Looking at the game of algorithmic stablecoins from LUNA

After the Fed announced a rate hike, the crypto market fell as a whole, and then crypto panic intensified. At the same time, the Terra ecological team LFG announced to adjust the withdrawal gap of the UST-3Crv pool. The giant whale address sold UST, causing the first algorithm stable currency UST to be seriously de-anchored, and then LUNA collapsed and fell into a death spiral. A series of operations to encircle and suppress UST further brought down the market, and also allowed the market to witness the game of algorithmic stablecoins again.

A brief review of this event: Terra (the token Luna) is a public chain ecosystem built around stablecoins (UST). Terra deeply binds its stablecoins to public chain businesses. Ancho, the DeFi platform officially launched by Terra, has shaped the demand for stablecoins with an extremely high APY (Annual Percentage Yield, or annualized yield) of around 20%, thereby attracting users and starting ecological construction. The setup mechanism is: For every UST minted, $1 worth of Luna must be burned. Luna maintains the peg of UST to the US dollar through arbitrage and seigniorage mechanisms. During this process, the actual controller obtains funds by cashing out or destroying Luna; the cashed-out funds continue to be subsidized to promote the development of the ecological cycle. However, when the UST-3Crv pool was shorted during the withdrawal period and the market fluctuated greatly, the panic of users was aggravated and the sell-off phenomenon was expanded. At the same time, the LFG rescue mechanism was difficult to maintain, thus a series of games were staged in front of encrypted users. The phenomenon of algorithm imbalance, stablecoin de-anchoring, and project token collapse.

As the largest algorithmic stablecoin, the collapse of UST once again sparked heated discussions in the market. Is the algorithmic stablecoin unsustainable? Is a death spiral inevitable? Are algorithmic stablecoins not a good option?

Top Stablecoin Tokens Ranked

According to Coinmarketcap data on May 12, the top five top stablecoin tokens by market capitalization are USDT, USDC, BUSD, UST, and DAI.


(Top stablecoin tokens by market capitalization on coinmarketcap, May 12th data)

From the perspective of the main stablecoins, there are three main modes of stablecoins: stablecoins collateralized by fiat currency (USDT, USDC, BUSD), stablecoins collateralized by cryptocurrency (Dai), and algorithmic stablecoins (UST). These three models also reflect the path of stablecoins from “connecting the world of fiat currency” to “encrypting native coinage”. From the current development point of view, although the algorithmic stable currency of encryption native coinage is imaginative and subversive innovation, it is difficult to complete the regulation based on market will and algorithm. It is filled with a large number of games, speculation, arbitrage and other behaviors, which are naturally full of controversy in the market.

Fiat-backed stablecoins

First of all, the background of the birth of stablecoin is that the price of cryptocurrencies fluctuates greatly. As a medium of exchange, it connects the world of digital currency and the world of fiat currency.

Mainstream encrypted assets such as Bitcoin and Ethereum are all non-stable coins, and their currency values ​​will constantly change with market fluctuations. In order to better realize the transaction and exchange of assets, and to facilitate the connection with the real world, crypto practitioners hope to create a “stable currency” that has relatively stable value.

At this time, the most common and arguably the simplest stablecoin collateralized by fiat currency appears, the typical representative is USDT. Tether Limited established by Bitfinex in 2014 issued USDT, which is a cryptocurrency with stable value and is currently the top spot in the stable currency market. Tether claims that for every USDT issued, it deposits 1 USD in the bank to anchor the USD to ensure stability.

Under this fiat currency reserve mortgage model, the stable currency held by the user is actually the IOU of the stable currency issuing company. The centralized issuing company mortgages its own assets to issue stable currency. Each stable currency corresponds to its existence and the bank. Equivalent assets to ensure that the stablecoins held by users can be converted into fiat currencies in proportion.

Through stablecoins collateralized by fiat currency, such as USDT, users realize the two-way exchange of fiat currency-USDT (issued by a centralized company)-encrypted assets.

