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What is the best stablecoin type?

TerraUSD (UST) overturned BinanceUSD (BUSD) to third place in the market cap list and didn’t last long. The once mighty stablecoin that powers the entire Terra ecosystem is reduced to “Terra is more than UST” tweets. While no one knows for sure if LUNA can make a comeback, UST will surely go down as one of the algorithmic stablecoins that went bust in the same manner as Basis Cash — which Terra creator Do Kwon was rumored to have been a part of — and Mark Cuban . supported Iron Finance.

The failure of UST raises the question, are algorithmic stablecoins really doomed to fail? And is fiat-backed or crypto-backed stablecoin the only way investors can find the “most stable” way to protect themselves from crypto market volatility?

Pros and cons of different stablecoins

By now, most are familiar with the types of stablecoins such as fiat-backed stablecoins, crypto-collateralized stablecoins, and algorithmic stablecoins. There are other types of stablecoins like commodity-backed and seignorage, but the three above are the most popular.

Users have their reasons for choosing one type of stablecoin over another. For example, some prefer to use algo stablecoins due to their decentralized narrative. Others would opt for fiat-backed cryptocurrencies like Tether (USDT) and USD Coin (USDC), although they are centralized due to the private firms holding the appropriate fiat reserves for each token issued. However, one benefit of fiat-backed coins is that there is an actual asset backing the coin.

The stability of its peg will remain as long as there are demonstrable holdings of such fiat reserves. However, the most obvious risk here is a bank run scenario, which could be problematic for Tether considering it is largely exposed to commercial paper. Issued by large corporations, commercial paper is a type of unsecured debt instrument that can have a term of more than 270 days. A large number of redemptions can leave Tether insolvent, which is why it has slashed its commercial paper holdings over the past six months.

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Crypto-collateralized stablecoins like Dai (DAI), on the other hand, are backed by an oversupply of another cryptocurrency, in this case Ether (ETH). DAI requires a collateral ratio of at least 150%, which means that the dollar value of ETH deposited in a smart contract must be worth at least 1.5 times more than the borrowed DAI. For example, if a user wants to borrow $1,000 worth of DAI, they need to lock $1,500 worth of Ether. If the market price of Ether falls below the minimum collateral ratio, the collateral is automatically paid back into the smart contract to liquidate the position.

The VAT case

Of course, stablecoins are meant to keep their value at their level. However, what happened to UST was remarkably unprecedented, even threatening the collapse of the entire market. UST is a hybrid between an algo stablecoin and a crypto-collateralized stablecoin. When UST’s price moves above its dollar peg, users are incentivized to burn $1 worth of LUNA so UST can sell them for a profit. If UST falls below the peg, users can burn UST in exchange for a discounted LUNA. It has been crypto-backed since the Luna Foundation Guard acquired large amounts of Bitcoin (BTC) collateral as a contingency plan. As it turned out, this was ineffective, and the last few holdings of BTC and other assets were allocated to small farmers as compensation.

The collapse of Terra began with the large withdrawals of the Anchor protocol on May 8th. Millions of UST were pulled off the record and quickly sold, causing a downward spiral. What followed was even more panic. The algorithm eventually couldn’t react fast enough – by burning LUNA – to the rapid fall in value of UST.

In hindsight, the evidence was obvious as the primary demand for UST was inferred only from demand in Terra’s anchor log. UST’s low trading volume suggests that users are more interested in keeping it on the log than actually using it for trading.

DAI remains stable

Amid the panic, when Tether even briefly lost its peg to the US dollar, the DAI had actually remained relatively stable. At some point on May 9, USDT fell to around $0.994 while DAI surged to $1.001. DAI was even recently hailed as “the” true decentralized stablecoin.

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DAI has been around since 2017 and has survived many extreme conditions in the market, which no algo stablecoin has ever managed to do. Still, there can never be a lack of risk, especially in the crypto market.

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Fry Electronics Team

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