How Stablecoins Maintain the Price Stability
The cryptocurrency market has been in turmoil after the collapse of Terra’s algorithmic stablecoin (Ticker: UST). The collapse of UST not only raises concerns about algorithmic stablecoins, but shines the spotlight back onto stablecoin products as a whole. The financial industry has been fervently discussing the economic impact caused by algorithmic stablecoins and their ability to hold a stable value.
There are different types of stablecoins such as fiat-backed, commodity-backed (e.g. gold), and algorithmic. Algorithmic stablecoins carry the most risk of this group, as they rely on a computer program to balance their price relative to another asset (e.g. the U.S. dollar) utilizing various forms of collateral. The collateral, which is typically composed of various assets such as Bitcoin (BTC), Ethereum (ETH), or other tokens (e.g. the foundation’s native tokens, which in the case of UST, was the LUNA token), is usually held and managed by the organization or program that founded the algorithmic stablecoin.
What Went Wrong with UST?
In the case of Terra’s UST, which aimed to maintain a pegged balance through controlling supply-demand and spread arbitrage between tokens, failed because of its inability to maintain demand for one side of the arbitrage. The UST was pegged to LUNA, the native token of the Terra blockchain. To mint UST, users need to have LUNA tokens first and burn an equal amount of LUNA tokens to create UST. The system relied on market arbitrage between UST and LUNA to stabilize the price. Terra maintained the 1-to-1 peg between UST and the U.S. dollar by allowing for market participants to always redeem UST and LUNA at a 1-to-1 ratio, hence the opportunity for a guaranteed arbitrage gain. However, the demand for LUNA fell rapidly as investors looked to take off risk as macroeconomic conditions deteriorated. Once the lack of demand reached a critical mass, the arbitrage model imploded and the stability of UST collapsed.
This algorithmic arbitrage mechanism works in a well-functioning market. However, since the demand for LUNA collapsed, UST holders did not want to burn their UST holdings to obtain more LUNA. Instead, they sold UST on exchanges with more stable assets like the US dollar itself. Essentially, arbitrageurs, which maintained the UST-USD peg, were not willing to buy the other side (the LUNA tokens). This created a run on the algorithm. The value of LUNA is based on users’ trust in the Terra platform, however, once the supply-demand mechanism for LUNA and UST broke, the risk-reward for market arbitrageurs no longer provided the economic incentive. This led to the whole system crumbling eventually, which is what happened in the recent UST price volatility event.
Fiat-backed Stablecoins and Their 1:1 Redeemability
In contrast, fiat-backed stablecoins are redeemable with the underlying fiat currencies like the U.S. dollar or the Japanese yen. Users buy stablecoins in fiat currency and institutions issue stablecoins with the guarantee that the tokens are 1:1 backed by fiat or fiat equivalent collateral.
As 100% fiat-collateralized stablecoins, GYEN and ZUSD will only be issued when the corresponding collateralized fiat is confirmed in the fiat custody account. All the tokens are redeemable 1-to-1 with their underlying fiat currency, resulting in a peg.
To mint GYEN or ZUSD, a user deposits fiat currency into custody accounts, and an equal amount of tokens will be issued once the deposit is confirmed. The fiat deposit will be accounted for as a custodial liability to the token holder and will be in the custody of FDIC-insured U.S. banks. Conversely, when a user requests a redemption, the tokens are first sent to a customer-specific wallet address for burning, and then an equal amount of the underlying fiat currency will be transmitted to the user’s fiat custody account.
This mechanism ensures the amount of stablecoins issued will always be equal to the deposits held in our custody bank(s). All stablecoin holders have the security and comfort of knowing that our GYEN and ZUSD stablecoins, respectively backed 1-for-1 by the Japanese yen and U.S. dollar, have the stability of their respective fiat currencies, both of which can be redeemed on-demand with GMO Trust at a stable 1-for-1 ratio.
Which Elements are Integral to the Efficient Working of Trustworthy Fiat-backed Stablecoins?
Three major components that are essential for trustworthy fiat-backed stablecoins to perform consistently are –
Reserves — Offer Collateral Security
In the case of fiat-backed stablecoins, maintaining the price stability, which depends on market forces, is vital. Fiat-backed stablecoins must always be collateralized by secure assets, which will help preserve their stability.
Of the various reserve assets, fiat currency and/or fiat equivalent assets such as short-term treasury are the best choice. Usually, fiat-backed stablecoins are tied to U.S. dollar reserves. The presence of a strong reserve supports the price stability of stablecoins. The reserves offer the necessary collateral to the fiat-backed stablecoins.
Attestations — Ensures Greater Transparency
A fiat-backed stablecoin’s value depends on the currency reserves underpinning it. That said, there need to be regular attestations of the reserves by an independent, reputable auditor. The attestations by the auditor will instill confidence in the users that they can access the underlying collateral. Furthermore, the attestations enhance the transparency in the operations of the reserve and bolster the faith of the holders in the stablecoin system.
Regulations — Gains and Manages License
There is no doubt that regulated stablecoins are well-managed and trustworthy. The regulatory bodies ensure that the central entity issuing the fiat-backed stablecoins act according to the guidelines and norms. This, in turn, provides a sense of relief to the holders protected by the regulatory bodies. The smooth functioning and effective management of the fiat-backed stablecoins certainly depends on the working of these bodies.
While pursuing a more efficient and transparent process outside of traditional finance, stablecoins, as a medium of exchange, still need a transparent and stable mechanism to maintain the basic value of trust. Not only the type of reserves that backs a stablecoin but how it keeps the price stability and the level of security against its risk exposure, all of these will be indispensable elements for a stablecoin that provides actual value.
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DisclaimerThis content is not financial advice and it is not a recommendation to buy or sell any financial instruments, FX trading, cryptocurrency or engage in any trading or other activities. You must not rely on this content for any financial decisions. Acquiring, trading, and otherwise transacting with financial instruments or cryptocurrency involves significant risks.We strongly advise our readers to conduct their own independent research before engaging in any such activities.GMO Trust does not guarantee or imply that any cryptocurrency or activity described in this content is available or legal in any specific reader’s location. It is the reader’s responsibility to know the applicable laws in their country.