Stablecoins — your constant risk management

• Different types of stablecoins, how do they work?
• LUNA/UST situation
• Decentralization
• Useful tips

In the past week, everyone learned that markets could be very volatile. Usually, people escape from high volatility to “no-risk assets”, usually it’s the most popular store of value — dollars, in crypto it’s “crypto dollars” AKA stablecoins. Stablecoins are cryptocurrencies designed to hold a certain value relative to something else, for example, the US dollar. But what if you can’t even be sure that your stablecoin is actually “stable”? After the UST and LUNA collapse, many people were so scared about the reliability of their stablecoins that some of them were exchanging their USDT (the most popular stablecoin in the whole crypto) for USDC in a 10% loss.

Stablecoins are one of the most important parts of the entire crypto market. We have stablecoins in crypto for the same reason why we have US dollars in traditional finances. Ariadne protocol is and will be focused on stablecoins yield farming, that is why today we want to, learn more about different kinds of stablecoins, look in retrospect at the recent LUNA/UST disaster, and why decentralization really matters.

Different types of stablecoins

All stablecoins have the same purpose, they need to imitate other currency prices and remain “stable”. Today we are going to talk only about the most popular stablecoins — those which represent a dollar value. In order to remain at the same price of a represented asset (i.e. “maintain peg”), stablecoins need to be able to survive any sale pressure and keep the peg to the price of the underlying asset, to do that they need to be collateralized or backed by something valuable. There are different kinds of backing systems for stablecoins, here are the most popular ones:

• Stablecoins backed by securities, financial instruments, and commodities
• Stablecoins collateralized by fiat money
• Stablecoins backed by cryptocurrency
• Algorithmic stablecoins

All of those stablecoins can be separated into two groups: centralized and decentralized.

Let’s look at a few examples to explain how each of these types works.

Stablecoins backed by securities, financial instruments, and commodities

The first example is a fully centralized stablecoin backed by treasury bills, fiat money, and other financial instruments — USDT.

USDT is the stablecoin created by private company Tether it was launched in 2014 and is the most used stablecoin with a market capitalization of over $75 billion.

Tether USDT reserves

100% of USDT supply is backed by assets such as treasury bills, cash, commercial papers, etc. USDT coins are being minted when customers are buying them by paying equivalent in fiat money to the issuer, and USDT coins are getting burned when customers make a redemption by exchanging their tokens for dollars, to do that you need to be verified by Tether, this way you can always trade 1 USDT for $1 and vice versa.

Stablecoins collateralized by fiat money

The second example is a fully centralized stablecoin collateralized by US dollars.

The second biggest stablecoin USDC was created by Circle and Coinbase in September 2018. In order for 1 USDC token to be created someone needs to pay $1 to the issuer, this way just like USDT USDC coins is fully backed by real dollar equivalent. You can exchange your USDC coins for dollars or buy USDC by paying from your bank account at any time.

USDT and USDC are about reliability and convenience in exchange for privacy and centralization.

Stablecoins backed by cryptocurrency

The best example of such stablecoins is the decentralized stablecoin by MakerDAO — DAI.

DAI was launched in 2017, it’s №4 by market capitalization among all stablecoins and №1 among decentralized ones.

It’s important to understand that DAI is not hard-pegged to the US dollar, it maintains a free-floating peg that experiences extremely low volatility.

DAI coins are not getting created from the air, DAI tokens are being minted when the user borrows them against crypto collateral that is being locked in the MakerDAO vault, if the DAI borrower wants to get his collateral back he needs to return borrowed DAI tokens back in exchange for his collateral.

MakerDAO DAI collateral

As you can see DAi is more than 100% collateralized by crypto-only assets. DAI stablecoins are fully transparent and non-custodial. The dollar price peg is being achieved by smart-contracts minting/burning tokens and arbitration.

Algorithmic stablecoins

The most known algorithmic stablecoins are UST, FRAX, MIM, and USDD.

Unlike any other type of stablecoins algo stables by design are uncollateralized, they do not rely on the value of some kind of asset. Usually, algorithmic stablecoins work in pairs with another token, for example, UST and LUNA pair, FRAX/FXS, USDD/TRX, etc. To maintain the peg of algorithmic stablecoins math and incentives are being used, all stablecoins use different kinds of mechanisms but usually, it’s the incentivization of buyers/sellers’ behavior and manipulation of tokens supply by the algorithm in order to keep the price of the stablecoin as close to the price of the underlying asset as possible.

