoins
The most popular stablecoins are backed 1:1 by fiat currency. Because the underlying collateral isn’t another cryptocurrency, this type of stablecoin is considered an off-chain asset.
Fiat collateral remains in reserve with a central issuer or financial institution and must remain proportional to the number of stablecoin tokens in circulation.
For example: If an issuer has $10 million of fiat currency, it can only distribute 10 million stablecoins, each worth one dollar.
Other stablecoins use other cryptocurrencies as a means to collateralize their debt. Such is the case for AstridDAO. Because cryptocurrencies carry more price fluctuations, the minimum collateral ratio tends to be higher.
In function, however, collateral-backed stablecoins, whether they are backed by fiat currency or cryptocurrency make use of the same hard and soft peg mechanisms to achieve price stability.
Algorithmic stablecoin
Algorithmic stablecoins, as the name implies, use algorithms and smart contracts rather than collateral to manage the supply of tokens in circulation. To do so, coins are either burned or minted to keep the coin value in line with the target price. For UST, that’s where LUNA comes in.
LUNA backs UST. When UST’s price is too high (>$1), the protocol incentivizes users to burn (destroy) LUNA and mint (make) UST. When UST’s price is too low (<$1), the protocol incentivizes users to burn (destroy) UST and mint (make) LUNA.
Why are some stablecoins more stable than others?
Since UST and LUNA crashed, the crypto community has been asking itself:
What was the cause of the crash?
How could it have been prevented?
What makes some stablecoins more stable than others?
Answers to some of these questions have already begun to surface. However, one important conclusion can already be inferred:
Algorithmic stablecoins are inherently less stable than fully-backed and collateralized stablecoins.
In the case of UST, it is an algorithmically-programmed stablecoin, meaning there’s no collateral backing it.
The arbitrage mechanism bears 100% of the weight to support the peg. If it fails, the entire system fails.
Todd Phillips, a former FDIC lawyer who is now the director of financial regulation and corporate governance at the Center for American Progress, put it succinctly:
“The assets underlying traditional stablecoins have other purposes. With the algorithmic stablecoin, Luna, the other token associated with Terra, its whole reason for existing is to maintain the Terra peg.”
Collateralized stablecoins, by contrast, are more stable because they are backed by assets that serve different purposes. As a result, they are more resilient to market volatility and can, by and large, withstand runs.
Why did UST fail?
To answer that question, we must first answer how UST works.
When the price of UST falls below $1, traders can burn UST — removing it from circulation — and raise the price back up. They are awarded the equivalent dollar in LUNA for doing so. But when the price of UST goes above $1, traders can burn LUNA and earn an equal amount in UST.
The critical issue is that the entire system depends on the demand for LUNA. Therefore, if and when the market for LUNA collapses, the system as a whole tumbles. Without a deep and liquid order book for LUNA, the peg cannot be maintained because the arbitrage mechanism ceases to function.
Although in retrospect, we can see the inherent risks in such a system, it nevertheless worked until last week when the price dropped below $1 and then snowballed further, igniting a mass sell-off, plunging the price of UST to $.13 as of this publication. LUNA, the linked cryptocurrency, fell from $116 in early April down to $.000188.
What makes AstridDAO’s stablecoin, BAI, different?
To best explain what makes AstridDAO’s stablecoin, BAI, separate from the rest, we must examine the context under which it operates.
AstridDAO is a decentralized money market that enables borrowers to borrow $BAI, a fully backed USD stablecoin at 0%. Borrowers must keep a minimum collateral ratio to avoid being liquidated by a stability pool.
This instant liquidation mechanism is what permits BAI to remain stable.
Five key features differentiate BAI from other stablecoins.
- Overcollateralization = more stability. AstridDAO takes a conservative approach regarding its reserves and is, in fact, overcollateralized. This means that the value of its collateralized assets exceeds the value of outstanding BAI at any given time.
- High capital efficiency = more leverage & more liquidity. AstridDAO’s efficient liquidation mechanism allows users to get the most liquidity for their favorite crypto assets and maximize their leverage exposure.
- Native stablecoin = high APY. AstridDAO closely collaborates with other DeFi protocols in the Astar/Polkadot ecosystem to provide optimized yield strategies and higher APY.
- XCM bridge = Polkadot ecosystem exposure. As a DeFi protocol in the Astar/Polkadot ecosystem, AstridDAO will soon reap the benefits of the XCM bridge, which will permit it to interoperate with the entire Polkadot ecosystem and other parachains.
- DAO governance = more flexibility & decentralization. On-chain governance can adjust protocol parameters (e.g., liquidation ratio), add collateral assets, and improve proposals via veATID tokens.
Below are some of the critical features of AstridDAO examined more in-depth.
Instant liquidation
What makes such high capital efficiency possible is the instant liquidation mechanism.
Unlike MakersDAO, AstridDAO does not use an auction mechanism when liquidating under collateralized vaults.
Both borrowers and stability providers benefit from instant liquidation.
For borrowers, instant liquidation is the basis for the high capital efficiency that permits them to borrow up to 90.9% of their collateral. So, for example, if a borrower has $100 worth of Bitcoin, he can borrow up to $90.9 BAI.
This represents 11x leverage.
Stability providers also benefit from the high capital efficiency associated with instant liquidation. Instant liquidation gives them an incentive to maintain their assets in the stability pool.
