The UST Depegging. It is by far, the biggest story in crypto right now. As we are preparing this for you it says 20 cents. And it’s supposed to say $1. UST broke its peg and we will have more details about that in the coming days.
Therefore, this issue led us to an important question. Which stablecoin is the most resistant to depegging? And a similar and related question, which stablecoin is the ‘safest’ to park your money? So if you still need to be holding stablecoins in your portfolio as we do, then you will want to see what we have to say about these leading stablecoins.
I want you to carefully listen to this. This is a video from May 2020 when Nevin Freeman, the co-founder of Reserve Protocol, warned us about Algorithmic Stablecoins like UST. And it seems his prophecy was right!
Nevin Freeman (@nnevvinn) from Reserve (@reserveprotocol) talks about the dangers of algorithmic stablecoins like Terra and Celo at @laBITconf. $RSR $RSV pic.twitter.com/G37tyUMt7R
— Reserve El Lödgé (💸,💸) (🅡,🅡) (@ReserveCommmune) May 13, 2020
1) UST: The Cause of This Mess
UST is an algorithmic stablecoin on the Terra Luna network. And the algorithm manages the peg by minting or burning $1 of LUNA for UST or vice versa. We probably don’t need us to tell you about the amount of depeg that UST has gone through in this last week.
What happened is a huge sale of UST out in the marketplace. This reduced the price to under $1 temporarily, or so we thought. What’s supposed to happen next is first UST sells $1 of LUNA to mint $1 of UST. Then if something else happens, the Luna Foundation Guard had a reserve of both Bitcoin and Avalanche that they could sell to redeem $1 value in UST.
What happened is that the death spiral started as the value of all 4 assets (UST, LUNA, BTC, and AVAX) ALL declined in value together but especially LUNA. The mechanism says that you must mint LUNA when you burn UST so as we will show you in more detail below, supply skyrocketed while price tanked. Needless to say, it’s gone poorly for all parties involved. LUNA’s currently trading at less than 1 cent when it was over $100 just 2 weeks ago.
On the other hand, Terra is trying to accelerate the burn/mint mechanism through Prop 1164. And there will be a collateralization measure that the community votes on making UST a hybrid of algorithm and crypto collateralized. Needless to say, UST has done poorly. It’s the reason we are talking about this today.
1/ The prevailing peg pressure on $UST from its current supply overhang is rendering severe dilution of $LUNA.
The primary obstacle is expelling the bad debt from UST circulation at a clip fast enough for the system to restore the health of on-chain spreads.
— Terra (UST) 🌍 Powered by LUNA 🌕 (@terra_money) May 12, 2022
This massive UST-depegging has once again put stablecoins in a tough spot. Investors are frantically moving their funds from USDT to BUSD or some other coin. But guys calm down, take a breath and read this article until the end to clearly understand which is the safest and most reliable stablecoin.
How Stablecoins Peg to the USD
First, let’s review the types of stablecoins and how they peg their value to the dollar. The most common methods are:
By far the most common type of stablecoin is backed by fiat money. This means that if the issuer is running their coin honestly, 100% of their funds are in cash or what investors like to call cash equivalents like money market funds and instruments with total liquidity at any time.
We’ll get into this in a couple of minutes but the largest stablecoins right now are fiat-backed. By backing their coin 1:1 with fiat, they maintain their peg with the USD.
Problems of Fiat-Collateralized Stablecoins
The issue with this type of backing is based on 2 factors:
- There is a central issuer. Fiat backed coins are by definition centralized as someone needs to issue the coin and someone needs to track that the collateral is backing it 1:1
- We must trust that what they say and report about their 1:1 backing is true. USDT Tether in particular has an ongoing issue with this. Many believe they do not have the collateral to back their coins and they are running a fractional system as legacy banking does.
2. Commodity Collateral
The least common of the 4 ways to back a stablecoin is commodity-backed. The most popular of these coins is the PAXG, a gold-backed stablecoin issued by Paxos, owners of the itBit exchange in the US. And you can see PAXG is the #95 project with a market cap of $596 million. Its peg is not to the USD but the price of gold.
Paxos is a very important player in stablecoins as they are an issuer of 3 stablecoins, 2 of which are in the top 9. Like fiat-backed, commodity-backed stablecoins maintain the 1:1 with a long-term store of value or hard commodities like gold or silver.
