Late on Monday, April 18, the stablecoin terraUSD (UST) edged out Binance’s BUSD to become the third-largest stablecoin by market cap. There are now nearly $18 billion UST in circulation. That’s well below the nearly $50 billion total for Circle’s USDC, or the $82 billion worth of Tether’s USDT roaming the Earth.
But UST is also much different from those competitors, in ways that could make it incredibly risky.
Stablecoins are tokens tracked by a blockchain, but in contrast to assets like bitcoin (BTC), they’re intended to consistently match the buying power of a fiat currency, most often the U.S. dollar. Stablecoins were first created to give active crypto traders a tool for moving quickly between more volatile positions, though as we’ll see, the potential for big interest rates on loans has also helped attract capital.
USDT and USDC are so-called “backed” or collateralized stablecoins. They keep their 1:1 dollar “peg” because they are (ostensibly) backed by bank accounts holding dollars, or by other dollar equivalent assets, for which tokens can be redeemed – although Tether has been notoriously reticent to specify the nature of its reserves.
UST, by contrast, began life as what’s known as an “algorithmic” stablecoin. These could also be referred to as “decentralized” stablecoins because decentralization is their primary reason for existing. A collateralized stablecoin like USDT or USDC is reliant on banks and traditional markets. That makes them in turn subject to regulation, enforcement and ultimately, censorship of transactions. Circle and Tether are run by centralized corporate entities with the ability to blacklist users and even seize their funds. Both systems have done this, sometimes at government behest.
In principle, algorithmic stablecoins like UST don’t have this censorship risk because they are not run by centralized corporate structures and do not hold backing in traditional institutions like banks. Of course, in reality “decentralization” is relative, and most such systems today still have key men, such as Do Kwon at Terraform Labs, or affiliated organizations that provide labor and funding. Whatever a system’s “decentralized” branding, regulators can still go after such public targets, a risk that’s worth keeping in mind.
What that algo does
Instead of being backed by assets like dollars or bonds, algorithmic stablecoins are intended to maintain their dollar peg by what looks to some like financial alchemy. But experts are highly skeptical that these systems’ designers have actually figured out how to turn lead into gold.
Broadly, algorithmic stablecoins rely on a pair of tokens, both created ex nihilo at the token’s launch. One token is the stablecoin itself – terraUSD, frax, neutrinoUSD – and the other is the corresponding “balancer token” – LUNA, FXS or WAVES, respectively. Generally, the balancer token can be “burned,” or destroyed, to create more of the corresponding stablecoin.
The defining algorithm in an “algorithmic stablecoin” is a function that changes the amount of the balancer token required to create the stablecoin. This changing burn value is intended to create arbitrage opportunities for traders: gaps between the price of the balancer token and the stablecoin that they can profit from, but that also drive the price of the stablecoin toward its peg. In principle, this would attract profit-motivated traders to drive the stablecoin back to $1 whenever the peg wavered.
The nuances of these systems vary, but it doesn’t take much financial expertise to see reason for skepticism. Let’s hear it from an expert anyway.
-- David Z. Morris, CoinDesk chief insights columnist
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