UST Will Inevitably Consume the Stablecoin Market
In 2008, Satoshi Nakamoto released a whitepaper with a vision of “a purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.” While Bitcoin has clearly gained widespread popularity, its use case has turned from electronic cash into digital gold. This is because it has had a tough time of filling out its mission as a payment system or medium of exchange. Bitcoin continues to see price volatility in the short term, as well as 200% risk adjusted annual appreciation, so individuals are lot less likely to use it to transact. This is where stablecoins have found their product-market fit. Users can benefit from the stability and network effects of fiat currencies while providing lightning quick settlement times and cryptographic ownership.
However, the stablecoins that have thus-far seen large adoption within the crypto and DeFi space have been antithetical to Satoshi’s vision of purely peer-to-peer transactions. Let’s explore why these options aren’t ideal.
Problems with Centralized Stablecoins
The problems stablecoins of the likes of Tether and USDC stem from their centralization and the collateral supposedly backing their stablecoins. How they are supposed to work is that for every stablecoin that is minted, there is an equivalent US dollar in the company treasury. In practice, this isn’t the case, and we have seen Tether and Circle under intense scrutiny over how their treasury is handled and the quality of their investment vehicles (“commercial paper”, etc.). Because of this uncertainty, they are constantly under regulatory surveillance, and any centralized stablecoin that will continue to hold and contract US dollars will need to work closely with and abide by these regulators. As long as there is this control, regulators or the companies themselves are able to change the rules of the system at any time. In fact, there have been many instances () in which Tether and Circle have frozen accounts and reversed transactions at the request of law enforcement.
If a central entity can have control over a transaction, it immediately violates Satoshi’s vision for purely peer-to-peer cash. This also presents problems if you’re a DeFi product built with USDC or Tether as a main source of liquidity, because you are held hostage to the decisions or regulatory pressures of Circle or Bitfinex, despite having an aim of decentralization.
Even DAI, touted as a decentralized stablecoin, falls victim to the same problems. This is because 60% of all DAI in circulation is backed by USDC, so any problems that fall under Circle’s jurisdiction indirectly affect DAI holders. Another issue with DAI is its over-collatoralization. For every DAI minted, you need to provide 1.5x the value in another cryptocurrency. This provides scaling issues, because in order for expansionary monetary policy to work well there needs to be an equal amount of supply to match demand. When the incentives to mint DAI are only to leverage the underlying asset of higher value, this doesn’t work. Algorithmic stablecoins on the other hand are very easy to scale, because there’s often a mechanism in which stablecoin demand can be quickly and easily matched with supply. In the case of Terra, you are always able to burn $1 worth of LUNA for 1 UST.
In order to build truly decentralized applications, they must be centered around completely permission-less, censorship-resistant, scalable, decentralized stablecoins. We’re going to see a slow shift of protocols and individuals realizing the burden that centralized stablecoins can have on how they operate in the DeFi space, and people will inevitably land on stablecoins that are completely decentralized, in which UST will be clear winner.
Terra isn’t the only protocol creating decentralized algorithmic stablecoins. In fact, many that have tried have found their stablecoin completely drift from the intended peg. What sets Terra apart? I’m going to assume you already have general knowledge of how UST maintains peg, but if not here’s a great video explaining it. In simple terms, protocol seignorage allows anyone to create one UST by burning a dollars worth of LUNA, or mint a dollars worth of LUNA by burning one UST. This can provide arbitrage incentives, because if UST is trading over $1 someone can buy dollars worth of LUNA, burn it for one UST and sell it for a profit. The same is true of UST is trading under $1, someone can buy UST for a discount, swap it for $1 worth of LUNA and profit the difference. What Terra’s founders realized is that the only way these assets could survive a death spiral would be to provide real world use cases for the stablecoin. But beyond that, in order to build an extra layer of protection they were able to give the underlying volatile asset intrinsic value, build trust in the system through large growth and stress tests, and close the money loop where there is no need to exit to fiat or other stablecoins. Many of the founders of other algorithmic stablecoin failed to establish these points. At their infancy, the only use case the stablecoin had, and the only intrinsic value the native token had, was to yield farm more of the coins themselves. Taking Iron finance as an example, as soon as whales pulled their liquidity from the pools and the Iron stablecoin was trading off peg, there was no stability behind the protocol to keep people’s faith in the system, and a panic sell induced.
Terra, on the other hand, took a completely different approach. Their very first step was to create real world use cases. They integrated their KRT stablecoin with Chai, a payment app which already has over 2.5 million users, around 5% of the South Korean population. As UST was introduced, they very quickly came out with Mirror Protocol, a synthetic asset protocol that follows the prices of real world assets, and eventually Anchor Protocol, I high yield savings account. Now that there were people actually using the stablecoin day-to-day, a large number of its holders would be a lot less likely to panic sell if the token temporarily loses peg. LUNA was then able to gain intrinsic value, because it could now provide its stakers with transaction fees gained through their real world usage. To understand why intrinsic value matters read this thread by @larry0x about what backs UST.
As the use of these protocols grows larger, the trust of the system also continues to grow, as more capital is needed to ultimately affect the peg. In times of immense instability in the crypto markets, there is a large run to fiat, causing sell pressure in both the underlying volatile asset and stablecoin, which increases delta risk of arbitrage and provides a true test to the peg mechanism. Terra was able to withstand this instance during the May Day crypto crash, having brief periods of de-pegging but very quickly getting back to $1. Both instances of growth and anti-fragility help build trust in the pegging design and make people less likely to panic sell if they notice UST trading below its intended peg.
Finally, the ecosystem being built around UST is vast and will cover all areas in which you can use money: to spend, to invest, and to earn yield. You are already able to earn yield on Anchor, invest in mirrored equities through Mirror, and can pay through the Chai app, ultimately creating a closed loop if you so choose. With the development of many new applications and protocols continuing to facilitate each of these uses, there will be less and less of a need to exit the ecosystem, and will therefore provide reduced pressure to the sell side of UST’s peg.
All in all, Terra has built rock solid layers of protection around its pegging mechanism that have allowed it to survive as crypto’s only truly decentralized stablecoin to reach sufficient scale. Now that UST has established real world use cases, has survived stress tests, is built to scale easily, and carries out Sathoshi’s vision of true decentralized peer-to-peer cash, it is clear that UST is technologically the superior stablecoin and will inevitably swallow the entire stablecoin market whole. It is not a matter of if, but when.
- Bitcoin Whitepaper
- Terra Whitepaper
- CoinDesk: Circle Confirms Freezing $100K in USDC at Law Enforcement’s Request
- Bitcoin.com: Tether Freezes Millions of Dollars USDT in 40 Addresses Amid Regulatory Pressure
- How Does Terra Work? (Terra)
- @larry0x Twitter thread
- Real Vision: Terra: Progressing Toward the First Decentralized Stablecoin
- Exposing Tether — Bitcoin’s Biggest Secret (Coffeezilla)
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