UST sequel: Is there a future for algorithmic stablecoins?

UST sequel: Is there a future for algorithmic stablecoins? – Mail Bonus

TerraUSD (UST) is a stablecoin algorithm that is priced at $ 1.00. But on the evening of May 19, the price was 0.083 dollars.

Of course, this should not happen, but last week UST, together with its associated currency Terra (LUNA), carried out a kind of death spiral that “wiped out almost 50 billion dollars from investors’ money in a few short days,” according to Newsletter NYDIG 13 May.

The crash shook the cryptocurrency industry, but it also raised some questions: Is this one flawed project or is it also a whole bunch of cryptocurrencies – algorithmic stablecoins – that use arbitrage systems instead of fiat reserves to keep their market value stable? That is to say, are algo stables inherently unstable?

Also, how have last week’s events affected more traditional stablecoins, such as Tether (USDT), the industry’s largest, but which also briefly lost a 1: 1 dollar to the US dollar? And what about the consequences for the cryptocurrency and the blockchain space in general – has it also been tarnished by the fall of ICT?

Finally, what lessons, if any, can be learned from the stormy events of the week so that this does not happen again?

Can algo stables survive?

When the dust settles, some ask if the UST / LUNA flat line is the beginning of the end for algorithmic stablecoins as a category. Note: Some algo stables, including UST, may be partially insured, while algo stables rely heavily on market maker “arbitrage” operations to maintain their $ 1.00 market value.

Pure algo stables, with no collateral at all, are “inherently fragile,” according to Ryan Clements, an assistant professor at the University of Calgary’s law school. They “rely on numerous assumptions about operational stability, which are neither secure nor guaranteed. As he further explained to the Cointelegraph:

“In particular, they need continued demand, willing market participants to carry out arbitration and reliable price information. None of this is safe and they have all been tight in times of crisis or increased volatility. “

For these reasons, it would have been possible to predict the bank raid on LUNA and UST last week and the “death spiral” that followed, said Clements, who certainly warned of something like this in the October 2021 article published in the Wake Forest Law Review.

“Before ICT failed, I argued that stablecoins’ algorithms – those that are not fully guaranteed – are based solely on trust and confidence in the economic motives of the underlying ecosystem of the issuer’s stablecoin. As a result, there is nothing stable about them.”

“I do not see how stablecoins algorithms can survive,” Yves Longchamp, head of research at SEBA Bank – Swiss digital asset bank – told Cointelegraph. Last week’s draw in the stablecoin space showed that:

“They are not all created equal and that quality matters. Relatively transparent, fully-fledged fiat stablecoin USD Coin performs better than a fairly opaque fully-fledged fiat stablecoin Tether, which in turn performs better than a partially guaranteed, stablecoin UST algorithm.

Is more insurance the answer?

Others, such as Ganesh Viswanath-Natraj, an assistant professor of finance at Warwick Business School, agreed that algo stablecoins are “fragile in nature” but only to the extent that they are under collateral. They can be strengthened with “dollar reserves or the equivalent of blockchain stablecoins. Alternatively, they can introduce a system of over-insurance with smart contracts. The latter is how distributed stablecoins like Dai (DAI) and Fei (FEI) work.

Kyle Samani, founder of Multicoin Capital, largely agreed. “The problem with ICT was not the algorithm, but the lack of insurance.

“Algorithmic stablecoin is very challenging,” said Campbell Harvey, Duke University professor of finance and co-author. DeFi and the future of finance, said the Cointelegraph. “Every time you are mortgaged, you run the risk of a so-called bank run.

What was worse in the UST case is that it used a linked cryptocurrency, LUNA, to help keep its price stable. LUNA was “very much related to the fate of ICT,” Harvey said, and when one went down, the other followed, driving the price of the first symbol even lower, and so on. He added:

“Does this mean it will be difficult to launch another algorithmic stablecoin? Yes. Does this mean the idea disappears? I’m not sure. I would never say never.”

What’s safer is that ICT was using faulty models, inadequate stress testing and a lack of circuit breakers to break the fall when the death spiral began, Harvey said.

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Is there even a need for algo stables?

One hears again and again that algorithmic stablecoins are a “magical” experiment with important consequences for the future of international finance. In fact, a purely algorithmic stablecoin that maintains non-reserve operational stability is sometimes seen as a “holy grail” in the development of diversified finance (DeFi), Clements told the Cointelegraph, adding:

“This is because if it could be achieved, it could grow exponentially and still be ‘censorship-resistant’.”

“We need distributed stablecoin,” said Emin Gün Sirer, founder and CEO of Ava Labs. declared last week. “Fiat-backed stables are subject to legal seizure and arrest. A decentralized economy needs a decentralized stablecoin where backing can not be frozen or confiscated.

Are stablecoins subject to seizure? “This is certainly true,” said Samani, “but it has not been a big problem historically. In general, I think most people overestimate this risk. “

“I see the point,” Todd Phillips, director of financial and corporate governance at the Center for American Progress and a former lawyer for the Federal Deposit Insurance Corporation, told Cointelegraph.

