Understanding the Risks of Cryptocurrency. Image by Freepik Introduction Cryptocurrency has become increasingly popular in recent years, offering a decentralized and fast alternative to traditional currency. However, despite its many benefits, it is important to be aware of the risks involved. In this article, we will explore the various risks associated with cryptocurrency. Market Volatility: One of the main risks of cryptocurrency is its high volatility. The value of cryptocurrency can fluctuate greatly in a short period of time, making it difficult to predict and potentially leading to significant losses. Lack of Regulation: Another risk associated with cryptocurrency is the lack of regulation. The cryptocurrency market is largely unregulated, leaving investors vulnerable to fraud and scams. Additionally, the anonymity of cryptocurrency transactions can make it difficult to recover lost funds. Security Concerns: Cryptocurrency is susceptible to security risks, including hacking and ...
TerraUSD (UST) is a stablecoin built on the Terra blockchain that was designed to always retain its $1 value, or to be "pegged" to the US dollar. The idea is that regardless of market conditions or any macro event, the value of a UST should always be $1. That did not quite work out.
It was de-pegged on May 9, rapidly losing value, and is now nearly worthless as of this writing, hovering around 2 cents per UST. Those who invested in UST have lost the majority of their money, mirroring the 2008 Financial Crisis.
LKB & Partners, a South Korean law firm, is suing Do Kwon and Daniel Shin, the founders of Terraform Labs, the company that developed Terra blockchain, on behalf of five investors, alleging a total loss of approximately 1.4 billion Korean won ($1.1 million). Other investors are also planning to file their own lawsuits, focusing on whether Terraform Labs accurately represented its products and the risks of investing.
How did a "stablecoin" become so volatile? To answer that question, we must first define what a stablecoin is, why they exist in the first place, how they function, and finally, what happened here. We'll conclude with some general advice for anyone thinking about purchasing stablecoins in the future.
What is a Stablecoin?
A stablecoin is any cryptocurrency that is pegged to the price of a stable asset, such as gold or a fiat currency like the US dollar. Some stablecoins, depending on their mechanism, are linked to a Decentralized Autonomous Organization (DAO) that controls issuance and pricing.
Why would there be a need for stablecoins?
Cryptocurrencies have historically been extremely volatile. The entire crypto market lost roughly 70% of its peak value in early 2018, entered a bear market until late 2020, rallied for about a year, reaching its peak in mid-November 2021, and has since been tumbling down again. All major cryptocurrencies (e.g., bitcoin, ether) are down 50% on average since their peak in mid-November 2021. Intraday swings can also be significant; cryptocurrencies can move more than 10% in a matter of hours.
With such high volatility, using cryptocurrency as a reliable medium of exchange is difficult, if not impossible. Merchants can't afford to be paid in a coin that will lose half its value the next day. Stablecoins attempt to address this issue by stabilizing the coin's value, making it less volatile. By tying it to the price of another asset, the coin's value remains constant in relation to that asset.
Different mechanisms are used to keep the value of stablecoins stable. We'll go over three of the most important methods:
Centralized, fiat-collateralized stablecoins:
A centralized company keeps assets reserves in a bank or trust (for currency) or a vault (for gold) and issues tokens (i.e., stablecoins) that represent a claim on the underlying asset. They generate stablecoins in the amount of the underlying asset that they own. Because it represents a claim on another asset with a defined value, the digital token has value. The reserves for those assets are audited on a regular basis.
Tether (USDT) was the first stablecoin to try this in 2014, and it currently has the largest market share of all stablecoins. In terms of market capitalization and volume, the top three stablecoins are all centralized fiat-collateralized stablecoins – Tether (USDT), USD Coin (USDC), and Binance USD (BUSD), which account for roughly 90% of stablecoin market capitalization. Since its inception, this type of stablecoin has managed to keep its peg to the US dollar at all times.
When TerraUSD (UST) began to rapidly lose value, investors fled to the top three stablecoins, converting UST and similar algorithmic uncollateralized stablecoins (discussed further below) to centralized fiat-collateralized stablecoins. This conversion may have exacerbated UST's decline.
Decentralized cryptocurrency-collateralized stablecoins:
The stablecoin is backed by other decentralized crypto assets in this mechanism.
One example is the MakerDAO stablecoin (DAI), which is pegged to the US dollar and encapsulates decentralization features. While centralized stablecoins are controlled by a single entity, DAI is not controlled by a single entity.
DAI is instead backed by Ethereum-based assets that are locked up as collateral in an Ethereum smart contract. How exactly does that work? The collateral is stored in a smart contract, where it can be accessed by repaying the stablecoin debt or sold automatically if the collateral falls below a certain threshold.
