Stablecoins and the Gateway to the Crypto Winter
TerraUSD, a stablecoin pegged to the dollar, lost its stability and entered a death spiral that brought a collapse to its underlying blockchain. This event triggered a ‘run on the bank’ style sell-off of TerraUSD which brought the price from $0.99 on the 9th to around $0.15 on the 13th. As for the blockchain that issued the stable coin, Terra Luna, it plummeted from an all-time high of around $119 on April 5, 2022, to around $0.00019 on May 18th, with most of the fall happening around May 5 – May 13. This disaster has evaporated over $50 billion and brought down the entire crypto market in a matter of days.
At a time when the belief of a crypto winter was thought to have come to an end, it only took one failed project to awaken a forgotten trend. Yet, this was predictable. Not the entire market but the underlying technology of Luna that would’ve in due time caused the collapse. This technology is algorithmic stablecoins, a product of financial engineering that relies on software and traders to keep the price at a dollar. With no actual backing of any assets, this dangerous method was prone to fail.
The onslaught of crypto prices that soon ensued, due to the collapse of Luna brought about the beginning of crypto winter. Crypto winter is analogous to a bear market but instead of the 20% loss in equities, crypto on average experience anywhere between 40% to 90% loss in their value. Luna, losing around 99% of its value, had no correlation to other projects except for the stablecoins used in trading. When the price collapsed, this triggered a takedown of the entire market. Despite only one project being flawed, similar to a few rotten apples running the harvest, one crypto collapse brought every project down.
While crypto winters are especially painful for first-time investors, they are boom times for long-term holders. This period, generally around two to three years, allows investors to collect more of their assets before the next bull run. This pattern originated and still correlates to Bitcoin which has experienced the most notable boom and bust periods based on its halving cycles.
Stablecoins and the Different Types
While cryptocurrencies provide pathways to economic freedom, there are some risks associated with this new and arising technology. One of the biggest concerns to merchants, in regards to adoption, is volatility. To counteract this difficulty, a new breed of crypto was created, entitled stablecoins. These coins, are “intended to maintain price parity with some target asset, USD, or gold” and to “provide the necessary consistency that investors seek to participate in many DeFi applications.” Stablecoins also allows the ability for exposure to non-crypto-related assets, such as stocks, exchange-traded funds, commodities, and others. This is accomplished through three methods of implementation: fiat collateralized, crypto collateralized, and non-collateralized. These differentiations are solely based on their underlying backing.
To the conservative investor, stablecoins allow them to slowly enter the field. But if one asks either a bitcoin maximalist or a crypto pundit, they would snarl at this aspect of the technology for being either redundant to the role of fiat currencies or obsolete in relation to any self-sufficient blockchain. These viewpoints are as diverse as any topic, but with the benefit of open-source software, anyone can build, regardless of what it is, and the community can judge the merits of its importance.
The first group, and the largest in circulation, are fiat collateralized. They are “backed by an off-chain reserve of the target asset.” The coins are created to run, primarily either on the Ethereum or Bitcoin networks, and custodied by an external entity that holds the underlying assets to back up the coins. This may be abstracted to a digital representation of the original usages of paper currency, where the bank would issue bills that are redeemable for a fixed amount of gold. Fiat collateralized are built upon the same concept. The risk associated with this type of coin is the underlying entity that backs them. “They are centrally controlled and maintain the right to blacklist accounts” but what concerns more investors recently is if the entity has the assets to back up the coins. One noticeable example is the recent short-selling bets on Tether USD. Justification for the shorts has stood that Tether Holdings Ltd. paid an $18.5 million settlement over accusations that they have misled clients over their reserves. The Wall Street Journal reported that “Tether Holdings Ltd., its parent company, has promised a full audit of its reserves for years but never produced one.” They have also “gone to court to block public-records requests about its business” to prevent future disclosures. If these allegations are true or not, one thing is certain and that is that Tether USD has kept its stability through this ordeal, except for a momentary drop due to volatility relating to the TerraUSD collapse. Fiat collateralized are no different than physical currencies, like the dollar or the euro, but are more useable within the digital economy.
