By Chris Kilbourn | Crescent City Capital Market Analyst Intern
Stablecoins play a valuable role in the world of decentralized finance, though this role is admittedly undercut in situations where they lose their pegs and trend towards $0.00. Algorithmic stablecoins are at particular risk of de-pegging, yet every ecosystem tries its hand at perfecting the holy grail of a totally uncollateralized cash cow. The latest is the Terra ecosystem, whose UST has a $16B market cap and whose anchor protocol claims to be the official savings account of crypto, with a 20% APR for locked UST. The stability of UST is a matter of grave importance for all those who keep their sidelined capital on Anchor, so it bears questioning whether UST’s peg could ever depeg permanently, as other algorithmic stablecoins have in the past. Deciding whether or not this is a risk we’re willing to take requires a bit of research and a bit of review, so anyone familiar with the workings of stablecoins and UST in particular may prefer to skip to the “Today’s Scenario” section.
There are two basic types of stablecoins, collateralized and algorithmic, and the difference between the two involves how they maintain their peg to the US Dollar. Collateralized stablecoins assert an intrinsic value that is defined by assets they keep in reserve, and they primarily rely on market participants to price their coin accordingly. For example, USDC is a fully backed stablecoin, which means that for each USDC in existence, Centre has $1 held in reserves. With this being the case, traders and exchanges acknowledge that the 42.5 billion USDC in circulation are backed by $42.5 Billion, and $1 is the agreed upon price. While greater than average demand may drive the price above $1, traders and exchanges would then be incentivized to sell to take advantage of the premium. This often takes the form of cross-exchange arbitrage, in which algorithms exploit the difference in price between multiple exchanges and buy large amounts of $1.00 USDC before sending it to another exchange to be sold for $1.01. By this method, USDC has managed to remain pegged to the USD for the past four years.
While it’s easy to see the appeal of such a system, it’s also easy to see why developers would be curious to amend it. $42.5 Billion is a nice bit of money, and anyone managing a $42.5 Billion treasury would start to wonder how little of it they could get away with keeping in reserve. Algorithmic stablecoins were created to solve this problem. Instead of holding collateral to back the stablecoins currently in circulation, the coins are issued by a smart contract that employs an algorithm to maintain the peg, allowing the supply to be uncollateralized so the reserves can be put to use elsewhere.
Price stability is the chief concern when it comes to stable coins, and price is always a function of supply and demand – obviously if there is more demand than supply, the price will go up, and vice versa. A perpetual balance must be kept between the two, and algorithmic stablecoins have unique methods of accomplishing this.
The most common system requires two mechanisms to be in place. When inflation is occurring – when the demand and thus the price is falling – there must be a mechanism in place to reduce the supply. Reducing the circulating supply of these coins is referred to as burning. And when deflation is occurring – when the demand for tokens is driving up the price – there must be a mechanism in place to increase the supply. Increasing the circulating supply of these coins is referred to as minting.
In the case of UST, this manipulation of the circulating supply is done by a form of arbitrage which is handled within the ecosystem and involves not one but two native tokens – UST and Luna. UST is a stablecoin which is pegged to the US Dollar, but like all stablecoins, its price wants to move up as it undergoes wider adoption and is met with higher demand. In this situation, Terra needs to dilute the existing supply by minting more in order to bring the price back to its peg.
Where UST differs from many other stablecoins is the role played by Luna. When the price of UST fluctuates above or below $1, traders can perform arbitrage in house by exchanging their Luna for UST at a value of $1 per coin. Even if UST is priced at $1.01, traders can still exchange $100,000 worth of Luna for $101,000 worth of UST. When this action is taken, new UST is minted in proportion to the amount of Luna traded in, which dilutes the supply and restores the peg. As an aside, this action also burns a percentage of the Luna when it is exchanged for UST, driving up the price of Luna in direct proportion to the demand for UST.
This much we already know, and the material has been covered well by interns past. What hasn’t been covered is the story of another stablecoin entirely – a stablecoin from 2021 known as Iron.
Much like UST, Iron relied on another native token for its burning and minting mechanism. On the Polygon chain, it was collateralized by a token called Titan; on the BSC chain its mechanism was identical and it was collateralized by an analogous token named Steel. Much like its namesake, Steel proved more resistant to stress and did not cause Iron to depeg, nor did it collapse and jettison several billion dollars’ worth of token value, so in the interest of brevity we’ll focus on the Polygon side of the story below.
Iron was designed to be a partially-collateralized stablecoin, and it could be redeemed for $1 worth of the smart contract’s reserves – a ratio of 25% Titan and 75% USDC. As a scheme to steadily lower the amount of collateral held in reserves, the ratio of these two was designed to be reduced over time, and Iron to be backed with an ever-greater proportion of Titan. One intricacy of this variable ratio mechanism was its use in incentivizing arbitrage – the contract itself could modify the target ratio of collateral coins under the assumption that a higher proportion of USDC would be more alluring to arbitrageurs. At times when Titan was below $1, the target collateral ratio would be raised to incentivize the purchase of Titan to be cashed in for USDC. The system appeared flawless – until it didn’t.
In some ways, the governance tokens that underlie their algorithmic stablecoin counterparts function as plays on the stablecoin’s future breadth of adoption. If users are required to burn Luna in order to mint UST, then the assumption that UST will see a never-ending surge in demand would suggest that Luna’s supply will be burned into oblivion – and its price will continue to skyrocket as more and more UST is minted. This equation works both ways, however, and fear, uncertainty, or doubt about the well-being of the stablecoin inevitably casts a shadow on the governance token to which it is tied. After all, if stablecoin adoption flags, presumably there will be less minting of the stablecoin, less deflation of the governance token, and thus less upward price pressure.
