Not All Stablecoins are Created Equal
Assessing risk in the wake of the UST implosion.
I’ve been in the crypto space since 2014 and there have only been a handful of times where we had to post the suicide hotlines.
Bitconnect and the 2018 collapse come to mind.
And here we are once again.
With a few notable exceptions here and there, very few people would have believed it was possible for an ecosystem as huge and vibrant as Terra to basically death spiral to zero in a matter of days.
It was so unbelievable that when UST first lost its peg and LUNA initially dropped from $90 to $30, then to $16, investors bought the dip thinking it would bounce back.
If they had only read the white paper, they would have known that treasury assets were selling off and LUNA was hyper inflating to defend the peg of UST.
The mechanism was programmed to do that, it was working as intended, and LUNA was definitely not going to bounce.
Do Kwon himself (the founder of Terra) explained it well in a tweet thread shortly after the de-peg.
As the reality of the situation set in and the contagion spread, the value of the entire crypto asset class ripped down by $50 billion.
It was truly breathtaking to watch.
The full impact is yet unknown.
What even is a stablecoin?
For the purpose of this analysis, a stablecoin is any cryptocurrency that aims to trade for exactly one US dollar.
There are some that peg to other things like precious metals, commodities, other fiat currencies, or even a basket of crypto currencies. But I’m going to stick with the most popular flavor, which are the US dollar pegged ones.
Like other cryptocurrencies, stablecoins are accessible to everyone in the world. They can be moved over the internet (between crypto wallets) without either party needing to have a bank account.
They are very useful in commerce because they make it possible to do payments over the blockchain without being exposed to the volatility of native coins like Bitcoin and Ethereum.
Also very useful to crypto traders because they provide a safe haven from volatility on chain.
Basically, it’s crypto without losing your money.
Until…
Stable Kwon
A lot of ink will be spilled on this event in the coming weeks and months.
The Terra network was the darling of DeFi, it had big funds backing it and Anchor protocol was a financial vortex that pulled in capital from an incredibly diverse group of investors.
This was not the same degen crowd that piled into OlympusDAO and all the forks offering insane APYs back in ’21 (although there may have been some overlap).
Terra was main stream and UST was supposed to be risk off.
I heard that one VC actually had all their analysts and fund managers converting their paychecks into UST and depositing into Anchor.
Maybe that’s what makes this one feel different.
And why it shook the market so hard.
Beyond the pain of individual UST/ LUNA holders, this event demonstrated that stablecoins have become critical infrastructure in crypto and poorly designed ones represent a systemic threat to the entire thing.
They are a relatively recent invention and many of them have not yet been subjected to a nation-state attack, a severe liquidity crunch, or even a prolonged bear market.
For my own sake, I’ve taken a fresh look at the landscape of stablecoins and read up on a handful of them in an effort to better understand their mechanics.
Tl;dr
How to assess a stablecoin
When I started looking under the hood at these things it got really crazy really fast.
There are dozens of factors that affect the overall risk profile of a given stablecoin, but these are the ones I found the most relevant:
Adoption
What ecosystems, chains and dApps is the token being used on? Is it available on both centralized and decentralized exchanges?
Nearly every stablecoin has been bridged to nearly every EVM chain, which increases adoption and liquidity, but some stablecoin issuers go one step further, deploying canonical tokens on every major L1 chain.
This eliminates the contract risk inherent to bridging.
Is it redeemable?
Some stablecoins can be redeemed 1 for 1 by the sponsor, others depend on a DeFi platform where the price could be volatile.
Is there enough liquidity to redeem large amounts? Is the liquidity on every chain or is it concentrated on one or two.
Is it compliant?
This is an interesting one because centralized stablecoins are more compliant and therefor seen as having lower regulatory risk than decentralized stablecoins.
But if stablecoins were ever subject to an all out government ban (which could happen if the US launches a Central Bank Digital Currency), then the decentralized stablecoins would be far more difficult to ban.
Ability to hold peg
Definitely the most important factor.
For centralized stables, regulatory risk is the main threat. For decentralized stables, there is risk of the mechanism being exploited, risk of the reserve being looted and contract risk.
Let’s dig in.
USDT (Tether)
Tether is the largest stablecoin by market cap and the third largest cryptocurrency overall.
It has a reputation for poor liquidity, price manipulation and not being fully backed. It is also probably the most widely used crypto for money laundering and its relationship with regulators is not good.