The advantages of this model are obvious, the process is considerable, assets are used as collateral, and the technology is simple to implement. Of course, the shortcomings are also obvious. The issuing company of the stablecoin is a centralized private company, which cannot prove whether it has made a full mortgage and has risks such as bankruptcy and running away of the centralized company. Once there is a lack of trust, there will be situations such as thunderstorms and slumps.

Of course, regulated stablecoin USDC and mainstream platform stablecoin BUSD, etc. appeared in the market subsequently.

Digital Asset Collateral Mode Stablecoin

If the above-mentioned first-generation fiat currency-collateralized stablecoin is an important bridge between fiat currency and cryptocurrencies. Then the emergence of the second-generation digital asset mortgage model stablecoin (Dai) has opened the way for the development of decentralized stablecoins.

Digital asset mortgage mode The stable currency mode is to mortgage digital assets on blockchain smart contracts to issue digital currency anchored to the price of fiat currency. In this mode, the collateral itself is mainstream digital currencies such as BTC and ETH. Because the collateral itself is decentralized and can be executed through smart contracts, the trust risk of the fiat currency collateral model is eliminated.

The main advantage is that it embodies the idea of ​​decentralization of the blockchain. The collateral is locked in the smart contract, which is open and transparent, cannot be misappropriated and frozen, and no one or institution can control the issuance of stable coins.

However, there are also disadvantages. Due to the huge price volatility of the collateral cryptocurrency, it is prone to “insolvency”, that is, the so-called “liquidation” liquidation. And liquidations occur that cause prices to continue to fall, which in turn leads to more liquidations, with a knock-on effect. For example, a series of liquidations occurred after the 3.12 black swan event in 2020. In the follow-up, to deal with market risks, MakerDAO introduced some centralized assets as collateral, such as USDC, wBTC, etc. For stability, MakerDAO made certain trade-offs in decentralization.

Algorithmic Stablecoins

As the above-mentioned first- and second-generation stablecoins gradually gain widespread adoption, and the vision to pursue native coinage in the cryptographic field continues to evolve, unsecured/algorithmic (minting rights model) stablecoins emerge.

The stable currency of the coinage model is different from the previous two mortgage models. The former two use centralized and decentralized assets as collateral, while the coinage model is the model of the algorithm central bank. The central idea is to automatically adjust the market through algorithms. The supply and demand relationship of the token, and then the price of the token is stabilized at a fixed ratio with the fiat currency.

So how does the algorithm automatically adjust? To put it simply: unsecured/algorithmic stablecoins can be called coinage model stablecoins. This model, as the name suggests, truly realizes the native tokens in the cryptographic field, which is analogous to the real world. Functionally, their monetary policy is similar to the way central banks manage money. In reality, the central bank can maintain relatively stable purchasing power by adjusting interest rates (reserve reserve ratio, base interest rate, etc.), bond repurchase and reverse repurchase, and adjusting foreign exchange reserves. Adjustment means that algorithmic banks can also sell, repurchase shares, and adjust mining rewards to ensure that the price of stablecoins is relatively stable.

The algorithmic stablecoin mainly wants to increase the market supply when the stablecoin price is higher than the anchor price by simulating the monetary policy function of the central bank, and then recover the supply when the stablecoin price is lower than the anchor price, so as to maintain the stability of the stablecoin price. balanced. Algorithmic stablecoin can be said to be one of the most imaginative and subversive projects so far. It realizes the function of a central bank to adjust the currency circulation without a central bank, creating “no central bank”. the “central bank model”.

Algorithmic stablecoins appeared in 2018, but they were not as popular as they are now. The originator of algorithmic stablecoins is AMPL (Ampleforth), which is also the first generation of algorithmic stablecoins. Subsequently, ESD mode, Basis mode, FRAX partial algorithm stable coins, etc. appeared. Interestingly, at that time, the emergence of algorithmic stablecoins attracted the attention of the industry with “unstable prices”. In 2020, the skyrocketing market such as ESD, BASIS, and FRAX led by AMPL has kept the popularity of algorithmic stablecoins high.

