Why some are more likely to fail than others

Stablecoins have been in the news lately. In this article, Diego Vera of Buda.com explains the different types of stablecoins and why some are more likely to fail than others.

In May, we saw the collapse of the Terra Protocol. It included the LUNA and UST cryptocurrencies. The collapse has heavily impacted the cryptocurrency ecosystem.

Afterwards, the issue of stablecoins or stablecoins was again in the foreground. How secure are stablecoins really?

Before answering this question, let’s take a quick look at what happened to UST, the Terra stablecoin.

Why did the UST collapse?

In this year’s April 1 newsletter, we told you how Terraform Labs, the controlling firm of the UST stablecoin and LUNA cryptocurrency, was spending $100 million a day on Bitcoin (BTC) purchases. They argued that they “support the UST in the event of selling pressure that could decouple the stablecoin from the dollar.”

The company managed to purchase a total of 80,000 BTC (about $2.3 billion at current prices) for this purpose. So the plan didn’t work?

Terra’s main attraction was the Anchor Protocol, a set of instructions programmed into the blockchain that offered a 20% annual return on the UST stablecoin for leaving your coins there. This 20% was funded by the creation (old fashioned “printing”) of new LUNA tokens. The LUNA tokens were in turn also responsible for maintaining the parity of the UST with the dollar using an algorithm. These types of stablecoins are called “algorithmic stablecoins”.

An algorithm is a sequence of logical steps to perform a specific function. In this case, these are algorithms created to maintain cryptocurrency paritydollar.

Stable coins: not so stable

With the price drop in the crypto market occurring in the first weekend of May, LUNA lost around 50% of its value in just 1 day. This caused UST to lose parity with the dollar (since LUNA supports UST). People started withdrawing their UST from the protocol, and that weekend $7 billion was withdrawn.

The algorithm, trying to prevent UST from continuing to lose value, started printing more LUNA, artificially, and injecting it as a “return” into this stablecoin. By doing this (increasing the supply of LUNA without increasing the demand), the token strongly devalued, thus also UST.

This is called “the stablecoin’s algorithmic death spiral.” UST is not the first to experience this. Well-known failed algorithmic stablecoins include IRON, ESD, ZAI, and several others.

What about Terra’s 80,000 BTC? The company said that “they used almost all of these to try to keep the UST afloat.” This is without positive results.

Stablecoins have been in the news lately.  Here's why some are more likely to fail than others.

Why aren’t all stablecoins the same?

We have already encountered algorithmic stablecoins, but what are the others?

There are 2 main categories of stablecoins:

• algorithmic

• asset backed

Stablecoins: asset-backed – centralized

These types of stablecoins, or stablecoins, are backed on a 1:1 basis with dollars or low-volatility short-term assets of equivalent value. In other words, for every coin minted, there is $1 in a backup bank account.

Very similar to how national currencies used to be, where banknotes were backed by gold. In these stablecoins, the tokens are backed by banknotes (although since the 1970s domestic banknotes have ceased to be backed by gold).

USDC or USDT, the two largest stablecoins in the ecosystem, fall into this category. Both are issued by centralized entities (Center in the case of USDC and Tether in the case of USDT).

USDC is the most transparent, audited and regulated stablecoin (which is why we chose it on Buda.com). It is also the fastest growing, most likely for the same reasons.

The issuing company publishes monthly accounting reports on the reserves and their respective support, produced by the New York firm Grant Thornton.

In the case of USDT, the issuing company, Tether, assures that its reserves are 100% guaranteed, although it has had problems with the law in the past, where even the Attorney General of New York has accused them. to “cover massive financial losses”.

It should be noted that Tether publishes accounting reports every three months, in which it assures that its backing is indeed 1:1.

In recent weeks, and after what happened with UST, USDT’s market capitalization fell by 13%, losing $10 billion, while USDC’s increased by 10%, i.e. the equivalent of $5 billion. This revealed the value that users place on transparency in these types of assets.

Stablecoins: asset-backed – decentralized

These types of stablecoins are backed by other cryptocurrencies, such as Bitcoin or Ether. The collateral used for its issuance is greater than 1:1. Thus, they manage to maintain the value of the currency in the event of a sharp drop in the market.

The best-known case is DAI, whose creator protocol is the decentralized enterprise ManufacturerDAO.

Anyone can use this protocol, without the need for private intervention.

How it works? Its logic is similar to the credits supported by Buddha.com Bitcoin, but in a decentralized way.

First, to mint DAI, you need to use a dApp (decentralized application). You must have a wallet that allows you to connect to it, such as MetaMask. Let’s say someone wants to receive 2,500 DAI (equivalent to 2,500 USD).

For this you must leave locked in the protocol, at least, $3,750 (150% guarantee).

But what if the price of ETH drops against the dollar? The collateral (ETH) will be instantly liquidated by the dApp’s smart contract, and the person will only keep the DAI.

On the contrary, if the price of ETH increases, you will be able to exchange the DAI for the ETH collateral that you previously left locked in the protocol. The difference is that this ETH is now worth more in USD.

To reduce the risk of instant liquidation in the event of a drop in the price of ETH, the user can, for example, enter $5,000 instead of $3,750. In this case, the collateralization would be 200% and the room for downward movement of the price of ETH, before the liquidation occurs, will be greater.

DAI encryption

Attention

Decentralized protocols carry a high risk of losing all or part of your investment, even when you fully understand how they work.

It is essential that if you are considering participating in a project, you do your own research on the risks involved, so that your experience in the world of crypto is as positive as possible.

About the Author

Diego Vera is Head of Communications at Buda.com. It aims to spread the Bitcoin philosophy and looks forward to the communicational transformation we are experiencing. He learns a little more about the world of cryptography every day.

Got something to say about stablecoins or something else? Write to us or join the discussion in our Telegram channel. You can also find us on tik Tok, FacebookWhere Twitter.

Disclaimer

All information contained on our website is published in good faith and for general information purposes only. Any action the reader takes on the information found on our website is strictly at their own risk.

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