Different types of stablecoins and how they keep a peg

The market cap of stablecoins surpassed $100billion in 2021, and USDT has become the 3rd largest cryptocurrency by market cap. Their ability to offer the stability of a fiat currency and the borderlessness, trustlessness, and security of a cryptocurrency has given them a lot of utility and thus has led to massive adoption by both crypto enthusiasts and even those less acquainted. They are a favored tool to transfer value between markets, and hold a lot of utility in the remittances sector as well.

With the recent event of project Terra’s LUNA token crashing amidst a de-pegging of their stablecoin UST, we figured you might be looking for more information on just how a stablecoin maintains its peg, what it means to be pegged to something, and how a stablecoin might lose its peg.

Different types of stablecoins

When we talk about maintaining a peg, we have to consider the different types of stablecoins and how they function. Here, we’ll cover collateralized stablecoins and algorithmic stablecoins. So, we’ll talk about what distinguishes them, and how they maintain price stability.

Collateralized stablecoins

Collateralized stablecoins are backed by fiat money or crypto held in reserves. For example, USDT is backed by dollar reserves held by Tether, the project that issue’s USDT. In Tether’s case, as with other collateralized stablecoins, the reserves are meant so that users can redeem the crypto for USD.

We can delineate further by mentioning that there are crypto-collateralized, fiat-collateralized and commodity-collateralized stablecoins:

Fiat-collateralized stablecoins- As mentioned above, an example of a fiat-backed stablecoin would be USDT. For every USDT in circulation, there is a corresponding dollar held in reserves. Unlike crypto-backed coins, reserves are held off-chain, in a central reserve. This, of course, has brought about discourse over the decentralization, or lack thereof, of USDT due to the fact that a centralized institution holds the reserves responsible for this type of stablecoin’s price stability.

The way the system here works is that users deposit US dollars into Tether’s bank account in exchange for an equal amount of USDT. So, the amount in circulation is equal to the amount in reserves.

In short, USDT maintains its peg simply because every token has a corresponding dollar held by a central institution.

Crypto-collateralized stablecoins- An example of a crypto-collateralized stablecoin is MakerDAO’s DAI coin. Like USDT, DAI is created when users spend ETH to purchase an equivalent amount of DAI.

You might be wondering, “how does a crypto-backed stablecoin maintain its peg when the price of something like ETH is volatile”? DAI utilizes what’s called “overcollateralization”, which means that there is higher dollar value in ETH underlying the DAI token that it’s backing, so that if ETH fluctuates a certain amount, DAI can still maintain its peg.

Commodity-collateralized stablecoins- These types of stablecoins maintain their peg via being backed by physical assets. Projects like Paxos issue commodity-backed stablecoins like PAX Gold (PAXG). Because the assets the stablecoins are tied to are often stable and even rise in value, users can be assured that the coin is less vulnerable to depegging from its asset’s price, and could even benefit from the positive value change.

One advantage of commodity backing is that users can gain access to previously hard to attain asset classes. However, because holding a certain amount of, for instance, PAXG means that one would only hold a fraction of the underlying asset, it would prove hard to exchange that stablecoin for the gold it’s tied to, making it less liquid than something fiat-backed like USDT.

Algorithmic stablecoins

Algorithmic stablecoins, on the other hand, utilize algorithms defined in smart contracts to maintain their peg. These smart contracts regulate the supply and demand, and thus value, of the stablecoin. This is done through an exchange mechanism between the stablecoin and another cryptocurrency.

There is also a monetary incentive for token holders to help the coin maintain its peg. Say that a project’s stablecoin goes above $1 because of high demand. Traders can exchange 1USD worth of the project’s associated cryptocurrency to get over 1USD worth of that stablecoin. So, 1USD of the non-stablecoin is burned, and the supply and demand is kept in check while traders make money through arbitrage.

Terra’s UST is one such algorithmic stablecoin. So, let us go into a bit more detail about how an algorithmic stablecoin might lose its peg.

How an algorithmic stablecoin loses a peg

So, an algorithmic stablecoin, as said previously, maintains a peg via a smart contract regulating supply and demand. Terra’s stablecoin, UST, utilizes a mint and burn mechanism where users can exchange an amount of LUNA, the project’s governance token, for a dollar amount of UST or vice versa to maintain its stability.

So what happened to cause it to depeg, or deviate from a $1 value? Well, according to a report by CoinDesk, high amounts of UST were withdrawn from various sources. This sudden volatility caused the stablecoin to depeg. And because of the high volumes of withdrawal, the algorithm failed to keep up and restore UST’s peg.

Why did Terra’s LUNA crash?

It is worth mentioning that not only did UST depeg twice in a couple of days, the second depegging was sustained, and the stablecoin had fallen to $0.50 on May 11 according to a tweet by Terra co-founder Do Kwan.

And because UST significantly and sustainedly depegged, investor confidence in the project has understandably been thoroughly shaken, leading to massive selloffs of LUNA, driving its price to nearly $0.