Market researchers pointed out that at that time, people found that they could speculate based on the algorithmic characteristics of the algorithmic stablecoin itself, so as to obtain high returns. Algorithmic stablecoins can be said to be one of the most imaginative and subversive innovations so far, but it is difficult to be fully regulated by market will and algorithms. I want to completely offset the price control brought by centralized institutions through algorithms, but I do not have enough market recognition to maintain its own price stability. By giving arbitrage space for a cold start, most of the users who enter are for the purpose of obtaining The excess returns of the early “rich spiral”, rather than the real use of algorithmic stablecoins as payment tools or value storage tools. If demand for the stablecoin shrinks or suffers a crisis of confidence, algorithmic banks will have to issue more stocks and bonds, which will be converted into more money supply in the future, and then fall into a death spiral.

Why did LUNA fall into a death spiral?

Terra (the token Luna) is a public chain ecosystem built around stablecoins. Its business goals can be summarized into two points: to promote the prosperity of the Terra public chain; to promote its stablecoins represented by UST (an algorithmic stablecoin). Mass adoption. Whether it is a stablecoin or a public chain, the project party can benefit from its development and indirectly tax (rent-seeking). Terra also successfully got out of the circle through the stablecoin + public chain model.

Terra deeply binds its stablecoin to the public chain business. Specifically, Terra’s public chain ecology provides an initial application scenario for stablecoins and solves the biggest problem of stablecoins, that is, cold start. Stablecoins such as UST need to be minted by destroying Terra’s token Luna. The larger the issuance scale of stablecoins, the larger the scale of Luna deflation, and the smaller the total supply. On the contrary, when UST is reversely redeemed for Luna, the supply of Luna will increase. . For every UST minted, $1 worth of Luna must be burned. Luna maintains the peg of UST to the US dollar through arbitrage and seigniorage mechanisms. If $UST price is > 1$, there is a chance to burn $Luna, mint $UST, and take the difference with the peg as profit. If UST is < 1$, $UST can be burned for $Luna to restore the hook. Buy 1 UST for less than $1 and get $1 worth of Luna. Then sell $Luna for profit. Luna is burning day by day as demand for $UST continues to grow.

At the same time, Terra officially launched the DeFi platform Anchor Protocol (hereinafter referred to as Anchor) in March 2021. The lending protocol Anchor, as a “state-owned bank”, promised a super high demand yield of 20% to absorb public deposits (with UST). form).

Therefore, Terra has achieved cyclic development, created DeFi scenarios in the public chain and provided subsidies (represented by Anchor), which shaped the demand for stablecoins; the demand promoted the scale of UST casting, and users began to be introduced; improved ecological data performance, such as TVL, the number of addresses, the activity of transfers, and the number of projects participating in the ecosystem; the boost of indicators has strengthened the appeal of Luna’s narrative; based on the improvement of consensus and fundamentals, cooperation with more leading projects has been promoted; narrative and consensus Enhancement increases the trading breadth (number and area of ​​investors) and trading depth of Luna, and gradually pushes up the price; the actual controller obtains funds by cashing out or destroying Luna; the cashed-out funds continue to be subsidized to promote the above cycle.

But the above logic is that the actual controller can obtain funds by cashing out or destroying Luna to support the subsidies provided by Anchor. If the demand for the stablecoin shrinks or encounters a crisis of confidence, causing a massive sell-off in the market, even if the LFG support is unsustainable, it is easy to fall into a death spiral. Of course, the collapse of LUNA has the factor of being surrounded and suppressed by giant whales, but in general, it is related to the fact that when algorithmic stablecoins try to formulate the monetary policy of an economy, it is difficult to completely rely on market will and algorithmic regulation.

It can be said that the innovation and difficulty of algorithmic stablecoins have become market consensus, and even many trading products have taken into account the decoupling of algorithmic stablecoins. For example, OKX’s official Twitter message said that on May 8, the price of LUNA dropped to 65USDT, and the price of UST had a short-term decoupling for the first time, triggering the risk control system. OKX has launched an automatic redemption mechanism to remove all users’ assets from the chain. Redemption for distribution. When redeemed, the UST price is 0.996USDT.

