Can Traders Still Count On Stablecoins After The Luna Fall?

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Stablecoins continue to play a crucial role in the cryptocurrency world. Even though recent incidents affecting Terra / UST, USDD, DEI, and NIRV have shown these assets are not always stable, they will remain relevant for some time to come. However, the future of stablecoins may look a bit different from what people are used to today.

What Are Stablecoins?

A stablecoin is a blockchain-based asset that maintains a value of $ 1 – or 1 EUR / GBP / whatever currency it is pegged to – at all times. Centralized stablecoins, like USDT and USDC, rely on bank reserves to ensure every asset in circulation has equivalent backing in fiat currency or other financial instruments. Even though these stablecoins involve an intermediary – Tether for USDT and Circle for USDC – they are also the “safest” stablecoin options due to their fiat currency backing.

Other projects may explore an algorithmic approach to maintain their peg. One good example is DAI, the native stablecoin of the Ethereum ecosystem. Users can supply cryptocurrency collateral to acquire DAI, although the MakerDAO protocol forces users to adhere to a 150% collateralization ratio. You need to supply $ 1.5 in crypto assets to acquire $ 1 in DAI. Over-collateralization always ensures enough reserve money to convert from DAI to crypto assets.

Users often leverage stablecoins to trade against other crypto assets – in search of a profit to repay borrowed stablecoins – or to engage in yield farming by providing liquidity on decentralized exchanges. In addition, a stablecoin can be used as a payment tool for goods and services due to them not fluctuating in value.

Unfortunately, other stablecoins attempt to maintain a peg to fiat currency without fiat currency reserves or over-collateralization. Numerous currencies attempting that approach have failed spectacularly, yet developers keep trying to achieve the impossible. That goal may not be impossible, but the approaches tried to date have failed miserably.

The Spectacular Demise Of Luna / UST

The year 2022 has been off to an interesting start for the stablecoin industry. While these pegged assets maintain a relatively high market cap – at least where USDT and USDC are concerned – the algorithmic versions pose some severe issues and risks. That became all the more obvious when UST, the algorithmic stablecoin on the Terra network, plummeted from its peg to a value below $ 0.01 in a matter of days.

Several factors contribute to the demise of this popular stablecoin. Ongoing market volatility was a problem, as UST was backed primarily by other cryptocurrencies. When that collateral started losing value, it became more and more difficult to maintain the market peg. Columbia Business School professor Omid Malekan went one step further and labeled UST as an “inevitable death spiral”.

More specifically, using an algorithm and sister currency – LUNA – to maintain a $ 1 peg is virtually impossible. Users could mint UST and see the equivalent value in LUNA destroyed. However, traders could always reduce 1 UST for $ 1 in LUNA, regardless of UST being worth $ 1. That, ultimately, became a big problem resulting in a massive LUNA inflation while UST continued to bleed value. Ultimately, both currencies lost all value]and the stablecoin was abandoned altogether.

The demise of UST was not entirely unexpected. Various stablecoins have attempted an algorithmic approach without much success. UST did last much longer than prior attempts, but the complete collapse awards the same fate. Furthermore, UST Depegging forced more users to cash out their stablecoin in favor of LUNA, inflating that asset’s value and continuing the vicious cycle.

Learning From Past Mistakes

It is evident that the issues affecting LUNA and UST should not be allowed to repeat themselves. Unfortunately, it appears that algorithmic stablecoins will not go away either. Even despite recent issues affecting NIRV and DEI, there is still hope such currencies can maintain their fiat currency peg through algorithms. Again, that is not an impossible goal, but the previous approaches clearly do not work.

Joining the ranks of crypto-collateralized stablecoins is the GTON Capital Dollar (GCD). It maintains a soft peg to the US Dollar through smart contracts and can be minted by providing cryptocurrencies as collateral. Moreover, GCD will become the gas currency of GTON Network, an Optimistic Rollup network built on Ethereum. Instead of using volatile crypto assets to cover transaction fees, they can do so with a stablecoin.

It makes sense to create a way to reduce the circulation of GCD by tying it to transaction fees. The success of that stablecoin will depend on how much interest there is in GTON Network, which will go into beta in September 202. Other Optimistic Rollups solutions and crypto-collateralized stablecoins compete for similar traction, but GCD will be the first asset to be used as a gas currency for rollups, which may give it a competitive edge.

Other projects issuing a new stablecoin include Aave Protocol (GHO, over-collateralized with crypto assets), the relaunched Beanstalk Farms stablecoin (BEAN, previously hacked for over $ 75 million), Stablesats (Lightning Network-based derivatives to create a Bitcoin-backed synthetic dollar), etc. The space continues to heat up and grow more competitive with various ideas and approaches, undoubtedly creating many new opportunities.

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