The big advantage over fiat is that while gold and silver markets can be manipulated too, they are less likely to be and are manipulated for shorter periods than fiat currencies. They should maintain their value over time.
Problems of PAXG
Like any fiat-backed coin, there has to be an issuer and a way to account for the amount of commodity held to maintain the 1:1 relationship between the stablecoin and the commodity.
- Although some can and do provide proof of reserves, again lots of trust is required for these coins.
- They are not popular enough or liquid enough for the common uses of payments or in trading pairs on exchanges
3. Crypto Collateral
Next, we have stablecoins backed by crypto. Because we have a crypto that’s backed by crypto to price in dollars, you may have guessed that the way to collateralize with crypto is to OVERcollateralize. So this means that instead of 1:1 like with fiat backing, it might be 1.3 to 1 or 1.5 to 1.
Problems of Crypto-Collateralized Stablecoins
We have 2 big problems with crypto backed coins:
- There’s the added risk of crypto backing crypto
- All crypto-backed coins are not capital efficient. As we just mentioned, over-collateralization is necessary for a crypto-backed coin. So a coin could have $100 worth of ETH on deposit but only issue $60 worth of stablecoin. There are better ways for us and the system to use our capital.
Last we have algorithmic coins. These use an algorithm to manage the peg. It was an algorithmic stablecoin, UST, that started it all earlier this week.
The algorithm manages the peg in a smart contract usually by having a mint and burn mechanism. For example, Neutrino’s USDN has this mechanism with the WAVES token and Tron’s USDD has this mechanism with Tron. The Tron stablecoin just launched and they are already trying to back it with a reserve. USDD also already has depegged once.
Problems of Algorithm Stablecoins
The problems with this kind of stablecoins are the lack of collateral and the ‘death spiral’. The death spiral is where we have a vicious circle of many people all at once wanting to redeem their stable for the other coin pushing the value of both coins down.
This is what is happening with LUNA and UST. Many want to get out of their UST positions so burning it creates more LUNA and now LUNA is flooding the market and its value is declining too. And circulating supply by burning UST for LUNA has skyrocketed.
Again, we will have a deep dive into what’s happening with LUNA and UST in a couple of days when things start to stabilize.
What’s Going on With Stablecoins Now?
There is a total crisis of trust in stablecoins right now. Those of us who invest in crypto understand the risks when we buy a coin whether it’s a blue-chip, small gem, favorite game, or NFT project.
But we expect and want less risk when we hold funds in stablecoins. The effect of some stablecoins losing their peg to the USD and losing value is devastating to the whole industry.
Therefore, we will have an entire article soon on this UST mess so we will save most of the details for that. Except to say that UST losing its peg was the beginning of all this. This all started on Monday on what looks like a coordinated attack before the start of the new Curve 4pool.
$USDT is off peg on all exchanges.
Especially with the undermined confidence right now. pic.twitter.com/hrwNC7fzyw
— Harry (@CryptoHarry_) May 12, 2022
What’s happened since then? Well, Tether briefly lost its peg on Thursday morning Asia time, too. At this time, it’s back to 99 cents, which is almost back on the peg. These are 2 of the 5 biggest stablecoins. Much more volume goes through these 5 which are:
Than any other stablecoins in the market. These 5 are $159 billion out of the $170 billion markets We are going to talk about these 5 and #6 Frax in more detail. But before we do that, it’s important to understand that EVERY stablecoin has depegged and one time or another.
Moreover, as you can see from this chart from Cryptorank, every coin has gone below 98 cents at one time. Some of these lows are as low as 57 cents for USDT and 89 cents for USDC.
📣 $UST reached an all-time low of $0.67. Although stablecoins are pegged to $1, their value can change due to market conditions or reserve volatility. For instance, $USDN once traded at $2.52 and $USDT traded at $0.57 shortly after launch.
👉 https://t.co/eZCeLUNjze pic.twitter.com/kJJXR6iYkX
— CryptoRank Platform (@CryptoRank_io) May 10, 2022
And they’ve depegged on the upside too. Four of the top 5 have had a price of $1.15 or higher at one time or another. So sometimes this happens just due to market sentiment.