Example of Luna/UST

Even tho algorithmic stablecoins remain undercollateralized some of them are tending to build some kind of collateral or increase algorithm stability by integrating other backing mechanisms. A good example is the plans of the Luna Foundation Guard to build $10 billion in Bitcoin collateral for UST stablecoin. Or for example, FRAX is not just an algorithmic stablecoin, its supply is mainly crypto-collateralized. Around 80% of FRAX is backed by collateral like USDC, and another 20% is backed by an algorithm that manages FRX (Frax Share) supply.

What happened to UST and LUNA?

On May 8 UST stablecoin lost its $1 peg and at this moment 1 UST costs around $0.07. Everything started with massive selling of UST after withdrawals from Anchor protocol (DeFi protocol that offers 18.5% yield for UST) and imbalance of Curve 4pool which lead to even more sales pressure on UST. LFG (Luna Foundation Guard) voted to deploy $1.5 billion in Bitcoin in order to maintain the UST price peg, but the price of UST and LUNA kept going down. In order to keep the peg price new LUNA coins were minted and sold, which pushed the LUNA price down even more but didn’t help that much to maintain the UST price peg, the lower was the price of LUNA the more LUNA tokens were needed to be minted, LUNA became hyperinflationary and the price started to drop insanely fast, during two days LUNA lost almost 100% of its value and price of UST kept moving down.

The whole Terra blockchain ecosystem was built around UST and LUNA, UST reliability was based on the expectation of an ever-increasing flow of money of investors who were promised 20–18% APY on their stablecoins. The UST collateral was a risky LUNA minting/ burning scheme and planned reserves of $10 billion in Bitcoin only $3.5 bn of which were actually bought at that moment.

Stablecoin is undercollateralized by a high-volatile asset (Bitcoin/LUNA) with promised passive income for everyone… Does it sound like a Ponzi scheme to you? Technically, it wasn’t a financial pyramid, but the whole algorithm sustainability was very vulnerable to market movements and LUNA/BTC valuation. And the idea of collateralizing something that should be stable by highly volatile assets is in the first place pretty weird, especially in the bear market, so investors have to be extremely careful when holding their money in this kind of asset, especially if its the money they can’t afford to lose.

Importance of decentralized stablecoins in crypto

Crypto is not only about buying and selling coins on centralized exchanges. DeFi space is also developing very fast, and the need for decentralized versions of stablecoins is due to the need for the absence of all shortcomings of centralized ones. The idea of crypto, in general, is decentralization, transparency, availability, and absence of censorship, this is why it’s so important to have a convenient dollar-like asset that cannot be frozen by the issuer, all collateral is visible because all the funds are on the decentralized and transparent blockchain network, you don’t need to believe some private company words about the real backing of their stablecoin. Generally speaking: decentralized finances need decentralized stablecoins as a convenient store of value that cannot be controlled by anyone else except the user.

Сonclusion

• Always research what you investing in even if it’s a stablecoin, thousands of people were storing their life savings in UST thinking that it’s safe.
• We don’t recommend storing all of your “crypto dollars” in one stablecoin, it’s good to diversify your money between the most trusted ones. Also, think about diversifying your assets between different decentralized wallets and crypto exchanges.
• Many UST investors were buying it only because of the 18–20% yield on Anchor protocol, but you can almost always achieve these APY numbers by yield farming with the most trusted stablecoins like USDC/USDT/DAI/FRAX, etc. But don’t forget about the risks of DeFi protocols.
• Remember, there is never a “stable” % of income in crypto, it’s impossible to generate money out of the air, if you hear promises about consistent APR/APY% you need to think about where this money flow comes from and think twice about buying this asset.
• Remember!
  Always measure your risks and never invest more than you can afford to lose.

Ariadne

If you looking for an easy way to yield farm with stablecoins and earn rewards from protocol fees/incentives — we recommend you to visit our website and learn about Ariadne protocol: https://ariadne.finance/. By using the Ariadne app you will be able to save on transaction gas fees and easily enter/exit the different stablecoin farm pools on their native chains while staying on the blockchain of your choice. Always remember, that most of the time the greater APR/APY % — the greater are risks of the farm pool you want to farm in. Ariadne is focused on improving your DeFi experience by giving its users many different options of farm pools and assets that are appearing in them, for example, you can farm in the pool with USDC/USDT pair which is pretty safe to do but your APY% will be not that big, or you can choose to farm in the pool where one of the assets is USDD with all outcoming risks of this stablecoin but APY % will be probably much bigger than in the previous pool. If you have questions about how does Ariadne protocol works — please check out FAQ or you can always ask any questions in our telegram group.

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