Despite these issues, I believe Tether is one of the safest stablecoins.
The team has provided multiple audits from private accounting firms and while the regulatory risk is significant, I think Tether is very unlikely to experience the kind of rapid collapse we just witnessed with UST.
Adoption: Strong
Tether has hundreds of trading pairs across every crypto exchange, both centralized and decentralized and it has a native (canonical) token deployed on every major L1 chain.
Redeemable: Yes
Tether is directly redeemable for US dollars. It does not require KYC for direct redemption. There is a $100K minimum for redemption plus a .1% fee.
Compliance: Weak
Refusing to undergo a formal audit and allowing direct redemption without KYC has raised the ire of regulators in the US and Europe. And with the recent collapse of UST, they are likely to take an even harder line on Tether.
The one credible threat to Tether that I can see is at the nation-state level.
It’s possible that the US could freeze Tether’s bank account the same way it did to Russia’s FX reserves in response to the invasion of Ukraine.
I have no clue how to assess the likelihood of that.
Ability to hold peg: Strong
Tether is centralized, meaning that it’s treasury consists mostly of cash and cash-like assets held in a bank account. Only a small portion of its assets are in longer-term, higher-risk investments that generate yield.
It’s difficult to steal billions from a bank and that’s what it would take to de-peg Tether for an extended period. Therefor, I think that risk is very low.
In the past, many feared there would be a bank run on Tether, but it has since gone through several market upheavals where demand surged and it never lost its peg for more than an hour or two.
The lowest it ever dropped was 90 cents during the crash of 2018.
USD Coin (USDC)
USDC is the fourth largest cryptocurrency by marketcap and is the gold standard of stablecoins.
It was developed by the Centre consortium and is issued Circle and Coinbase.
Circle is an official Money Transmitter, which means it obtained a license from the US government to operate as a money services business.
This makes it pretty much an open financial book. Before the issuance of USDC, the equivalent amount of USD is deposited with one of Circle’s accredited partners, creating a verifiable link between the tokens and the reserves.
Adoption: Strong
USDC also has hundreds of trading pairs across every major centralized and decentralized exchange. And it has a canonical token on several L1 chains.
For example, Avalanche has USDC and USDCe.
USDCe is a bridged version of the ERC20 token and therefor has smart contract risk. Whereas USDC on Avalanche is a canonical token that was natively deployed on Avalanche by Circle.
It is generally considered to be the most liquid of all stablecoins.
Redeemable: Yes
Redemption from Circle requires KYC and costs $250 or $1000 per month, depending on service level.
Compliance: Strong
USDC undergoes regular, formal audits to maintain its Money Transmitter license. It meets the highest compliance standards on every level.
Ability to hold peg: Strong
For all the same reasons as Tether, USDC is unlikely to experience de-peg for any extended period.
DAI
DAI is a fully decentralized and overcollateralized stablecoin that was created and issued by MakerDAO (MKR).
What do I mean by decentralized stablecoin?
Unlike Tether and USDC whose value is backed 1:1 by US dollars in the bank, DAI is backed by crypto collateral that can be verified on the blockchain.
There is no need for a centralized authority or a traditional bank. The project lives entirely on Ethereum, making DAI a trustless and decentralized token which cannot be shut down or censored.
Overcollateralized simply means that each DAI is backed more than 1:1 by its crypto reserves.
Adoption: Strong
DAI and MakerDAO experienced a surge following the collapse of UST.
MKR is now the second-largest DeFi token, accounting for 7% of the $146 billion total value locked in decentralized protocols, surpassing Curve, SushiSwap, and Lido.
DAI in not available on some centralized exchanges in the US due to non compliance with regulations but has deep penetration across DeFi.
Redeemable: No
DAI is not directly redeemable for US dollars.
Compliance: Non existant
DAI does not attempt to comply with any financial regulations in any jurisdiction.
Ability to hold peg: Weak
MakerDAO maintains the DAI peg through margin trading, CDP smart contracts and several other stabilization mechanisms.
DAI’s collateral consists mostly of ETH, which is a volatile crypto asset.
While the mechanisms have been able to maintain the peg up to now, there is no guarantee that it will continue to do so.
For example, if ETH were to experience a severe enough drop, the margin loans would be liquidated and DAI holders would end up with ETH that was worth less than their original USD value.
The price of ETH has fluctuated between $80 and $4600 in the last three years. Even 10x overcollateralization does not guarantee the peg with that kind of volatility.
