The Stablecoin Ecosystem: Terra Collapse and Questions for the Future

If you are part of the crypto community, there’s no way to avoid hearing about the recent collapse of Luna and the UST stablecoin.

In early May, Terra (LUNA) lost 99.99% of its value in a week, dropping from $87.15 to below $0.01. The associated stablecoin UST also fell in price by more than 60% in 3 days. On May 26, the asset was trading for $0.036.

So why did Terra collapse? According to analysts, the collapse is related to UST not being pegged to the dollar. The asset is pegged to the underlying fiat currency (the USD) price. But unlike other stablecoins, UST has no fiat backing. Only an algorithm and another native network token, LUNA, are used to maintain the price.

The spill of LUNA’s UST token stunned the entire crypto market but not Joshua Scigala, the Co-Founder of TheStandard.io. Scigala was talking about the potential of Terra and other pure algorithmic stablecoins to fail catastrophically as far back as 2019 at Labitconf.

Throughout May, we saw increased volatility across all stablecoins.
On May 12, USDT fell to $0.95 and DAI dropped to $0.99 and then rose to $1.01. The situation is already under the supervision of the U.S. Securities and Exchange Commission. It looks into the Terra incident and suggests enacting legislation to regulate the stablecoin market.

The collapse of LUNA and UST significantly undermined investor confidence in stablecoins. At the moment, investors are looking for the most reliable stablecoins to save their money. This article will help you understand what types of stablecoins exist and which are most likely to survive the crypto winter.

Types of stablecoins

There are several types of stablecoins, each with its own list of benefits and drawbacks.

Fiat-backed stablecoins

Here you use euros, dollars, or other fiat currency to purchase stablecoins, which you can later exchange for your original currency. Unlike other cryptocurrencies that fluctuate significantly, fiat-backed stablecoins tend to have tiny price fluctuations. But that doesn’t mean that stablecoins are a completely safe bet. They’re still relatively new with a limited track record and unknown risks and should be invested in with caution.

Here, the most typical example is the Tether (USDT) stablecoin. One of the most famous and reliable stablecoins on the market. Each Tether token has a corresponding $1 collateral deposited in its account. While some concerns were raised regarding the company’s accounting practices, the price of the token remains stable within a deviation of $0.05.

The big drawback for these 1:1 fiat-backed stablecoins is that they are extremely centralized and could easily be taken down in multiple scenarios. The other issue is that in jurisdictions like the EU, there are negative interest fees — if a fiat-backed stablecoin issuer is holding billions of euros in bank accounts, then the company would be paying higher interest amounts, effectively breaking the business model.

Another issue with these fiat-backed stablecoins is that if the banks that are holding the currency suddenly became insolvent as we saw in 2018, the crypto market would be crippled if a major stablecoin got taken down due to a legacy financial system collapse. Remember that bank accounts are generally only insured up to 250K in the US through the FDIC and 100K in Europe through the EDIS.

Crypto-collateralized stablecoins

Other crypto assets back these stables. Because the reserve asset can be volatile, crypto-backed stablecoins are over-collateralized to provide the value of the stablecoin. For instance, a $1 stablecoin can be pegged to a $2.5 underlying crypto asset. If the underlying cryptocurrency loses value, the stablecoin has a built-in airbag to keep it at $1.

These assets are less stable than fiat-backed stablecoins. Thus it’s a good idea to watch how the underlying crypto asset behind your stablecoin is performing. One of the most prominent crypto-backed stablecoins is DAI, as it’s pegged to the U.S. dollar and runs on the Ethereum blockchain. DAI uses a collateralized debt position (CDP) via MakerDAO to secure assets as collateral on the blockchain. TheStandard.io is taking some of these aspects and building them into its protocol.

Commodity-backed

These cryptos use commodities like gold, real estate, or oil to maintain their value. The stablecoins are always centralized, which some crypto communities may see as a disadvantage. Still, this centralization also protects the coins from cryptocurrency volatility. TheStandard.io is also using some of these mechanisms to back the protocol. Vaultoro was the first crypto commodities exchange in the world and shares co-founders with TheStandard.io DeFi protocol.

Some investors have always considered gold a hedge against stock market fluctuations. Gold-backed stablecoins allow investors to invest in precious metals without the hassle of transporting and storing them.

Tether Gold (XAUT) and Paxos Gold (PAXG) are two of the most popular gold-backed stablecoins. Vaultoro is about to release theirs, which will plug into TheStandard.io Stablecoin Protocol.

Algorithmic stablecoins

They are not backed by any asset, making them the most challenging stablecoin to trust, especially after the UST collapsed.

These stablecoins use a computer algorithm to ensure that their coin’s value does not fluctuate too much. Suppose the price of an algorithmic stablecoin is pegged at $1, but the stablecoin rises higher. In that case, the algorithm will automatically release more tokens into supply to lower the price. If it falls below $1, it will cut the supply to raise the price. The number of tokens on the market will change, but they will still reflect the overall stake.