It is worth mentioning that, starting from the loss of UST’s anchoring, as of May 12, there has also been a series of chain reactions in the stablecoin market. The first is that USDT once fell to $0.94864, breaking the anchor by more than 5%. However, Tether CTO Paolo Ardoino reminded on Twitter that Tether is executing USDT redemption at a price of $1 through tether.to. More than 300 million have been redeemed in the past 24 hours, so it can be said that there is no pressure. USDC rose for a while due to its regulated nature, but as of press time, USDC has now fallen back to 1.017 USDT.

Ouyi OKX pointed out that after the deviation of the USDT Curve pool, the remarks about “USDT thunderstorm” appeared on a large scale, resulting in some funds fleeing in exchange regardless of the cost, resulting in abnormal fluctuations in the exchange rate of USDT against other stablecoins .

At present, there is suspicion of excessive risk aversion. Unlike algorithmic stablecoins and over-collateralized stablecoins of encrypted assets, USDT has relatively more reliable value support, better liquidity, and a consensus accumulated through time-tested accumulation. Considering that every time the market is down, there is similar false news, so don’t panic too much.

In fact, the encryption market has always advocated innovation. Even after USDT and USDC have flourished, the market still has expectations for algorithmic stablecoins, mainly because algorithmic stablecoins try to build an algorithmic central bank and achieve digital native innovation, but due to its combination with a large number of There have also been many crash moments in the coexistence of behaviors such as gaming, speculation, and arbitrage. It can be seen that social experiments of algorithmic stablecoins still have a long way to go.

New trends in stablecoin regulation

It is worth mentioning that with the rapid fermentation of UST’s loss of anchoring, many regulatory agencies have also put the supervision of stablecoins on the agenda.

May 12 news, US Treasury Secretary Yellen: Terra is a real example of stable currency risks. The Treasury Department is gearing up to develop a stablecoin risk report. Yellen reiterated the need for a comprehensive framework for stablecoins.

In addition, Ashley Alder, chairman of the International Securities Commission (IOSCO), an association of market regulators, said that a joint body responsible for coordinating global cryptocurrency regulation is urgently needed and could become a reality within the next year.

On May 10, the Federal Reserve released its latest Financial Stability Report on Monday, emphasizing the risk of a run on stablecoins. Some types of money market funds (MMFs) and stablecoins remain prone to runs, and domestic banks have lower capital risks, but some money market funds, bond funds and stablecoins still have structural vulnerabilities, the report wrote. Back in January, Federal Reserve researchers published a study on the risks and benefits of stablecoins that said the Financial Stability Oversight Board could step in to oversee stablecoins if Congress does not enact new laws targeting the industry.

On May 11, at a financial markets conference hosted by the Atlanta Fed, Nellie Liang, the U.S. Treasury’s undersecretary for domestic financial affairs and report leader of the U.S. President’s Working Group on Financial Markets (PWG), said that even now it is largely unaffected. Prudentially regulated stablecoins must also comply with the Bank Secrecy Act (BSA) and Anti-Money Laundering (AML) requirements at the national level.

On May 12, according to a document, the European Commission is considering strict restrictions on the ability of stablecoins to replace the widespread use of fiat currencies. EU finance ministers have proposed tough measures aimed at preventing stablecoins from replacing the euro, and have called for a halt to issuance if a single day’s volume exceeds 1 million or the transaction value exceeds 200 million euros. The document is marked “off-paper”, meaning it does not reflect the official position of the Committee. European Union lawmakers and the government are trying to finalize a landmark cryptocurrency law known as Market Regulation in Crypto Assets (MiCA), with the committee to hold closed-door negotiations at a later stage.

In April of this year, the British Treasury also stated that it intends to pass legislation to bring certain stablecoins into the regulatory scope. Some stablecoins have the potential to become a wide range of payment methods, including retail customers. The revised electronic currency framework can provide a A consistent framework to regulate the issuance of stablecoins and the provision of wallet and custody services.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/looking-at-the-game-of-algorithmic-stablecoins-from-luna/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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