DAI makes use of the collateral debt position concept (CDP). A CDP can be thought of as a secure vault for locking collateral while also having the ability to obtain liquid stablecoin, DAI. To reclaim their collateralized assets, the user must return the DAI loaned along with a fee. DAI is overcollateralized to prevent liquidation (more on that below). Because this mechanism employs smart contracts – self-executing code – it can also be regarded as a crypto-collateralized algorithmic stablecoin.
The issue with this mechanism is that the collateral backing the stablecoin may be volatile because it is backed by crypto assets, which may lose value too quickly. As a result, most projects that employ this mechanism are overcollateralized to protect against sharp price fluctuations.
MakerDAO's stablecoin requires a Liquidation Ratio of 150 percent – the minimum required collateralization level for each vault type before it is considered undercollateralized and subject to liquidation. A vault with a 150 percent Liquidation Ratio, for example, will require a minimum of $1.50 in collateral value for every $1 in DAI generated. If the collateral's value falls to or below $1.49, it will be liquidated to cover the generated DAI plus a fee known as the Liquidation Penalty. This may not provide adequate protection in the event of a black swan event (such as a financial crisis).
MakerDAO, which was founded in 2017, is the first decentralized stablecoin. In terms of market capitalization and volume, it is the fourth largest stablecoin. It has survived the crypto winter of 2018 and the trials of the Covid lockdown of 2020, and when UST collapsed, investors saw DAI as a safe haven.
Decentralized, uncollateralized stablecoins:
This mechanism ensures the coin's value stability by controlling its supply via an algorithm executed by a smart contract.
In some ways, this is similar to central banks, which do not rely on a reserve asset to maintain the value of their currency. The difference is that central banks, such as the Federal Reserve, publicly set monetary policy based on well-defined parameters, and its status as the issuer of legal tender lends credibility to that policy.
Stablecoins do not have this level of credibility, and TerraUSD (UST) is an example of one.
How does UST in particular work?
UST has an arbitrage mechanism built in between it and the Terra blockchain native coin, Luna. To make UST, you must first burn Luna.
The arbitrage works like this: One UST can always be exchanged for one Luna. If UST falls to 99 cents, traders can profit by purchasing UST and exchanging it for Luna – a 1 cent profit per token. The effect works in two ways: buying UST raises the price, while burning UST during its exchange to Luna deflates the supply.
Furthermore, the Luna Foundation Guard, a consortium tasked with protecting the peg, had approximately $2.3 billion in bitcoin reserves, with plans to increase that to $10 billion in bitcoin and other crypto assets.
If UST fell below $1, bitcoin reserves would be sold and the proceeds used to purchase UST. If UST rises above $1, creators will sell it until it returns to $1, with the proceeds used to purchase more bitcoin to increase the reserve value.
To entice traders to burn Luna and create UST, Terra blockchain creators offered a 19.5 percent yield on staking, which is crypto terminology for earning 19.5 percent interest on a deposit, via the Anchor protocol.
A rate of interest this high is simply unsustainable. Someone must borrow at or above this rate in order for the lender to receive 19.5 percent interest. Banks make money by charging high interest rates on borrowing (such as mortgages or loans) and paying low interest rates on savings (such as a traditional savings account or a certificate of deposit (CD) account). In January, an analysis of the Anchor protocol revealed that it was at a loss.
The Anchor protocol was a Ponzi scheme, according to one of the allegations in the lawsuits filed against Terraform Labs' founders.
What went wrong with Terra (Luna)?
On May 7, over $2 billion in UST was unstaked (taken out of the Anchor protocol), with hundreds of millions sold immediately.
The reason for this has yet to be determined. It is possible that this was a malicious attack by someone attempting to break UST in order to profit from shorting (selling) bitcoin. Whether this is true or not is irrelevant: it is the platform's developers' responsibility to create a more secure and compliant system.
Whatever happened, the result of these massive sells pushed the price down to 91 cents. Traders attempted to profit from arbitrage by exchanging 90 cents of UST for $1 of Luna. However, Terra's protocol limits the amount of UST that can be burned for Luna per day to $100 million. When the stablecoin couldn't keep its peg, investors panicked and rushed to sell their UST. In the week following the initial de-peg, it fluctuated between 30 cents and 50 cents, and it is now hovering around 3 cents.
It's even worse for Luna owners. After reaching a high of just under $120 in April, the value of Luna is now effectively zero (as of this writing, it is worth $0.000105).
Lessons to investors:
"There is no such thing as a free lunch," as the old adage goes. Vigilant investors should be aware of the following:
- A mechanism based on arbitrage is doomed to fail. No arbitrage is long-term.
- High staking interest is not sustainable (think about how banks make their profit)
- Perform your due diligence. Investigate how the mechanism works and whether it can be used.
Stablecoins are still being scrutinized by regulators, especially in light of the recent event. Stablecoin regulation is on the horizon, as investor and consumer protection is critical. In the meantime, investors should exercise caution and learn from Terra.
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