Terra’s notorious UST is an example of an algorithmic stablecoin that was supposed to be equipped to handle demand shocks but failed. While there are a number of problems with pure algo stablecoins, one of the major problems is that attackers already know how algorithms will react to certain events. This means an outsider can plan and execute an attack with a cumulative feedback loop until total destruction.

This type of attack works like an army marching in unison across a bridge and the resonance frequency of the soldiers stopping creates a cumulative feedback loop that is said to bring down bridges. This is why arm’s break stride by inserting a double step into their march when crossing bridges. This breaks up the resonance. The same could happen to pure algo stablecoins where an attacker pulls and pushes liquidity in and out of the system to amplify how the algorithm reacts.

CeFi vs. decentralized vs. algorithmic stablecoin operation models

Depending on the type of governance, there are two main types of stablecoins: centralized and decentralized.

Centralized stablecoins are backed by fiat currency in a bank account that functions as a reserve to support the tokens on the blockchain. They typically require a certain level of trust in the custodian. However, they are increasingly providing greater transparency through Chainlink Proof of Reserve solutions. The team behind Vaultoro and TheStandard.io invented one of the easiest proof of reserve mechanisms back in 2014 known as “The Glass Books Protocol” and there are other more complex systems described by Peter Todd and Gregory Maxwell.

Alternatively, decentralized stablecoins are typically over-collateralized with cryptocurrencies on the blockchain and require price data to maintain total collateral. For example, user collateral can be worth more than 150% of the total loan value.

By design, decentralized stablecoins are more resilient and transparent as no single party controls them, and anyone on the blockchain can audit the protocol’s security.

And then, there are algorithmic stablecoins that are not fully backed by reserves. In other words, if there are 1 billion coins worth $1 each in circulation, then only $0.5 billion of these coins can be backed by reserves from cryptocurrencies or other assets.

At the same time, the price is supported by unique mechanisms used by the stablecoin developer, such as seigniorage, rebalancing, or backing with a native coin. The active element of these mechanisms is the users, who are stimulated to take specific market actions.

The issuance, circulation, and burning of algorithmic stablecoins are decentralized. That is, they are available to everyone through interaction with smart contracts. Partial collateral can increase the efficiency of investing in such stablecoins and allows the ecosystem to scale faster as the number of holders grows.

Decentralization makes it impossible to block algorithmic stablecoins on users’ wallets. At the same time, the issuing company can block centralized stablecoins stored in user wallets, which has happened in the industry multiple times in the past.

Disadvantages of centralized and non-asset backed stablecoins

The problem with centralization is probably the most significant drawback associated with stablecoins and the one that is entirely against the general ethos of blockchain technology.

Transactions are entirely transparent and immutable on public blockchains. As a result, they are not controlled and cannot be changed by any party. Unfortunately, this is not the case for most stablecoins.

Often, a single entity owns and manages the stablecoin with off-chain transactions and trades. For example, USDT, the most widely traded stablecoin on the market, is controlled by a company called Tether.

Tether behaves just like any other profit-maximizing company — in its interests. Tether regulates both the USDT pool and its distribution rate. The company is not accountable to third parties for how it chooses to drive market stockpiles. This lack of decentralization creates obvious risks for anyone holding USDT, as a crash in Tether for any reason also means a crash of USDT.

As a result, we saw the full experience of the systemic risks of algorithmic stablecoins when UST lost its peg to the U.S. dollar, which led to the project’s collapse.

The history of the development of algorithmic stablecoins has shown that all systemic risks inherent in the DeFi industry are also relevant to them:

• hackers can use errors and vulnerabilities in smart contracts that ensure the emission and binding of a stablecoin to steal reserves
• possibility of price manipulations in case of erroneous oracle operations
• information attacks on q stablecoin to provoke panic sales and price manipulations

As a result of a crisis, a stablecoin can lose its peg. This can lead to:

• an avalanche-like sale or native coin that supports its price
• mass liquidations among holders of margin positions
• a panic withdrawal of capital by investors

Wrapping up

The most pressing question is whether the Terra collapse signals an end to the experiment of algorithmic stablecoins. And while it may not be over yet, the market will see an “all-proof” version of algorithmic stablecoins which will protect the algorithm from speculative attacks.

Today, there is still a massive demand for a decentralized asset-backed stablecoin. This type of stablecoin can protect the market from the principal risks and lack of transparency.

Decentralization will help protect stablecoins from manipulations on the owner’s side. The support of classical monetary and crypto assets will save stablecoin from market exploits and attacks as they unfold according to the laws of game theory.

TheStandard.io is engineered to deliver the best concepts of Crypto-collateralized, Commodity-backed, and protocol-controlled value-based stablecoins and roll them into the ultimate decentralized stablecoin solution.

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