Instant liquidation occurs when vaults that fall below the minimum collateral ratio get liquidated (or closed). Then, the debt of the vault is canceled and absorbed by the stability pool, and its collateral is distributed among stability providers.
To ensure that the entire stablecoin supply remains fully backed by collateral, vaults that fall under the minimum collateral ratio (e.g., 130% for ASTR) will be closed (aka. liquidated).
The vault owner still keeps the total amount of BAI borrowed but loses approximately ~(minimum collateral ratio — 100%) value overall; hence it is critical to always stay above the minimum collateral ratio, ideally by above 30% or 40% of the minimum collateral ratio.
How does BAI follow the price of USD?
Borrowers can redeem BAI for their collateral assets at face value (i.e., 1 BAI for $1 of the collateral asset). That, along with the ability to liquidate under-collateralized accounts, jointly creates a price floor and ceiling (respectively) through arbitrage opportunities. We call these “hard peg mechanisms” since they are based on natural supply and demand processes.
To see more clearly how this works, let’s look at two scenarios.
Scenario 1: Investors believe that the price of $ASTR will go up.
- The demand for BAI goes up. If investors believe that the price of $ASTR will go up, they will be incentivized to borrow BAI because users can borrow BAI at 0% interest. Investors will use $ASTR as collateral to borrow BAI. If $ASTR goes up in price, they will be able to borrow more BAI to buy more $ASTR, thus maximizing their returns.
- The shift in the BAI demand curve leads to an increase in BAI quantity and price. The rise in demand for BAI will cause the demand curve to shift to the right, causing an increase in BAI in the market. The net result will be an increase in BAI quantity and price. In other words, the price of BAI will be above equilibrium (i.e., >$1).
- BAI borrowers sell their BAI to pay back their loans and make a profit. Seeing the opportunity to make money off BAI trading at above $1, BAI borrowers will arbitrage this market disequilibrium. They will sell off their BAI to pay back their loan and cash in their profit. The resulting sell-off of BAI will shift the BAI demand curve left back to the $1 equilibrium.
Under this scenario, the market dynamics between asset prices and collateral ratios create a price ceiling for the price of BAI.
Scenario 2: Investors believe that the price of $ASTR will go down.
- The demand for BAI goes down. If investors holding BAI believe that the price of $ASTR will go down, they will be incentivized to sell $ASTR to avoid losses. To sell their $ASTR, investors will need to recuperate the $ASTR used as collateral for borrowing BAI. And to do so, investors would have to first pay back the BAI they have borrowed. The deleveraging process (i.e., paying back their BAI) will cause a decrease in demand for BAI.
- The shift in the BAI demand curve leads to a decrease in BAI quantity and price. The reduction in demand for BAI will shift the demand curve to the left, causing a decline in BAI in the market. The net result will be a decrease in BAI quantity and BAI price. In other words, the price of BAI will be below equilibrium (i.e., <$1).
- Investors borrow or purchase BAI to make a profit. Seeing the opportunity to make money off BAI trading at below $1, investors will be incentivized to borrow BAI and then resell it to make a profit once it reaches $1. The borrowing of BAI will shift the BAI demand curve back to the $1 equilibrium.
Under this scenario, investors’ ability to redeem their collateral assets at face value, causing a decrease in demand for BAI, creates a price floor for the price of BAI.
BAI also benefits from less direct mechanisms for USD parity called “soft peg mechanisms.” One of these mechanisms is parity as a Schelling point. Since AstridDAO treats BAI as equal to USD, parity between the two is an implied equilibrium state of the protocol.
Another of these mechanisms is the borrowing fee on new debts. As redemptions increase (implying BAI is below $1), so does the baseRate, making borrowing less attractive, keeping new BAI from hitting the market, and driving the price below $1.
Stability Pool
The Stability Pool is the first line of defense in maintaining system solvency. It achieves that by acting as the source of liquidity to repay debt from liquidated vaults — ensuring that the total BAI supply always remains backed.
When any vault is liquidated, an amount of BAI corresponding to the remaining debt of the vault is burned from the stability pool’s balance to repay its debt. The entire collateral from the vault is transferred to the stability pool.
The stability pool is funded by users transferring BAI (stability providers). Over time stability providers lose a pro-rata share of their BAI deposits while gaining a pro-rata share of the liquidated collateral. However, because vaults are likely to be liquidated at just below the minimum collateral ratios, it is expected that stability providers will receive a greater dollar value of collateral relative to the debt they pay off. They can then opt to immediately cash out and take the profit.
Conclusion
Considering all of these factors, we can see that a different type of stablecoin is emerging amid this bear market. Although ostensibly elegant, algorithmic stablecoins carry undue risk and are all but built on a house of cards. Fully-back collateral stablecoins, by contrast, are more resilient to market shocks and can provide stability and liquidity in volatile markets.
About AstridDAO
AstridDAO is a decentralized money market protocol and multi-collateral stablecoin built on Astar and the Polkadot ecosystem, allowing you to borrow $BAI, a stablecoin hard-pegged to USD against risk assets at 0% interest and minimum collateral ratio. This mechanism enables you to leverage the value in your risk assets, including $ASTR, $BTC, $ETH, and $DOT without selling them.
