Innovative Crypto Stablecoins- Still At Infancy And Experiencing Growing Pains

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The recent tightening of monetary policy has triggered a massive downturn in many financial markets, including crypto assets. Loss of about $1 trillion in market capitalization in just one week. Triggered by extreme market volatility Terra ecosystem disruption, TeraUSD (Ust), one dollar-judged Stablecoin, and its sister token Luna Fallen and siphoned off, investors lost billions and other cryptocurrencies piled up in the rubble. This debacle debunks tall claims of an innovative crypto-financial ecosystem believed to be immune to traditional finance (TradeFi). Bank runs, Stablecoins, a breed of cryptocurrencies touted for their perceived stability, weakened during the week ending May 13, 2022, showing how things can go horribly wrong. The algorithmic stablecoin UST lost its dollar peg, collapsed, and wiped out nearly $50 billion in market cap. The collapse of the Terra ecosystem raises urgent questions about novel crypto assets and the robustness of the regulatory framework surrounding it.

What are stable coins?

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stable coins Digital currencies are pegged to a reference value to provide stable prices and purchasing power. These coins act as a medium of exchange on crypto exchanges and decentralized finance (DFI) Liquidity Pools, Most outstanding stablecoins are broadcast on public blockchains, such as Ethereum, Binance, polygon, etc., and are US dollar-pegged. However, they can also be linked to other fiat currenciesBaskets of currencies, other cryptocurrencies, or commodities such as gold.

custodial stable coins Trusts are required in a third party and are issued by intermediaries, who act as custodians of the reserve assets. These intermediaries offer 1-for-1 redemption of stablecoins for US dollars or other fiat currencies. Major US dollar-pegged custodial stablecoins Tether (USDT), Binance (BUSD), Circle (USDC)And TrueUSD (TUSD), These US dollar-pegged stablecoins are over collateral, and the peg is hedged through US dollar asset reserves, i.e. bank deposits, treasury bills, commercial paper, etc.

non-custodial stablecoins Replace trust with new economic systems. These stablecoins are backed by overcollateralized cryptocurrencies and/or smart contracts. Deposited legal assets are never held by any intermediary or third party. Defending fiat pegs to non-custodial stablecoins is accomplished by two mechanisms. The collateral system uses crypto-asset reserves to maintain the peg. The algorithmic mechanism uses financial engineering to protect the peg by buying or selling stablecoins against the respective governance crypto tokens. Examples of non-custodial algorithmic stablecoins include TeraUSD (UST), Magic Internet Money (MIM), Frax (Frax)And Neutrino-USD (USDN), MakerDAO (DAI) A non-custodial is an example of an overcollateralized stablecoin.

Why are stablecoins so popular?

Investors prefer to buy cryptocurrency assets such as bitcoin, ether and more in order to maintain stable pricing and purchasing power. Stablecoin deposits offer high yields Compared to those available on fiat deposits, making them an attractive income-generating asset class. Additionally, stablecoins are cryptographically secure, enabling peer-to-peer financial transactions that are settled near-instant and 24-hour-a-day / 7-day-week / 365-day-a-year markets allow.

Terra Ecosystem

The Terra Economy primarily consisted of two token pools: one for the stablecoin UST and the other for LUNA. The UST-dollar peg was maintained by buying or selling the UST against the LUNA. If UST rose above the peg, the protocol gave impetus and traders were expected to mint UST as needed and burn Luna until UST dropped to $1; Increased UST supply will put downward pressure on its price. If UST fell below the peg, the protocol gave impetus and expected traders to do the opposite; Burn UST and mint LUNA continuously until UST increases to $1; The reduction in UST supply will put upward pressure on its price.

UST can also be traded with other stable coins on various crypto-exchanges and DeFi liquidity pools, which contributes to the stability of the dollar peg.

anchor protocol

Terra was the Achilles heel of the ecosystem anchor Protocol – a savings, lending, and borrowing platform that promised a 20% annual percentage yield (APY) only on UST staking/deposit and not other stablecoins like Tether’s USDT, Circle’s USDC, or Maker’s DAI on coins. Anchor’s attractive yield, especially on the UST, created a frenzied demand, leading to a sharp increase in the number of USTs in circulation. Wrapped up as a dollar-like asset, UST was primarily bought and deposited into Anchor to earn a 20% yield. In November 2021, UST’s market cap was just $2.73 billion, reaching a peak of about $18 billion in May 2022. During the same time, Luna also double in price, Anchor was home to $14 billion, 75% of UST’s entire circulating supply of $18 billion.

