Stablecoins have been on everyone’s lips lately. In this article, Diego Vera from Buda.com the different types of stablecoins and why some are more likely to fail than others.
In May, we all witnessed the collapse of the Terra Protocol. This also included the two cryptocurrencies LUNA and UST. The crash had a major impact on the entire crypto ecosystem.
In retrospect, there was again a specific question in relation to stablecoins or stable currencies: How Safe are Stablecoins Really?
Before we answer that question, let’s first take a quick look at what happened to Terra stablecoin UST in the first place.
Why did UST collapse?
In the April 1 newsletter this year, we told you that Terraform Labs spends $ 100 million a day buying Bitcoin (BTC). Terraform Labs is the company behind the cryptocurrency LUNA and the stack coin UST. The company claimed that Bitcoin reserves would “support UST in the event of selling pressure that could decouple stablecoin from the dollar.”
In total, the company bought 80,000 BTC (about $ 2.3 billion at the current price) for this purpose. So did the plan work?
The main attraction at Terra was the Anchor Protocol. The protocol is a set of instructions programmed into the blockchain, which offered a 20% annual return on stablecoin. These 20% were funded by creating new LUNA tokens. The LUNA token, in turn, was responsible for maintaining the parity of UST to the US dollar using an algorithm. This type of stablecoin is called “algorithmic stablecoin”.
An algorithm is a sequence of logical steps that make it possible to perform certain functions. In this case, the algorithms are designed to maintain cryptocurrency-dollar parity.
Stablecoins: Not so stable after all?
Due to the fall in the price of the crypto market on the first weekend in May, the LUNA price lost 50% in value in just one day. When LUNA supports UST, it lost its dollar bond. People eventually started pulling UST out of the log. $ 7 billion was raised in just one weekend.
To prevent UST from falling further in value, the algorithm artificially began generating more LUNA and feeding it to the stack coin like a hedge. By increasing the LUNA supply without an increase in demand, the token suffered a huge loss of value and with it UST.
It’s also called “the death spiral of algorithmic stablecoins“designated. UST is not the first stablecoin to fall into this spiral. Well-known stablecoins that have also failed include IRON, ESD, ZAI and many others.
And what happened to Terra’s 80,000 BTC? The company says that “they used almost all of them to keep UST afloat.” Unfortunately without success.
The different types of stack coins
You have already learned about algorithmic stack coins, but what other types of stack coins are there?
Stablecoins fall into two main categories:
Centralized asset-backed stablecoins
This type of stablecoin is linked 1: 1 to the US dollar or a short-term asset with low volatility of the same value. In other words: for every coin minted, a US dollar is deposited into a bank account as collateral.
The banknotes in national currencies used to be backed by gold. In these stable coins, tokens are backed by banknotes, although these have not been backed by gold since the 1970s.
USDC and UST, the two largest stack coins in the ecosystem, are among the centralized asset-backed stack coins. Both coins are issued by centralized companies. At USDC the company is behind the Center and at USDT it is the company Tether.
USDC is a very transparent, audited and regulated stablecoin. That’s why we at Buda.com have also decided to offer USDC. For these reasons, USDC is also believed to be the fastest growing stablecoin.
The companies publish monthly financial statements on reserves and respective support. These reports are requested by New York company Grant Thornton.
In the case of USDT, the Tether Company ensures that the reserves are 100% covered. There have been issues with the law in the past where Tether has been accused by the New York Attorney General’s office of “to cover large financial losses“.
Tether publishes financial reports every three months that ensure 1: 1 coverage.
In the last few weeks and after the UST incident, USDT’s market value fell by 13% and lost $ 10 billion in value. USDC, on the other hand, rose by 10%. That is a $ 5 billion increase in market value. This makes clear how important transparency is for users with this type of stablecoin.
Decentralized asset-backed stablecoins
This type of stablecoin is supported by other cryptocurrencies such as Bitcoin or Ethereum. The security used is not in the ratio 1: 1. As the hedge is higher, the value of the cryptocurrency can be maintained even in the event of a sharp market decline.
The best known example is DAI, the stack coin from the decentralized company MakerDAO. The protocol is open to all and easy to use.
How does it all work? The way it works is similar to Buda.com’s bitcoin-secured loans, only stablecoin works in a decentralized way.
First, you need a decentralized application (dApp) to mine DAI. For this you need a wallet, for example MetaMask, which you can connect with. Let’s say you want to buy 2,500 DAI, which is $ 2,500. To do this, lock at least $ 3,750 on the log, which is 150% of the actual value. You can deposit this amount in Ethereum.
But what happens when the ETH falls against the dollar? The security in the form of ETH is immediately liquidated by the dApp’s smart contract, and you only keep DAI. However, if the ETH price increases, you can switch the DAI to the ETH security locked on the protocol. The difference is that your ETH is now worth more in USD.
To avoid the risk of immediate liquidation if the ETH price falls, users can simply freeze a larger amount as collateral. For example, if you lock in $ 5,000 instead of $ 3,500, the security is 200% of the stablecoin value. As a result, the collateral is only liquidated in the event of a sharp downward movement in the ETH price.
Do your own research. Always.
Even if you understand exactly how the decentralized protocols work, there is still a high risk of losing all or part of your investment. It is therefore important that you before the investment independently inform yourself about the risks of the respective project, so that your experience will be as positive as possible.
About the author
Diego Vera is Head of Communications at Buda.com. His goal is to spread the Bitcoin philosophy, and he is happy with the communicative change that we are experiencing at the moment. Vera learns a little more about the crypto world every day.
All information contained on our website has been examined to the best of our knowledge and belief. The journalistic contributions are for general information purposes only. Any action taken by the reader based on the information on our website is entirely at your own risk.