Stablecoins were developed to protect investors from the volatility of cryptocurrencies. These coins are typically pegged 1:1 to a fiat currency like the US dollar to ensure price stability. There are also different types of stablecoins, each using different techniques to maintain their peg to the currency they track.
There has been a lot of talk about algorithmic stablecoins in the past week. Algorithmic stablecoins, an amalgamation of technology, mathematics, and monetary economics, represented everything the modern DeFi world stands for i.e. experimentation, innovation, efficiency, etc.
However, all that changed after the crash of TerraUSD (UST), the largest algorithmic stablecoin by market cap. After briefly losing its peg to the US dollar, UST started falling wildly and is currently trading at $0.12, according to data from CoinMarketCap. The crash also sent the entire Terra ecosystem into a massive downward spiral, raising doubts about the effectiveness of algorithmic stablecoins and their future in the cryptocurrency industry.
But what are algorithmic stablecoins and how do they differ from their counterparts? Let’s find out!
What are algorithmic stablecoins and how do they differ?
Most stablecoins maintain a 1:1 pairing with the currency they track through a collateralized mechanism. The stablecoins in circulation are backed by cash or other assets to support the valuation of the stablecoins. For example, Tether (USDT), the largest stablecoin by market cap, is backed by off-chain assets such as cash (USD) and cash-like bonds held at a bank or other centralized entity.
However, it is not always possible to follow this approach as the protocols need to keep increasing their safety stock as circulation of the stablecoin increases. This is where algorithmic stablecoins come into play.
Algorithmic stablecoins work a little differently. They typically have no collateral and instead use complex algorithms to maintain their peg to the fiat currency they track. These algorithms can also stimulate and manipulate investor behavior to stabilize the price of the coin around the peg.
Types of algorithmic stablecoins and how they work
There are two types of algorithmic stablecoins – rebase and seignorage. Rebase stablecoins manipulate a stablecoin’s supply to maintain its pegging to fiat currencies. The protocol mints (adds) or burns (removes) coins in line with the stablecoin’s price movement to keep its valuation stable. If the price of the stablecoins falls below $1, the coins are withdrawn from circulation and vice versa.
Seigniorage stablecoins work similarly. However, they also combine the stablecoin with other cryptocurrencies to have more control over their valuation. Besides a mint-and-burn mechanism, the protocol also incentivizes market participants to buy/sell the paired cryptocurrencies in order to maintain the stablecoin’s price.
TerraUSD is a prime example of a seigniorage stablecoin. It uses Terra’s native cryptocurrency, LUNA, to maintain its valuation against the USD. However, this innovative approach to pegging also led to its downfall.
What happened to the algorithmic stablecoin TerraUSD?
The LUNA-UST pair works fairly straightforward. Users can exchange 1 UST for 1 $ Luna and vice versa. When $1 of LUNA is exchanged for 1 UST, LUNA is burned and UST is minted. It is vice versa when 1 UST is exchanged for 1 $ LUNA. This works well when UST’s valuation is stable and in line with the US dollar.
However, when the price of UST falls, market participants can start trading it for LUNA for a quick profit. In doing so, the circulating supply of LUNA skyrockets, causing the price to drop. For example, if UST falls to $0.5, users can buy 20 UST for $10. They can then exchange their 20 UST for $20 LUNA and sell them on the open market, resulting in a quick 100 percent profit.
This happened to the Terra ecosystem. On May 8, 2022, a whale dropped nearly $193 million worth of UST. This led to a short de-peg that saw UST slip to $0.98. While UST was showing signs of recovering from de-fixation, fear and panic had already set in, leading to a massive LUNA sell-off.
LUNA has fallen from $87 on May 5 to $0.00018 at the time of writing. UST has also failed to regain its peg and is currently at $0.14.
The future of algorithmic stablecoins
So far, algorithmic stablecoins have been used extensively in liquidity pools and speculative arbitrage trading. However, with the recent crash of Terra, the future looks bleak. Additionally, regulations could hit these stablecoins hard, with lawmakers keeping a close eye on developments in the industry.
In fact, the Terra case has already been introduced by US Treasury Secretary Janet Yellen in a hearing calling for stablecoin legislation. During the hearing, Yellen pointed out that UST is a “growing product and rapidly growing risks”. She added that “it is important, even urgent” for Congress to pass stablecoin legislation by the end of this year.
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