13. Stablecoin: Algorithmic Stablecoin

Non-Collateralized Stablecoins

Seigniorage Share

Seigniorage (algorithmic)

• stablecoins can be linked to a decentralized autonomous organization (DAO) which controls issuance and pricing
• supply of stablecoins is controlled by issuing and destroying coins depending on the market demand, until the target price is reached
• market participants are incentivitized to act in a way that the price is kept at target level by issuing either bonds(or shares), in times of decreasing price or seigniorage shares when the price is above target

Seigniorage Share

• Seigniorage: the profits when governments minted new money to finance their operations
• if price is too high = supply is too low -> smart contract can mint new coins and then auction them on the market, increasing supply until the price returns to $1
  • smart contract can get some extra profits == Seigniorage

If coin price is too low -> Decrease the supply

• buy up coins on the market to reduce the circulating supply
• if the seigniorage is insufficient to buy up enough coins
  • issue shares that entitle user to future seigniorage
  • next time they issue new coins and earn seigniorage, shareholders will be entitled to a share of those future profits
• Even if the smart contract doesn't have the cash to pay, because users expect the demand for the stablecoin to grow overtime, eventually it will earn more seigniorage and be able to pay out all of its shareholders

Criticism about Seigniorage Shares

• system resembles a pyramid scheme
  • "collateral" backing Seigniorage Shares is shares in the future growth of the system
  • if the system doesn't eventually continue growing, it will not to be able to maintain its peg
• it's defficult to analyze:
  • How much downward pressure can the system take? How long can it withstand that pressure? Will whales or insiders prop up the system if it starts slipping? At what point should we expect them intervene? When is the point of no return when the system breaks?
• market participants are unlikely to converge -> susceptible to panics and sentiment-based swings

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Algorithmic Stablecoin

Algorithmic Stablecoin

Algorithmic stablecoin

• backed by automated operations meant to maintain a stablecoin's value by increasing or decreasing its supply
• algorithm can be programmed to automatically create more units of a stablecoin or destroy existing units in response to swings in its supply and demand
• when price higher than its pegged value, more tokens are created and the price comes down
• when price lower than its pegged value, more tokens are taken out of the circulation and the price comes up
• a sister token with a volatile price is usually involved (ex. Luna)

 

TerraUSD

TerraUSD (UST)

• linked to a sister token, Luna: price was set by the market (volatile)
• 1 UST = \$1 worth of Luna -> 1 UST is always considered to be equal to \$1
  • while the amount of Luna handed over in a swap for UST would vary, a holder of \$1 UST would always get a \$1 in value back
  • creating arbitrage incentives for traders that were designed to keep the value of UST at or close to \$1

 

How UST pegged its value to $1

• 1 UST can always be exchanged for a floating quantity of Luna with a market value $1
  • when exchanging, the currency(UST) is taken out of the circulation by the smart contracts
• When UST > $1
  • incentive to trade $1 worth of Luna for one UST (Luna -> UST)
  • puts more UST into circulation, driving down the price of UST
• When UST < $1
  • incentive to trade one UST for $1 worth of Luna (UST -> Luna)
  • takes some UST out of circulation, driving up the price of UST

 

How to make Demand

• Demand can be driven by the prospect of huge gains if the token catches on, or can be primed by providing a reward to currency holders
• In case of Terra, main attraction is Anchor, that promised interest rates as high as 20% for UST deposits, an offer that led to UST's explosive growth
• Luna Foundation Guard (LFG): to accumulate reserves to give UST another kind of backing (Bitcoin, Avalanche)

 

Criticisms about Terra: Ponzi scheme

• UST's only peg to Luna would only work if people believed that they would keep ther value, and that they would keep their value if more and more people bought them
• main attraction was Anchor: subsidized by investors in Terra -> not sustainable
• To the critics, LFG's creation of a crypto resrve was a doomed attempt to use some of Ponzi-like earnings of UST to create a more conventiona backing for the currency
• If demand for either UST or Luna fell, they said, the value of both could evvaporate in a "death spiral"

 

What Happend in Terra: Deth Spiral

• Anchor had dropped its yeilds from 20% -> 18% on May 2
• A few days later, large amount of UST was withdrawn -> Kwon said Terraform Labs had withdrawn to prepare for a new liquidity pool, but at roughly the same time, an unknown user exchanged roughly $84 million worth of UST for USDC
• Those large moves + interest rate cut -> more UST depositors to withdraw their stablecoins from Anchor -> UST off of its $1 peg
• More UST holders try to get their money out and only way was through Luna, which was already falling in its value -> massitve UST withdrawals led to a vast expansion in the supply of Luna, driving down its value even further
• According to LFG's official tweet, it spent almost all of its Bitcoin reserves in an attempt to save UST's peg
• May 16, Kwon gave up on saving the stablecoin but proposed preserving the Terra blockchain as a new entity that would only use Luna tokens

What does this mean for Stablecoin?

• US Treasury Secretary Janet Yellen said recently that Terra’s meltdown underscores the urgent need for guardrails and said it would be “highly appropriate” for lawmakers to enact legislation as soon as this year.