The 3 Fiat Coin Kings: USDT, USDC, and BUSD
About 60% of the total stablecoin volume on any given day is just in USDT and USDC. Today it’s $51 billion of $75.5 billion, respectively. The two together are pretty dominant. But they are reacting differently to the current market conditions.
There have been some long-running stories like this one from 2018. And some say it’s FUD, others that Tether does not have the collateral and runs a fractional system. That is contributing to the overall lack of trust environment and why they depegged this week.
As we said earlier, all fiat-backed coins including these 3 have a central issuer. So why are they reacting differently? Why are USDC and BUSD trading at ~$1.02 while USDT depegged? Again it’s trust. But this time through regulation.
USDT does not do regular audits although many industries and government entities have requested it from them. This helps continue the lack of collateral story. But the other two, USDC and BUSD are both US regulated. Their issuers are Circle for USDC and the afore-mentioned Paxos for BUSD that Binance uses as its stablecoin on its exchange.
Moreover, Circle and Paxos follow US regulations with regular court filings and audits showing their proof of reserves. And although they are a centralized issuer, they are seeing rewards from this compliance with increased trust from the crypto investing public that the assets are there.
So right now, we have:
- USDT-down depeg
- USDC- up
- BUSD- up
DAI: The Hybrid Stablecoin
DAI from MakerDAO is a mix of crypto-backed and algorithmic. This stablecoin started as algorithmic-only where deposits into the Maker vault would create new DAI in a decentralized way.
But then it went the crypto-backed route too. DAI, which is really what used to be called Multi-Collateral DAI is 80% backed by:
- USDC 38%
- ETH 24%
- Wrapped BTC 10%
- USDP (another Paxos stablecoin called the Pax Dollar #9 rank) 7.9%
The remaining 20% is from very small added sources. So that means DAI has added benefits and drawbacks to 2 pegging mechanisms.
The Drawbacks of DAI
First, it’s no longer decentralized as it’s dependent on USDC and ETH for 72% of its collateral backing. Second, it’s WAY WAY overcollateralized at 164%
The Benefits of DAI
First, it should be more stabilized than algorithmic alone coins and can avoid the ‘death spiral’ just by selling off collateral. Second, backing with crypto carries less risk when there’s an algorithm and smart contract involved in coin management.
Essentially one of each algorithmic and crypto-backed benefit helps to negate one of the other’s weaknesses to keep DAI strong. And while DAI is the weakest of the top 5 in terms of adoption, it’s holding up well and currently trading within peg at $1.01. So DAI is doing OK in this messy market.
FRAX: The Hybrid Stablecoin of the Future?
FRAX calls itself the first ‘fractional algorithmic stablecoin’, built by Frax Finance. According to its whitepaper, this is because it’s partly backed by the algorithm and partly by collateral. USDC to be exact. Today, FRAX is 87% backed by collateral and 26% backed by its algorithm. They use their coin FRAX Shares (FXS) to help manage the mint/burn mechanism of the algorithm.
Along with part USDC, FXS becomes the 2nd coin that you get when you redeem your FRAX. How much you get of each is based on the Collateral Ratio at the time of redemption and it varies. It’s a pretty smart setup and the coin has an almost $2 billion market cap.
Moreover, FRAX is also the 4th stablecoin (along with UST, USDC, and USDT) that are part of the Curve 4pool that started this whole chain of events. Therefore, by trying to use the best of the collateral and best of the algorithm features, they are holding up well in the current market. They spiked up as high as $1.05 early Thursday.
So FRAX, doing ok and maintaining its peg.
So this crazy chain of events in the last week is making people think about the stable part of stablecoins. How reliable are they? How well do they hold up against unusual one-time (black swan) events like a specific coordinated attack? Well, here’s our scorecard.
- Above Peg, Very Positive feeling: Here you have USDC and BUSD. They are leading in the trust category despite being centralized
- At Peg, Doing the Job: Here we have Frax and DAI our 2 hybrids. Their combo of best features of algorithms and collateral helps to increase their trust
- Slight Depeg, Neutral feeling to slightly negative: That’s USDT right now although we suspect this is only temporary
- Drastic Depeg, Existential Questions of whether it will be around 2 weeks from now: UST. While we do think UST can and will survive this, it will be a long, uphill battle for UST, LUNA, holders of both, and the LUNA ecosystem that needs these coins to operate.
We hope this is helping to explain some of what’s going on in the current marketplace.
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