Stablecoins

Crypto currencies aiming at stability

Stablecoins are cryptocurrencies that attempt to peg their market value to some external reference, typically the U.S. dollar.

They achieve their price stability via collateralization (backing) of fiat currencies or other cryptocurrencies.

Stablecoins have gained traction as they attempt to offer the best of both world's - the instant processing and security or privacy of payments of cryptocurrencies, and the volatility-free stable valuations of fiat currencies

Fiat-collateralized stablecoins

• fiat-collateralized stablecoins maintain a fiat currency reserve, like the U.S. dollar, as collateral to issue a suitable number of crypto coins

• such reserves are maintained by independent custodians and are regularly audited for adherence to the necessary compliance

• the most notable examples of fiat-collateralized stablecoins are Tether USD (USDT) and USD Coin (USDC).

Crypto-collateralized stablecoins

• crypto-collateralized stablecoins are backed by other cryptocurrencies

• since the reserve cryptocurrency may also be prone to high volatility, such stablecoins are over-collateralized, that is, a larger number of cryptocurrency tokens is maintained as reserve for issuing a lower number of stablecoins

• for example, $2,000 worth of Ether may be held as reserves for issuing $1,000 worth of crypto-backed stablecoins which accommodates for up to 50% of swings in reserve currency (ether)

• the most popular example of crypto-collateralized stablecoins MakerDAO's DAI, is pegged against the U.S. dollar and allows for using a basket of crypto-assets (including Ether and fiat-collateralized stablecoins) as a reserve

Algorithmic stablecoins

• algorithm-based stablecoins do not have any associated collateral

• the algorithm or the protocol is backing up these stablecoins works as the central bank

• it helps in increasing the supply (by minting new coins) when the stablecoin is above the peg or reducing the supply (by burning coins) when the stablecoin is below the peg

• the rules for such actions by the algorithm are available in smart contracts in an embedded form

• a popular example of algorithmic stablecoin was Terra USD (UST)

• unfortunately, the price of UST plunged more than 60% on May 11, 2022, vaporizing its peg to the U.S. dollar, as the price of the related Luna token used to peg Terra UST slumped more than 80% overnight, creating an academic death spiral example

The Terra/Luna economy

Luna is the variable counterweight to the Terra stablecoin and absorbs its volatility. To understand how Terra works, envision the entire Terra economy to consist of a Terra pool and a Luna pool, which are used to adjust the price via incentives for network participants.

Expansion (of the Terra Pool)

When Terra is trading at a price that is high relative to its peg, the implication is that demand for the stablecoin is higher than supply; this means that supply of Terra should be increased to match demand.

The protocol incentivizes users to mint Terra and burn Luna, which has the effect of lowering the Terra price (by increasing the supply) and increasing the Luna price (by reducing its supply). Users continue this arbitrage process until Terra trades at its target peg price.

Contraction (of the Terra Pool)

When Terra is trading at a price that is low relative to its peg, it implies that there is more supply for the stablecoin than demand. The network would need to reduce the supply of Terra until it matches the demand.

The protocol then incentivizes users to burn Terra and mint Luna, which has the effect of boosting the Terra price (by reducing supply) and lowering the Luna price (by increasing its supply). This arbitrage process is continued by users until Terra trades at its target price.