Ironic as it might sound, 2022’s crypto anxiety stems from the very financial products designed to give it a hedge against its own proverbial volatility.
Stablecoins are used not only to protect against wider crypto market fluctuations but also as idle cash storage and leveraged trading facilitators. However, last week’s worrying developments have proven that the assets have a long way to go before truly deserving their namesake.
Given their common intended purpose and shared pegging to the US dollar, it’s relatively easy to superficially group all stablecoins under one big umbrella. After all, they are perceived by market sentiment as an interlinked entity – as proven by their common woes. But those woes originate from very different technical principles.
Transparency Issues: Reserve-Backed Stablecoins
The bulk of the stablecoin market is dominated by reserve-backed assets, which include the popular USDC, USDT (Tether) and Binance USD.
Their 1:1 peg to the US dollar is maintained through collateral reserves, either on-chain (such as in the case of DAI) or off-chain, through USD reserves and a slew of ‘cash equivalents’. These usually represent debt instruments in both fiat and cryptocurrency.
While their reliance on more traditional backing techniques should make them the trustworthy option, some of the main projects in this space have nonetheless been at the centre of a fair amount of recent controversy. This was despite a wider optimistic market outlook, with very high growth all-around.
Relying on market confidence in the healthy nature of its backing reserves, this kind of stablecoin has had an uphill battle to fight in what is a fast-growing, unregulated industry. And most notably, one that sometimes struggles with transparency.
In particular, Tether has famously been under scrutiny for several years now. The Hong Kong-based company has done very little to dissipate the doubts generated by the vague terms in which it aims to define the exact partition of its reserves between actual cash and worrying debt.
Tether Limited has indefinitely delayed publishing its much-awaited audit and has received substantial fines for misrepresenting the coin as 100% backed, as well as being banned from operating in the state of New York after a settlement over hidden reserve losses in 2019.
USDT is the biggest stablecoin of the cryptoworld, with a market cap of 170 billion USD (solidly ahead of USDC), and plays a central role in supporting crypto trading. These murky circumstances have long been the source of major uncertainty and are seen by some as a potential systemic risk.
It is not, however, centralised reserve-backed coins that have been at the centre of this early May stablecoin apocalypse. The source of much concern in the crypto markets has instead been the other major type of pegged currency: algorithmic stablecoins.
The Danger of Innovation: Algorithmic Stablecoins
Born as a solution to the transparency issues outlined above, algorithmic backed assets are significantly easier to probe than a centralised entity like Tether. Their backing mechanisms are built into the blockchain and very much open to public scrutiny – potentially even too open, given how much this exposes their inner workings to exploitation by antagonistic or opportunistic investors.
These structures vary greatly and are often composites of different models, but can be broken down into three main categories:
- ‘Rebase’ – stablecoins that manipulate base supply to maintain peg, by adding (minting) or removing (burning) supply from circulation in proportion to the asset’s deviation from its $1 desired value.
- ‘Seigniorage’ – where a multi-coin system is established, with one coin assisting the other to maintain stability through a combination of mint-and-burn and free market price-shifting mechanisms.
- ‘Fractional’ – a highly complex fusion of collateralised and seigniorage systems with a focus on achieving a ‘best of both worlds’ solution.
The elaborate and experimental funding structures that power their pegs to the US dollar are the result of highly innovative development approaches. Their teams are stacked with out-of-the-box thinkers from the crypto space and tend to attract the type of visionaries who have the power to unlock the true potential of decentralised financial solutions.
Weaknesses Exploited
They do, however, also present the largest amount of vulnerabilities – as naturally comes with a highly complex infrastructure.
This week’s TerraUSD catastrophe was a perfect example of such a scenario. The algorithmic stablecoin was thrown in disarray when LUNA, the balancing cryptocurrency used to hold its dollar peg, collapsed in value during a widespread crypto and tech-stock crash. This in turn precipitated the value of TerraUSD to $0.30, wiping out capital across its user base.
In a perfect showing of the model’s fallacies, Terra creator Do Kwon was on record later in the week stating the likely solution to his company’s woes would be collateralisation of the currency through ‘exogenous capital’. This further reinforced the theories that decentralisation of stablecoins might not be feasible without significant over-collateralisation.
Just before TerraUSD, another stablecoin operating in a very similar manner, USDN (also known as Neutrino) depegged significantly and exposed some of its own weak spots. According to some, this might be the tip of a very worrisome iceberg.
Neutrino and the WAVES protocol it relies on are suspected of propping up their peg via debt incurred in other stablecoins, and insiders suspect that their system might only be standing thanks to reliance on a plainly unsustainable continued market cap growth.
Another algorithmic stablecoin, Beanstalk, was in a similarly precarious position last week as it announced plans to seek 77 million USD in borrowed capital to revive itself following a chain hack which collapsed its peg from 1:1 all the way down to $0.61.
A Horizon of Tightening Regulations
Furthermore, these assets’ potential for censorship and regulation resistance is simultaneously a possible use case and a reason for investors’ concern: it is attracting a lot of institutional attention from governmental entities across the planet keen to set legal boundaries.
On Monday 9th, the US Federal Reserve released a report identifying stablecoins as one of three key assets with high funding risks, mainly liquidity issues and investor runs. The report further highlighted how such a crisis could have ramifications deep enough to spill over into traditional markets and financial systems, providing a clear reason for institutional intervention in what remains a fairly wild financial environment.
Unsurprisingly, the highly crypto-critical US Treasury Secretary Janet Yellen went on record this week asking for stablecoin legislation by the end of the year. He stated that the risk posed by such instruments greatly outweighed their potential to promote innovation.
The Human Factor Issue
Much like the Fed report states, many in the space believe that recent events are proof that there is no future for algorithmic stablecoins. That is unless they can tackle their deep vulnerability to market sentiment, volatility and potential investor panic.
Just like their strength ideally resides in their decentralised, collectivised nature – a community-wide emotional reaction will always be their biggest threat.
Justin Rice, VP of Ecosystem for the Stellar Development Foundation, told online publication Decrypt that he’s pretty sceptical about the whole thing: “What we’re seeing now, and not for the first time, is an optimistic balancing mechanism unravelling due to natural human responses to market conditions.”
Back To The Drawing Board
It is no mystery that the crypto world strives for ever-increasing institutional recognition and widespread adoption – both developments seriously hampered by extreme volatility events.
As the unprecedented bull run of 2021 sizzles out into what looks like a decade of increased inflation, lower spending and slower growth, the wild price fluctuations that have drawn many new investors to the space are now a worrisome problem to be solved.
It is a crucial time for stablecoin projects, and shakiness and unreliability in fundamentals will be met with ruthless shunning by a market that is undoubtedly afraid. It might not be the right environment for experimental solutions and innovative instruments that require delicate balancing.