What he can not understand, however, is how diversified assets get around this mystery: Diversified assets are invariably more volatile than traditional assets, and then pledge that their assets will hold steady value – but not support them with stable assets like the US dollar but with other distributed assets, such as LUNA, or an arbitration system – is ultimately just asking for a UST-type scenario.

Many people were lamenting Terra and the “flawed” stablecoin model last week, but perhaps the idea of ​​an algorithmic stablecoin in itself is not so absurd, especially if one takes a historical view of money. Look at how the US dollar and other currencies evolved in terms of their support or “reserve fund,” Alex McDougall, president and COO Stablecorp – a Canadian fintech company, told the Cointelegraph – further explaining:

“Fiat currencies started out as ‘represented’, as with gold, silver, etc., and basically developed currency algorithms where the central banks were opaque algorithms that underpin and control their value.

Consequences for cryptocurrencies in general

In the long run, will the TerraUSD collapse have a lasting impact on the larger cryptocurrency and blockchain world?

“It will help to formulate clear principles for the design of stablecoin and the need for stable and liquid reserves to support the connection at all times,” said Viswanath-Natraj. “For regulators, this is an opportunity to introduce auditing rules and capital requirements for stablecoin issuers.”

Clements already sees some changes in the stablecoin environment. “In light of Terra’s failure and the contagion it caused in cryptocurrencies, demand has shifted to full or over-secured forms.”

Stablecoins are for the most part a US phenomenon, but the collapse of the ICT could also affect Europe, Oldrich Peslar, a lawyer at the Rockaway Blockchain Fund – a Swiss venture capital firm – told Cointelegraph. For example:

“In the EU there is a debate about whether there should be a real redemption requirement by law for all stablecoins, whether they should always be guaranteed at least 1: 1 and whether it is possible to stop issuing stablecoins if they grow too big, or even whether the regulation should apply to distributed stablecoins.

“The ICT history,” Peslar continued, “could serve as a conclusion for stricter rules rather than a softer approach.

Longchamp predicted that “algorithmic stablecoins will be under pressure and unlikely to be part of an upcoming regulation” in Europe – which is not good for algo stables because in Europe the regulation is tantamount to approval. “My prediction would be that only audited asset-backed stablecoins would be managed and encouraged.

Last week’s events could even “relax” institutional and venture capital formation for stablecoin and DeFi projects, at least in the near future, Clements suggested. It will also likely accelerate policy-making in the United States and internationally around all stablecoin forms, “identifying taxonomic forms and analyzing business models.” This is necessary because algorithm versions of stablecoins “are not stable and should be separated from the fully guaranteed forms.”

It could even reduce retail investment in cryptocurrencies as a whole “given the impact of Terra’s failure on the larger market,” Clements added.

On the plus side, Bitcoin (BTC), the oldest and largest cryptocurrency in terms of market value, often seen as a bellwether for the entire industry, performed relatively well last week. “Even though the market has collapsed and BTC has lost most of its value, its price has remained close to $ 30,000, which is high,” said Longchamp. “The value that blockchain and cryptocurrencies offer in the market is still strong.

In the stablecoin field, performances were mixed. “What was the impact on DAI? There was no effect, “Harvey said, referring to the leading distributed stablecoin. “What was the impact on FEI, another distributed stablecoin? There was no effect. It had no effect because this currency was over-mortgaged and have many methods to ensure that the connection stays as close to one dollar as possible.

“What happened to the USDC? Nothing, “Harvey continued, referring to USD Coin (USDC), a centralized stablecoin with 1: 1 USD support. “But what about Tether? Tether is a centralized stablecoin supported by fiat, but Tether is so opaque that we do not know what the guarantee is. The result: “Tether was hit” because “people said, ‘Well, maybe this is just a situation like ICT.'” He suggested that its opacity was against it.

In its defense, Tether stated in a statement on May 19 that “Tether has never even responded to a request for redemption from any of its established customers. As for the reserve fund, Tether said it was reducing its commercial paper investments, which it has been criticized for, and increasing its holdings in US Treasury bills.

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Lesson learned?

Finally, what lessons, if any, can be learned from the rise of ICT? It can probably be assumed that the “search” for pure algorithmic stablecoin will continue among DeFi developers, Clements told Cointelegraph. But it is important that it is “done within a regulatory environment that has sufficient security and information for consumers and investors.

Last week has brought us closer to cryptocurrency regulation in the United States, according to Phillips, “at least I hope so, because we need regulation so investors are not hurt.” At the very least, they should be warned about the risks.

Overall, given that the cryptocurrency and blockchain industry is still in its early teens – just 13 years old – one should probably expect regular failures like UST / LUNA, Harvey added, though “we hope the frequency and size will decrease. ”

Some philosophical calm might also be okay. “We have to take the position that we are 1% in this disruption using decentralized financing and blockchain technology, and it will be a rocky journey,” Harvey said, adding:

“The problems that DeFi solves are very big. It is much promised. But it is early and there will be many repetitions before we do it right. ”