Crypto-collateralized stablecoins, on the other hand, are “backed by an overcollateralized amount of another cryptocurrency. Their value can be hard or soft pegged to the underlying asset depending on the mechanism.”(1) One of the most popular stablecoin of this type is MakerDAO’s DAI, which is pegged to the dollar in value but is backed by Ethereum. How it works is similar to a pawn loan; the user will go to the protocol and borrow against his Ether for Dai at a certain collateralized percentage, but never close to an equal exchange. When the user is ready to repay his loan and reclaim his Ether, the user will return to the protocol with Dai, plus the market interest accrued and repay the debt. For example, you go to a protocol and borrow upwards of 80% of your Ether value for Dai, depending on the protocol and your personal financial need. You receive Dai and agree to a certain amount of interest that the protocol issues. In the case where Ether falls below the amount you borrowed, a margin call ensues and the protocol sells your Ether to reclaim the principal of your loan. You keep Dai in this case but lose the Eth. On the other hand, if Ether increases in value, then the collateralized ratio goes down and the position becomes less risky. No action is taken and your position remains. These types of stablecoins are used primarily in banking and lending protocols and then the general facilitation of transactions but they are easily accessible in the exchanges. While they have the advantages of decentralization and secured collateral, the drawbacks are limited scalability. To create a more stablecoin, the protocol must collect more of the overcollateralized debt position, and in some cases, like DAI, a debt ceiling further restricts the supply growth. Crypto-collateralized is primarily digital fiat representations used in exchange for borrowing and lending purposes.
Algorithmic stablecoins, on the other hand, are far more risker than other forms of stablecoins or fiat currencies. Instead of being backed by any type of assets, they are set to their peg through financial engineering. The most common type of financial engineering is the seigniorage model, which allows “the token holder in the platform [to] receive the increase in supply when demand increases.” If the demand decreases and the price falls below the peg, the “platforms issue bonds of some form, which entitle the holder to future expansionary supply before the token holders receive their share. This mechanism works almost identically to the central banks associated with fiat …” Yet while the government uses the funds for spending and other economic goals, the blockchain system uses it to keep the peg. Simplified, when demand increases for the stablecoin, the underlying blockchain issues more of the coin to increase the supply are return it back to the peg and vice versa, when the demand decreases, the blockchain would burn the supply, causing the price to rise. This is exactly how a central bank works, with inflation being the case where demand falls and there is an increased supply of the dollar, causing goods to rise, and deflation when there is an increase in demand for dollars and goods fall in price. The associated risk with this system of stablecoins is that there is no inherent underlying value backing them. This makes them an easy target for bank runs, as we’ve seen with the Terra Luna episode. Luckily for global users, the dollar, being held as a global reserve currency, will not experience a bank run because it is “too big to fail”. Algorithmic is a protocol’s own ‘fiat’ style currency, without anyone’s backing but their own.
Luna and the Largest Collapse, For Now
This leads us to an understanding of how the underlying technology of the Terra Luna stablecoin works, but not how the catastrophe occurred. What happened was during the weekend of May 7 and 8, there were “a series of large withdrawals of TerraUSD from Anchor Protocol”. Anchor Protocol is built on the Terra blockchain, and the major factor towards its popularity was its offer of a 20% annualized return for providing TerraUSD to the protocol, akin to a bank providing a 20% annualized deposit rate for your cash. As the withdrawals commenced, large amounts of TerraUSD were being sold for other assets. This brought the first notch at the de-pegging. As the coin lost its hold this “instability prompted investors to pull their TerraUSD from Anchor and sell the coin. That in turn, led more investors to withdraw … creating a cascading effect of more withdrawals and more selling.” This triggered a collapse that erased almost all of the value from the underlying blockchain and associated stablecoin. A total of $60 billion dollars, evaporated in a matter of two weeks, compromising roughly 2.7% of the entire crypto market. (ARK BITCOIN Monthly) In an attempt to prolong the inevitable, the Luna Foundation Guard, a nonprofit organization created to establish a reserve fund for UST emptied its reserves of Bitcoin and other cryptocurrencies in a failed attempt to maintain the peg. From the chart provided by Ark’s first Bitcoin Monthly, we see that Luna increased their Bitcoin reserves by 8x within the period of March to May of this year. One can assume that they knew that there would be some kind of bank run or attack and attempted, albeit failed, in a fortification plan to preserve the blockchain. What solidified the loss was the suspension of trading of TerraUSD and Luna from the Binance platform and the twice halting of the blockchain itself. The circulating supply of Luna tokens has ballooned from 350 million to 6.5 trillion during the entire ordeal and a hard fork has been implemented, with a new capped supply of 1 billion LUNA tokens. The original Terra Luna chain has been rebranded as Luna Classic (LUNC) and still trades around $0.00008.