This is precisely what doomed Iron. For whatever reason, on June 16th, 2021, several of the whales who provided liquidity on the Iron/USDC liquidity pool got spooked and decided to withdraw their funds and redeem their Iron for Titan and USDC. While the USDC was locked on the contract, the protocol was designed in such a way that new Titan would be minted whenever Iron was redeemed. In the exact inverse of the process described above, the massive redemption of Iron caused the supply of Titan to explode, and the subsequent cratering of Titan’s price was made even worse when investors immediately dumped their rapidly depreciating governance tokens.
Given that Iron was backed by Titan, and its theoretical value was propped up by the collateral underlying it, the collapse of Titan’s price – from $60 to $0 in relatively short order – also caused investors to run screaming from Iron, and it quickly lost its peg on the Polygon chain. Both coins wound up trading at $0 and are currently delisted from all major exchanges.
The question, obviously, is whether this could happen to today’s stablecoin du jour, which has a circulating supply of $16.72 Billion and whose collateral ratio is exactly zero USDC for every UST issued. UST has a few mechanisms in place to prevent this from happening, though it’s unclear whether this would be enough to prevent a depeg in the event of a Titan-style death spiral.
One of the fatal flaws in Iron’s design was the reliance of its peg on arbitrageurs buying the stablecoin for less than $1 to be exchanged for $1 worth of Titan. Once the death spiral began, however, the threat of Titan losing value was enough to discourage anyone from taking the risk of holding any. Nobody would bother arbitraging Iron if it involved being paid out in a governance token that may or may not be plummeting in value – even if it only represented 25% of the payout. UST recently took efforts to circumvent this threat by accumulating large amounts of Bitcoin to be held in reserves, and which UST could be exchanged for in times of de-pegging. Arbitrageurs can currently purchase UST for under $1 then exchange it for $1 worth of BTC, which may help this one potential issue.
Another source of Iron’s woes involved its oracle system. As in any defi product, actions are taken in response to price triggers, and price data is delivered to the contract by oracles that interact directly with the APIs of various exchanges. In this case, Iron’s peg was maintained by allowing arbitrageurs to exchange $0.90 worth of Iron for $1 worth of Titan. This condition required the contract to know Titan’s price, however, in order to determine how much $1 worth of Titan was, exactly.
In order to avoid any exploits that would capitalize on noise in the pricing data, the Iron contract used a time-weighted price oracle that averaged the price of Titan over the past ten minutes or so and then reported that number to be used in Iron redemption. In this case, however, the price of Titan fell so rapidly that the average price reported by the oracle wound up being considerably higher the current price, as it lagged behind any downward movement by up to ten minutes. This in turn reduced the amount of Titan that was given for each $1, so exchanging Iron for Titan actually lost money every time. Arbitrageurs quickly caught wind of the situation and abandoned their work maintaining the Iron peg.
UST has similarly attempted to escape this pitfall by employing a system in which validators who run nodes on its blockchain are required to submit pricing data on Luna/UST, Luna/USD, and UST/USD, then vote on the correct numbers. These votes occur every five blocks, so the prices are updated approximately every six seconds – a substantial improvement over the ten minutes it took Iron Finance to update the price of Titan.
In spite of these safeguards, it’s hard not to look at the history of de-pegs in algorithmic stablecoins and see the bigger picture. Regardless of whatever band-aids are put in place to remedy the specific issues that arose in the past, all algorithmic stablecoins rely on arbitrage to maintain their peg, and the purpose of the algorithm is to incentivize independent market actors to provide it. The conditions for all de-pegs are created when these actors are not sufficiently incentivized, and this possibility is so simple that it can be summarized in one sentence: if the premium on the tokens with which arbitrageurs are rewarded is not enough to warrant arbitrage, then arbitrageurs won’t take the risk.
Terra has already acknowledged this by starting to shift away from its model of an uncollateralized coin, but its frankly questionable whether this could be enough to prevent future de-pegs. Two points come immediately to mind.
One, that it doesn’t matter if Bitcoin is the premier decentralized reserve currency of the crypto world, if Bitcoin is in freefall as we’ve seen so many times before, any arbitrageur in their right mind will wait until its price stabilizes before spending $0.90 on $1.00 worth of BTC that could be worth $0.75 later in the afternoon. This lapse in arbitrage is in itself enough to end the peg of UST to the US Dollar.
Two, that the foundation responsible for purchasing the Bitcoin reserve that will supposedly undergird UST’s peg has pledged to purchase $10 Billion worth of BTC to be redeemed by arbitrageurs at times of heightened stress. This sounds like a great plan until you consider that UST’s current circulating supply is 16 Billion. Even if the 10 Billion BTC were in place right now to be redeemed for sub-peg Iron, it would still leave the stablecoin 60% collateralized, which is barely any better than Iron was. In light of the fact that UST has plans to expand ever-more aggressively into the normal, off-chain economy, the possibility that UST could command $100 Billion worth of the crypto economy with a 10% collateral ratio doesn’t exactly put the mind at ease.
Finally, the last thing to keep in mind is that the attractiveness of the governance tokens that incentivize arbitrage is entirely a product of the deflation produced by progressively more stablecoins being minted. Arbitrage is a terrific opportunity when Luna is consistently being burned to mint new UST and there is constant upward pressure on its price. As soon as UST adoption plateaus or begins to decline, the baseline level of arbitrage becomes considerably more precarious, and as we saw in the case of Titan, this proved a fatal flaw even when the governance token provided only 25% of the arbitrage rewards. Even selling billions of dollars’ worth of Bitcoin to arbitrageurs at a loss – hardly a sustainable solution – would not be enough to incentivize arbitrage, as a major percentage of the rewards would still be in a depreciating asset propped up only by the expansion of the UST supply.