Anchor’s 20% APY Greed – Creating A Ponzi Scheme?

Crypto Protocols Offer High Yields deposits generate income By further lending the accumulated assets and paying a part of the interest earned to the investors. However, Anchor Protocol was probably not generating enough income to pay the 20% APY payment as promised. Anchor Lending received only a 10% annual percentage rate (APR) on their extended loans. Anchor potentially generated additional income on the borrower’s down payment collateral, which likely contributed to reducing its payment obligations. Anchor also incentivizes borrowers by paying them 7% APY originally Anchor Protocol’s governance token (ANC) To borrow UST, to reduce its net inflow.

Anchor’s relationship with UST can be viewed as a simple mechanism to create demand for a fledgling stablecoin or as a hidden Ponzi scheme to lure money seeking yield. With a juicy 20% APY wrapper on assets marketed as a US dollar proxy, UST may have attracted even investors who generally avoid volatile crypto markets.

In February 2022, Do Kwon, the founder of TerraForm Labs (LINK) and the face of Terra, added $450 million in reserves Expressing concern to outsiders. Beginning in 2022, Do Kwon was also buying Bitcoins to increase reserves.

The payment outflow of 20% on UST share/deposit probably exceeded the accrued inflow on UST borrowings, creating systemic outflows and reserve deficit.

Terra Fall: Market Volatility, UST Size, APY Attraction of Anchor, and Algorithmic PEG

The collapse of the Terra ecosystem was catalyzed by a series of extreme volatility, the volatility of the crypto markets, the breakdown of the UST peg, and large withdrawals from Anchor. With large withdrawals, UST was being sold to trade for other stable coins (backed by traditional assets) through various DeFi liquidity pools.

When UST started to lose its peg and traders wanted to exit UST, they had two options.

1) Trade the UST-LUNA Burn Mint algorithm within the Terra ecosystem.

2) Trade discounted UST with alternative stablecoins (USDC, BUSD, ..etc) in DeFi’s Deep Liquidity Pool.

When UST dipped slightly below $0.02 during the week of May 9, 2022, traders began flipping UST for another stablecoin, i.e. Tether’s USDT or Circle’s USDC. Eventually, the specific liquidity pool that allowed these trades became imbalanced; It now has far more USTs than other stablecoins. To correct course, the pool began offering discounted UST to arbitrageurs in the hopes of doing the opposite trade to rebalance the pool, which was not happening. When the selling pressure on UST continued to mount, it lost its $1.00 peg and started falling uncontrollably. When traders were unwilling to buy them, UST and LUNA both went into a death spiral, lost confidence in the Terra ecosystem, and dried up UST liquidity in the DeFi pool. Once UST lost counterparty stablecoins to trade, it lost the pricing mechanism – leading to a market failure. Both UST and LUNA were delisted from all exchanges. Ironically, prior to the recession, UST was the third largest stablecoin by total market capitalization after only Tether and USD Coin.

The surprise crash of the Terra ecosystem, along with its stablecoin UST and sister token LUNA, resulted in the failure of the algorithmic stablecoin market to vaporize billions of dollars. The Terra LUNA/UST fallout was a wake-up call for everyone to recognize the risks inherent with each and every stable currency, and in some, much more than others. These developments also raise questions about the robustness and long-term viability of algorithmic stablecoins. Many fear that a crack in the one-to-one peg of US dollar-backed stablecoins could lead to cross-margin selloffs in other asset classes and could have serious repercussions for traditional financial markets and the crypto-sector. Following this bloodshed, regulators may decide to bring stablecoins within the ambit of electronic payments regulations in order to mitigate the systemic risks hidden from stablecoin markets. Michelle Triana, CEO mean fi states,”central bank digital currency (CBDC) backed USD can’t come fast enough to crypto. If someone wants to deposit their trust in the US dollar, the only entity they must rely on is the US Federal Reserve. To all those “a decentralized world needs a decentralized currency,” I say, yes, that’s what bitcoin is for.

Stable crypto assets are a much needed building block for bridging Tradefi and DeFi. Stablecoins are a new class of financial assets innovative in their field…

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