Exclusive: Was Terra’s UST disaster the canary in algorithmic stablecoin coal mines?

Last week was not easy. After the collapse of the second largest blockchain after the third largest stablecoin (UST) and Etherium (Terra), the depag contagion seems to be spreading further.

While the UST is completely detached from the US dollar, trading below $ 0.1 at the time of writing, other stablecoins have also experienced a short-term loss of their dollar peg due to market-wide panic.

Tether’s stablecoin USDT saw a brief depreciation from $ 1 to $ 0.95 in May. 12.

USDT / USD from last week May. 8-14 Source: CoinMarketCap

FRAX and FEI posted similar declines on May 12 at 0.97; While Abracadabra Money’s MIM and Liquidity’s LUSD decreased by $ 0.98.
FRAX, MIM, FEI and LUSD prices from May. 9 – 15. Source: CoinMarketCap

Although it is common for stablecoins to fluctuate in a very narrow range around 1 peg, these recent trading levels are only seen in extremely stressful market conditions. The question investors are now asking is: will the fear spread further and unpack another stablecoin?

Let’s take a look at the mechanics of some of the major stablecoins and how they are currently trading in the liquidity pool of Curve Finance.

The main purpose of stablecoins is to maintain stable values ​​and provide investors with a way to park their money when the volatility of other crypto assets is high.

Stable coins have two different processes – resource-supported and algorithm-based. Asset-backed stablecoins are the most common version and issuers claim to back up stablecoins with fiat currency or other cryptocurrencies. Algorithm-based Stablecoin, on the other hand, seeks to use algorithms to increase or decrease the supply of Stablecoin based on market demand.

With the exception of USDT, asset-backed stablecoins have become popular during the recession

USD Coin (USDC), Dai (DAI) and USDT are the most traded asset-backed stablecoins. Although these are parallel by Fiat reserves and cryptocurrencies, USDC and USDT are concentrated while DAI is decentralized.

USDC’s parallel reserves are held by US-controlled financial institutions, while USDT’s reserves are held by Teether Limited, which is regulated by BitFinex. In contrast, DAI does not use a central unit but uses the initial market lending rate to maintain its dollar peg, called the Target Rate Feedback Mechanism (TRFM).

DAI is destroyed when users borrow against their locked collateral and the loan is repaid. When the price of DAI is below $ 1, TRFM increases the rate of borrowing to reduce the supply of DAI because fewer people want to borrow, with the aim of returning the price of DAI to $ 1 (in contrast when DAI lies $ 1).

Although DAI’s pegging mechanism seems algorithmic, an additional parallelism of at least 150% makes it an elastic asset-backed stablecoin in volatile market conditions. This is comparable to the price action of the USDC, USDT and DAI last week where investors lost confidence in the USDT and rushed for a change as the USDC posted a significant increase on May 12 with the DAI.

USDT, USDC and DAI hourly rates. Source: CoinGecko API

Despite having a large market share in the stablecoin space, Tether’s USDT has long been controversial. It was previously fined by the U.S. government for misrepresenting the nature of the cash reserve. The USDT claims that Teether has cash or cash-for-return assets. However, a large portion of the reserves have turned into commercial paper – a form of short-term unsecured debt that is risky and not the “cash equivalent” of the US government.

The recent Terra Crisis and the lack of visibility in their stocks have given rise to new concerns about the USDT. Prices reacted violently with a brief depreciation from $ 1 to $ 0.95. Although the USDT price has recovered and briefly dropped to 1, concerns remain.

This is evident in the largest pool of liquidity in Curve Finance. Curve’s DAI / USDC / USDT 3 pool shows 13% -13% -74% share respectively.

Curve DAI / USDC / USDT 3 pool shares. Source: leelenahoo Tune Analysis

Under normal circumstances, all assets in a stablecoin liquidity pool are equal (or almost equal), since the value of three stablecoins is supposed to be about $ 1. But what the pools showed last week is an unbalanced ratio, where the USDT holds a much larger percentage. This suggests that the demand for USDT is much lower than the other two This could mean that the USDT needs more USDT units in the pool to maintain the same dollar value as the other two, suggesting a lower price for the USDT than the DAI and USDC.

Similar imbalances were observed in DAI / USDC / USDT / sUSD 4 pools. It is interesting to note that both sUSD and USDT rose proportionately during the May 12 fixed coin fear peak. But sUSD quickly bounced back to the same 25% share and has declined since then, while the USDT pool remains the top share.

Curve DAI / USDC / USDT / sUSD 4 pool shares. Source: leelenahoo Tune Analysis

The Curve 3pool has a daily trading volume of $ 395 million and a total locked value (TVL) of $ 1.4 billion. The trading volume of 4 pools is $ 17 million and one TVL is $ 65 million. Both pools show that the USDT is even less favorable.

Algorithmic stablecoins ready?

An algorithmic stablecoin is a different process than an asset-based stablecoin. It has no reserves; So it is unsafe. The bond is maintained by algorithmically minting and burning Stablecoin and its partner currencies based on market supply and demand.

Due to its insecure or less than 100% parallel nature, an algorithmic stablecoin is much more risky than an asset-backed stablecoin. The Terra-UST-Depeg defeat has certainly shaken investor confidence in algorithmic stabilcoins. It has manifested itself quite clearly in the Curve Liquidity Pool.

FRAX – an algorithmic stabilization coin of the FRAX protocol – is partly parallel and partly based on supply and demand algorithms. Although the currency is partially parallel, the parallel and algorithmic price ratios still depend on the market value of the FRAX.

In the recent perfect storm of stablecoin panic, the ratio of FRAX with the other three stablecoins increased to between 63% and 37%. Although the discrepancy has already been seen since the beginning of March 2022, the collapse of the UST has certainly raised fears of FRAX de-pegging.
Curve FRAX / 3CRV 3 pool shares. Source: leelenahoo Tune Analysis

There is a similar rise of fear caused by the Terra UST D-Peg event in the MIM-Abracadabra Money Algorithmic Stablecoin. The Curve MIM / 3CRV pool shows that MIM shares rose 90% – reaching the same level in January when the Wonderland scandal erupted.
Curve MIM / 3CRV 3 pool share. Source: leelenahoo Tune Analysis

Despite algorithmic similarities with DAI, MIM does not use ETH as a direct parallel, but instead uses Yarn Finance Interest-Bearing Token (ibTKN) – ywWETH. The added level of complexity makes it even more risky for catastrophic events like the UST Depag event.

The goal of all stablecoins is to maintain a stable value. But all of them are experiencing instability and many of them have deviated from the $ 1 peg much more than expected. Perhaps this is why it has led some regulators to joke that stablecoins are not stable or currency.

Nevertheless, the volatility of stablecoin is much lower than that of any other cryptocurrency when it comes to providing a safe haven for crypto investors. So it is important to understand the risks involved in the peg mechanism of different stablecoins.

While many stablecoins have failed in the past, UST is not the first and certainly not the last. Investors can anticipate potential risks in a bearish and volatile market by looking at the value of these stable coins, not just the dollar, but how they fit into the liquidity pool.

The opinions and opinions expressed herein do not necessarily reflect the views of the author and not necessarily those of Cointelegraph.com. Every investment and trading step involves risk, so you should do your own research when making decisions.

Leave a Reply

Your email address will not be published.