The collapse of Terra (UST) sent shockwaves through the crypto market this week. UST is a high-profile stablecoin that reached a marketcap of $18bn before collapsing 50% within days. LUNA, a cryptocurrency linked to UST and whose mechanism we will explore, collapsed by over 90% within 5 days.
While UST is referred to as a stablecoin, it has nothing in common with collateralized stablecoins like Tether USD₮. UST is an algorithmic stablecoin.
Why is Tether USD₮ More Reliable?
Given the recent losses UST investors suffered, many users may be questioning if they can trust Tether USD₮ given the spectacular collapse of UST.
Thankfully, all one needs to do is look at the history and track record of Tether USD₮.
Tether USD₮ has been relied on as the primary form of dollar-based liquidity in the crypto market for many years and the crypto market has not been without its share of dramatic crashes!
In order to understand the stability of USD₮, it's essential to know the difference between the market pricing of USD₮ on exchanges and the redemption facilities which are always available via Tether.
Since 2015, Tether has never failed to process a redemption request for USD₮ at a value of $1 per USD₮ token. On the open market, USD₮ has almost never deviated from that price as well, although there are a handful of short-lived instances where it did deviate on exchanges like Binance.
When this occurs, it doesn’t mean USD₮ is no longer backed by 1-to-1 with reserves, or that USD₮ peg is lost, or that Tether redemptions are being processed at less than $1 per USD₮. It simply shows that selling pressure on exchanges has exceeded the limited liquidity on that exchange.
Any given exchange will not have enough liquidity on its books to process the exchange of every USD₮ token for dollars. In instances where exchange liquidity is too low, investors come to Tether to request a redemption which is exactly what happened in May.
On May 11th and 12th the price of USD₮ deviated from its typical price of $1 on few exchanges. This caused investors to purchase USD₮ on those exchanges for a discount and then redeem those USD₮ tokens with Tether on a 1-to-1 basis.
Since May 11th Tether successfully processed $7bln of USD₮ redemptions for verified individuals. Every redemption request which was submitted was redeemed in full. The USD₮ peg was respected 1-to-1 with USD. The size of this redemption, managed flawlessly, shows that USD₮ is by far, the most robust stablecoin in the industry. Tether engages in constant risk-management and stress-test scenarios, ensuring it always has at hand, a liquid portfolio of assets to manage redemptions, even in a bank-run scenario.
How Does an Algorithmic Stablecoin Work?
Unlike collateralized stablecoins where each coin is fully backed by collateral, algorithmic stablecoins attempt to maintain their value via various market operations that have frequently failed dramatically. Compared to Tether USD₮, which is always fully backed by reserves, algorithmic stablecoins are highly vulnerable to market volatility.
While different algorithmic stablecoins use different mechanisms to try to achieve price stability, they commonly use some sort of supply adjustment where coins are created or destroyed.
Terra UST used a swap function between UST and LUNA to stabilize the value of UST at $1 for a time.
Terra had an on-chain swap where 1 UST could be exchanged for $1 of LUNA regardless of the price of either asset. Therefore, if the value of UST fell below $1, users were incentivized to swap the UST for LUNA. Additionally, when UST rose above $1 users could swap LUNA for UST where each dollar of LUNA minted 1 UST. During this process, a portion of the LUNA was burned and the remainder was sent to a corporate treasury.
Terra then used this LUNA to incentivize people to create and issue UST by paying out 20% interest on any UST deposited into a protocol they created called Anchor. They also used it to stabilize the price of UST when the peg came under pressure.
The interest that was paid by Anchor was the main incentive that drove the growth of UST as users minted it to earn interest. However, it quickly became known that the only way that Terra was able to pay 20% was by subsidizing the interest with funds from the corporate treasury.
This meant that unless the price of LUNA kept increasing, and users kept minting more and more UST, Terra would be unable to sustain the interest payments which drove users to use UST in the first place.
As soon as the LUNA price started falling, and especially once the marketcap of LUNA fell below the marketcap of UST, the price of both assets started collapsing quickly as LUNA was sold to try to maintain the peg of UST.
Can Algorithmic Stablecoins Work?
The track record of algorithmic stablecoins isn't good. While UST is the most high-profile collapse in recent memory, there are many algorithmic stablecoins that have suffered similar collapses.
These coins have not gone unnoticed, and the University of Calgary published a study in 2021 which demonstrated that these coins are inherently fragile and vulnerable.
“Built to Fail: The Inherent Fragility of Algorithmic Stablecoins” argues that algorithmic stablecoins rely on a consistent minimum level of demand for the coin, independent actors who are incentivized to stabilize the price, and reliable price information at all times without interruption.
As none of these variables are certain and typically deteriorate when prices start falling, the history of algorithmic stablecoins is one of failure and collapse.
Tether believes that the only viable stablecoin model is a fully collateralized stablecoin. Algorithmic stablecoins have a long history of spectacular collapses which have devastated investors and destroyed tremendous capital.
They also damage the overall reputation of the cryptocurrency sector. While the appeal for a decentralized stablecoin is high, history shows that designs for decentralized stablecoins either result in centralization (they end up backed by collateralized stablecoins) or result in abject failure (algorithmic stablecoin collapse).
Tether is proud to uphold its role as a primary provider of dollar-based liquidity to cryptocurrency markets which is always fully collateralized via Tether reserves.
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