It’s safe to say we’re in another crypto winter while projects go under and investors keep their heads together. The cause of this series of unfortunate events was undoubtedly the disconnection of TerraUSD (UST) from Luna in May, along with rising interest rates and macroeconomic recession.
Stablecoins can be tricky so I want to be able to give potential users a guide to what types there are, what to look for and why the Luna and UST depegging happened. Let’s dive in.
Types of stable coins
There are three types of stablecoins:
- fiat-backed (e.g. USDC)
- algorithmic (e.g. UST)
- overcollateralized (eg DAI)
Fiat-backed stablecoins are the most popular and widely used and are self-explanatory. They are usually backed by the government-issued US dollar, which is generally very stable.
Algorithmic stable coins, which everyone has been talking about lately, are not backed by any assets and try to maintain their linkage through algorithms, hence the name. In the case of UST, it was due to the beating and burning of its sister token, Luna, that as we saw in the recent market collapsed, and so did the $1 price of UST. People lost millions†
Over-collateralized stablecoins, such as DAI on Ethereum or aUSD on Polkadot, are always backed by more collateral than the amount of stablecoin issued in the market. For example, $100 million in collateral for $25 million in stablecoins. This overcollateralization helps prevent insolvency as more debt than assets are held by the stablecoin protocol, preventing depegging of the stablecoin due to fluctuating price in collateral assets such as ETH or DOT.
DAI is a perfect example of this. The DAI stablecoin has been around since the end of 2017 and has maintained a stable pen, despite countless ups and downs in the market. The revenue that can be earned on stablecoins is completely dependent on the apps that integrate them. Unsustainably high returns on stablecoins should definitely have you scratching your head and wondering, Is this too good to be true?
How to avoid getting burned again?
Simply put, algorithmic stablecoins do well in a bull market, but don’t work in a bear market, and recent events prove it. When Luna went, so did the peg of UST to $1. Next time there is a bull market, I wouldn’t be surprised if another algorithmic stablecoin comes to the fore and doesn’t learn from past mistakes. Anyone who has witnessed recent events can do our best not to make the same mistake twice and help educate others.
Just as investors who put their money in Bernie Madoff get insanely high returns and ask no questions, today’s investors should do their research and ask themselves if something is too good to be true. In this case, someone just had to lock in their UST and magically got a return close to 19.5%. A good example of this is Celsius. Recently, it offered double the yield of its competitors. Now we see this collapse where Celsius freezes its network.
My top three tips for future stablecoin holders
I want to make sure crypto participants have a stable framework to rely on in the future and avoid financial ruin. Here are my top three tips for avoiding problems.
- Buyer note: If it seems too good to be true, it probably is. A historical return on the market is 8% per annum, so don’t be greedy or be fooled.
- Look under the hood: See how a stablecoin actually works. If you value decentralization and owning your own assets, look to DAI on Ethereum or aUSD on Polkadot. If you prefer paper money and don’t mind centralization, check out fiat backed coins as real dollars are still trusted by many. From dollars to gold, you need to know what supports the token when you are looking for a stablecoin.
- Get comfortable: Make sure the stablecoin is offered on your platform of choice. See where certain stablecoins are offered and how much you can earn on that platform. For example, you can use stablecoins in decentralized financial apps. Or your preferred exchange like Coinbase can offer returns on stablecoins.
Months before the crash of these algorithmic stablecoins, the token issuers began buying billions of dollars worth of Bitcoin collateral, essentially trying to move to the DAI and an overcollateralized USD model. Their goal was to use the assets to ensure the pegging would not take place. It clearly did, despite attempts to use the Bitcoin to push the price of UST back to $1.
Why did they do it? Because overcollateralization works. Why? Think of it like going to the bank to get a $10,000 car loan and the bank just didn’t trust you, so you would have to give the bank $20,000 as collateral. Now that would never happen, but that’s how DAI and aUSD work. Both have an extreme safety net that ensures a stable $1 peg and a stablecoin suitable for use by decentralized financial apps to give users revenues.
Expect to see more stablecoins looking to incorporate this model in the coming years. Don’t be surprised if you see something similar to UST making a comeback.