How is StableUnit different from UST?
Imagine worrying about your stablecoins not being stable. This is exactly what UST holders experienced when the stablecoin’s value slid to $ 0.75 before briefly recovering. In the next days, UST’s value dropped further away from the $1 mark to reach $0.045 at its low.
Stablecoins are not a new concept and come in different shapes and forms, but, UST was quite a unique case study since it grew rapidly in popularity. UST surged in popularity because of Anchor, Terra’s flagship protocol, which offered a 20% yield for their stablecoin. This article doesn’t aim to cover the technicals of UST and Luna but it aims to simplify the situation for an easier global understanding.
The Luna downfall is a particular case because UST was the first algorithmic stablecoin to achieve such adoption. It was the only algorithmic stablecoin among the top five stablecoins by market capitalization.
While its popularity isn’t our topic, it raised interesting questions, especially about its design. In this article we will cover the design of UST, its limitations and the differentiation between algorithmic stablecoins and over-collateralized stablecoins such as Stable Unit Money ($SUM) or Dai.
Algorithmic stablecoins, the dual token model.
To understand the limitations of algorithmic stablecoins, it is important to understand their functioning. UST and Luna had a pretty simple general functioning, users can burn one UST for one dollar worth of Luna and vice-versa.
When UST is trading above $1, arbitrageurs can burn one dollar worth of LUNA to mint 1 UST and sell UST on the open market for a profit. When UST trades below $1, then arbitrageurs can buy UST on the market at a discount, and swap it for $1 worth of LUNA.
In a market where asset prices are on the rise, this design is quite successful as users who minted UST when Luna was cheaper are getting less Luna for their UST (causing at the same time less dilution in the supply). Luna holders are also compelled to stay in the system as they can exit Luna for UST and deposit that UST on Anchor for additional returns. To put it simply, when markets go up, less people want to exit the system making UST able to sustain its $1 value.
On the other hand, in a declining market, users may want to exit the system for fiat or other assets, this is when the dual token model hits some limitations. While UST’s supply isn’t designed to be correlated with market conditions, Luna is a volatile asset. With Luna’s price dropping, users who minted UST and who are now trying to exit the system, are also able to mint more Luna (diluting the supply at the same time).
The limitations of the UST/Luna algorithmic model
This combination of the Luna dilution from the UST holders who exit and the selling pressure from Luna holders leads to what we call the death spiral.
The death spiral is described as follows
By minting Luna with their UST, users can get 1$ worth of Luna considering the existing supply. Yet this operation dilutes the supply making the users effectively getting less than 1$ worth of Luna.
But what does it mean for the users and holders of the UST stablecoin ? UST holders, even before the depeg events, were in fact, holding an undercollateralized or barely collateralized stablecoin, and, the collateral backing the stablecoin is a volatile asset (Luna in this case).
With the price of this collateral going down and users exiting UST, new Luna was minted in an enormous quantity making the price go even lower pushing Luna holders to sell, and, the cycle is repeated until Luna has no value at all. This leads to a stablecoin with a value-less token backing it.
The Luna Foundation Guard understood this risk and aimed to mitigate it by diversifying the UST backing with 80,394 Bitcoins and 1,97 million Avax. Yet, it wasn’t enough to keep the peg.
While UST and other algorithmic stablecoins may offer higher yields, their holders also take a higher risk since there isn’t enough collateral for everybody to exit.
To be algorithmic or to be over-collateralized ?
Stable Unit Money or Dai are stablecoins that are categorized as “over-collateralized” stablecoins. In short, over-collateralized stablecoins are stablecoins which have a backing higher than the currency they aim to reach parity with.
DAI for example aims to achieve parity with the US dollar. On the secondary market 1 DAI is currently exchanged for $1. Yet, to be able to mint DAI, users have to deposit their virtual assets such as BTC, ETH, MATIC, etc. and borrow DAI against it. The amount deposited have to be higher than the amount of DAI minted. To redeem the assets, users have to deposit back the amount of DAI they generated and other interests and fees. This process can be compared to a mortgage where you “lock” your ownership rights for a bank loan. By repaying the loan and the interest, your ownership rights are “freed”.
In case of the collateral’s value dropping, liquidators come into play to bid for the assets in the vaults using DAI in an auction where the highest bid wins.
When the value of the collateral backing Dai drops below the liquidation level, then the stability of the system is at risk. The system stabilizer module sets up incentives for Keepers (incentivized external actors) to step in, push the system back to a safe state, and earn profits (Kenton & al., 2020).
DAI’s system is what we call the collateralized debt position (CDP) model and it uses an auction based liquidation mechanism. The following image explains in more details how the DAI liquidations work.
This is how DAI is able to maintain its value and what makes it a well established stablecoin in the industry. DAI also has other lines of defense to keep its peg. There is also an emergency shutdown in case of any attack or in case of coordinated updates.As we can now understand, Overcollateralization and liquidation mechanisms are what mostly makes DAI a “stable” stablecoin.
Stable Unit stemmed from a fascination and a passion for what DAI has achieved through the collateralized debt position model but with the aim to create a fair stablecoin, for everyone, where every single user benefits from the protocol’s success, and, anyone can vote for the protocol’s future.
For Stable Unit Money (SUM), instead of using an auction-based liquidation system, the choice was given to a fixed-spread asynchronous liquidation system to maximize the protocol’s gains without compromising the liquidation speed. More research will be published regarding our liquidation system and mechanism. Nonetheless, to read more about Stable Unit’s liquidation mechanism, head to our first article about our liquidation system design here.
Another differentiator with DAI is that Stable Unit Money (SUM) aims to avoid the use of any centralized stablecoin such as USDC or USDT in order to stay fully decentralized. Furthermore, SUM also offers yield directly in your wallet. SUM holders don’t need to stake their stablecoins, they automatically get half of what the protocol makes, and, it is governed by a decentralized autonomous organization (DAO).
These are only the main principles behind Stable Unit, but Stable Unit is more than that and to learn more about it, follow us on Twitter and join us on discord or telegram.