In Relation to Algorithmic Stablecoins, Let’s Introduce the United States CBDC
With the collapse of Luna, the largest algorithmic stablecoin in market capitalization, regulators and governments are threatening the crypto space with increased overwatch. Algorithmic stablecoins are in one way similar to synthetic CDOs, i.e., non-existent representation of assets. In the end, they do not hold any relation to a real asset. Instead, they hold, through financial engineering, its mirrored existence. They are nothing but a bet or a promise that the representation is worth in parity to what it represents. This is why they are extremely dangerous. They masquerade as the underlying asset but have no real connection to it. Unlike Pax Gold (a stablecoin with convertibility to actual gold) or USDC (backed by dollars), algorithmic stablecoins are no different than word-of-mouth backing. The underlying blockchain promises that they are worth a dollar, similar to current fiat systems. Governments assure us that the value of our currency holds with nothing more than grandstanding or promise.
Due to this instability, and crash, there is a possibility that with increased regulations, governments will also increase research and development on Central Bank Digital Currencies. As usual, governments will leverage a destroyed situation, even if it has no regard for them, and play off of it to their own advantage. With the technology years away, according to Janet Yellen, CBDCs will only increase in development and usage. One can assume that, with the current stablecoin crash, the United States government will further its implementation of CBDCs and speed up the process. This will digitize cash and place us one step closer to a cashless society.
Yet why is a digital dollar exactly negative to an overall society? With CBDCs, any crime using physical notes will become increasingly difficult to commit. Criminals will branch out into specific cryptos, that promise privacy, but all transactions will be recorded. That is one benefit, a supposed downturn in crime.
The negatives though, out way the positives as every single user of a CBDC will be tracked and extremely, easily linked to the person who owns it. There will be no more privacy in regard to financial transactions. Governments will have the power to freeze any account, without the intermediary of a bank, or if they deem you a hostility, they can cut off all financial access to you. This occurred recently in Canada in regards to the Freedom Convoy protest. Meanwhile, in China, over 123 million wallets were issued, as of October 2021. In order to receive a wallet, you must at minimum provide your phone number, and on average provide your banking information and ID. The privacy of using physical currency to transact will be assuaged away under a CBDC system. All power over finance is relegated to the hands of the state.
To avoid the leviathan’s grasp over our ability to transact, more users must become equipped with the knowledge of basic crypto technology and blockchain. Once they understand the use cases for this underlying technology and the inherent flaws of fiat systems and cryptosystems, we can push away from the workings of the past and move towards a decentralized method of the future. Stablecoins are useful for current needs, such as exchanging for other cryptos or remittances without volatility in the price, their hold on traditional and governmental systems is still strong. We must break this barrier of stability and stablecoins and build an infrastructure for a bitcoin and Defi monetary future.
Certain portions of the stablecoin technology do not hinder the freedom that crypto provides but leads the participant down the wrong path. For true economic freedom, freedom of fiat standards, and governmental manipulation, stablecoins are not the desired product, but a stepping stone for the novice who is entering the field. When the novice learns the ropes, he can advance to the next layer, from stablecoins to more volatile single-purpose chains, such as Bitcoin or Litecoin, and then public access multipurpose chains, i.e., Ethereum and Solana. Afterward, he will strip the usage of stablecoins and with growing adoption, be able to live without any interference from governmental actors. This is the path that needs to be learned and followed, the larger the following the better. The more users we have in the crypto economy the less we are all devalued by political actors. This power shift will bring decentralization to finance and democratize the global economy, no longer requiring the delays of middlemen such as banks and the reliance on liquidity with federal reserve printings.
While stablecoins are a considerable factor in the total market cap of the crypto economy, all major governments are working on plans to create a digital fiat, backed by their federal reserves. CBDCs will become inevitable, which every person holding a social security card can access. This allows the delegation of cash to become a niche form and eventually abate into nothing. Eventually, a cashless society will become imminent with every financial transaction being recorded and kept and traced to every user. No more privacy with regard to finance and in regards to the freedom of the user. Governments will exploit the mass population into believing that blockchain technologies are dangerous and used for fraudulent activities while using the same technology to build their 1984-esque financial tracking system.
Bitcoin and other self-sufficient cryptocurrencies were created to counteract the governments around the world. In the end, stablecoins are the first lesson to a better understanding and usage ability of the broader crypto economy. They are not meant to overtake the main purpose chains but allow stability in usage until the volatility with the main purpose chains subsides.
This article has been contributed by Mr. David Portyanskiy.
He is a young tech writer and has graduated in finance from the College of Staten Island. He is currently residing in New York City. He has been writing for a few years and has an interest in world literature and philosophy. He has recently published a short story in an Australian magazine titled FreeXpression and a literary website called Antarctica Journal. He is also a composer and a pianist.