This is the inherent risk of using cryptocurrency as collateral.
Other factors
MakerDAO was losing market cap to Curve and other projects before the UST collapse, however the mechanism seems to have held up remarkably well during this market volatility, which bodes well for the project long term.
Back in November, 2019 market demand caused DAI to trade as low as 92 cents.
In March of 2021, DAI experienced a deflationary deleveraging spiral that caused it to trade at $1.11.
FRAX
The Frax protocol is a two-token system comprising the FRAX stablecoin as well as a governance token, Frax shares (FXS).
FRAX is a “hybrid fractional” stablecoin, meaning it maintains its one dollar peg by being partially collateralized (aka, fractional reserve) with USDC.
Of its total market cap of $2.7 billion, $1.8 billion is invested in 20 or so different DeFi projects, some of which are pretty far out on the risk curve (like OlympusDAO and it’s own token, FXS).
If any of these treasury assets were to collapse, or if several of them were to sufficiently decrease in value, the FRAX token could suffer a bank run.
Adoption: Weak
FRAX has good coverage across chains. It has native tokens on Ethereum, Polygon, Avalanche, BSC, Fantom, Harmony and Moonriver.
I’m marking it weak on adoption because the market cap is low and no centralized exchanges support it.
Redeemable: No
FRAX is not directly redeemable for US dollars.
Compliance: Non existant
FRAX does not attempt to comply with any regulations in any jurisdiction.
Ability to hold peg: Weak
I think some of the projects FRAX is invested in are low quality and, similar to UST, it holds it’s own governance token.
For those reasons, there’s a decent chance it will experience a bank run at some point.
That being said, the FRAX smart contract is audited and the FRAX treasury is completely transparent.
So unlike UST, you can at least see which projects they’re invested in and decide for yourself if you are comfortable holding it.
Confirmation bias is real, but here goes.
UST
Last but not least, we have UST, an algorithmic stablecoin issued by Luna Foundation Guard (LFG) that grew incredibly big incredibly fast.
Prior the the crash, UST was a difficult token to evaluate.
While its security was audited and its track record for holding peg was basically flawless, the treasury was secretive and actively managed by the governance team, not a contract.
The team publicly announced that they were buying BTC and AVAX to backstop the UST peg, but there was no guarantee that their investment strategy would hold up in a bear market or a liquidity crunch.
Adoption: Strong
The market cap for UST prior to the crash was $18.5 billion.
It was not traded on very many centralized exchanges but had massive liquidity in DeFi.
Terra’s Anchor Protocol offered 20% APY on deposits of UST. About $14 billion of UST was deposited into Anchor before the crash.
Redeemable: No
UST is not directly redeemable for US dollars.
Compliance: Non existant
No attempt to comply with any regulations in any jurisdiction.
Funny enough, Do Kwon was served a subpoena from the SEC at a crypto conference back in December of 2021.
It was just before the price of LUNA went parabolic and he was still a relative unknown.
Ability to hold peg: Weak
Terra’s indifference to the growing systemic risk of Anchor, combined with their off-chain liquidity, and their ill-timed migration to the 4pool on Curve all converged and creating a critical vulnerability.
That vulnerability was spotted and exploited by a very well capitalized entity, which has yet to be identified.
And kablooie.
My first reaction to this was outrage at the perpetrators. Like, who was it that sold 20k bitcoins to LFG for UST and then spot dumped the UST on Binance?
That entity must be identified and at least socially shamed (since they probably didn’t break any laws).
But then a friend of mine who used to be a full time options trader and now works on a DeFi desk explained something to me that I didn’t previously understand:
Late last month (March 2022), the Terra and FRAX teams got together and created the 4pool on Curve.
The pool was composed of two algorithmic stablecoins, UST and FRAX, and two centralized stablecoins, USDC and USDT, and its goal was to become the most liquid offering for traders on Curve.
If this plan had succeeded, it’s safe to assume Do Kwon would have definitively won the Curve wars, and the penetration of UST into DeFi would have been 100x deeper.
At that point, it would have taken a lot more than $400 million to de-peg UST but if someone did, it would have made this collapse look cute.
So the interpretation goes, the shorts played their role.
Yes it was bloody, but we should actually thank this attacker for cleansing UST from the system before it became truly lethal.
Damn.
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Thanks for reading until the end. I work in crypto and think about it non-stop. You can find me on Twitter @danajwright_
