Disclaimer: This post contains thoughts on crypto, a volatile and risky asset class. It is not investment advice, and you should do your own research. All information is for educational purposes only. Please don’t take risks with money you’re not willing to lose.

Per the disclaimer and widely cautioned to outsiders, crypto is volatile. While Layer 1s offer complex DeFi ecosystems, their respective token prices sway with the rising and falling market. Being a participant means embracing these fluctuations - an unattractive feature to mainstream consumers. If blockchains are to replace every global industry, it’s inevitable that common applications need easily settled transactions.

Why Stablecoins?

Stablecoins provide a solution to the aforementioned dilemma. They are pegged to external references such as the US Dollar, gold, or any other financial instrument. Unlike BTC, stablecoins are meant to maintain their value, providing an alternative to the volatile nature experienced in most tokens. This effectively makes them suitable for everyday transactions that don’t necessitate more complex blockchain frameworks.

For instance, Solana was consolidating around $15 at this time last year. Up more than 10x, SOL now trades at ~$160 (down >20% from March highs). Bitcoin, Ethereum, and nearly all L1s / alts have experienced similar price action. The point being - volatility rewards traders, but forces routine consumer transactions to collaterally become speculative investments.

An Expensive Meal

Popular crypto lore tells the story of a man who once paid 10,000 BTC for two pizzas. While he is now forever baked into history (ha), the now $691m and continually growing purchase is as close to max pain as it gets. Consumers don’t want to spend their long-term investments on goods that don’t offer returns (in case price goes up). Conversely, merchants are rightfully weary of accepting currencies in their regular business transactions (in case price goes down).

Best exemplified by Bitcoin, most cryptocurrencies satisfy the three major functions of money: store of value, medium of exchange, unit of account. However, the above anecdote alludes to the fact that most tokens in their current state underwhelmingly qualify as a ‘medium of exchange’. To be an effective medium of exchange is to remain relatively stable such that purchasing power is retained in the short-term.

Types of Stablecoins

Different models for stablecoins exist because developers have conflicting opinions on whether the future of digital tender should be controlled by central banks or remain onchain.

Fiat-Collateralized

• reserve of fiat currency (or multiple); cash or cash equivalents (treasuries)

• maintained by independent custodians / regularly audited

• reserve value matches or exceeds the circulating supply

• i.e. USDC, USDT

Crypto-Backed

• reserve of other cryptocurrencies (generally BTC, ETH)

• decentralized and trustless, but more exposed to peg disruption

• over-collateralized to a specific ratio to ensure stability; deposits > mints

• i.e. DAI

Algorithmic

• don’t primarily rely on a reserve of assets

• leverage algorithms / incentive mechanisms to maintain value

• often operate under-collateralized; heavily dependent on market demand

• i.e. USDe, UST (de-pegged and crashed)

USDC

Issued by Circle, USDC is the second largest stablecoin by market capitalization (and my personal preference).

USDC is fiat-collateralized, backed 1:1 by the US dollar. As BTC is brought into circulation via Proof of Work (mining), new USDC is minted when users / businesses deposit USD into their Circle account. Conversely, redeeming USD means burning the equivalent USDC supply. This mechanism ensures that the value of fiat reserves always matches the # of tokens in circulation, effectively stabilizing the price at $1. It’s new age monetary policy - digital and code-enforced (tamperproof).

Underpinned by the most popular blockchains, Circle’s pegged digital dollar offers various solutions to the limitations observed in traditional financial markets (and other stablecoins).

Problem: Most payments / $$$ transfers are subject to local business hours, transferred through numerous fee-charging correspondents, and have no visibility while in transit.

Solution: USDC payments settle near instantly (24/7), are transferred directly from sender to receiver, and have full visibility during the process.

Problem: Fiat currencies are rapidly losing value, limited to use within national economies, and investment returns are vastly overwhelmed by inflation.

Solution: USDC is always redeemable 1:1 for USD, widely used + regulated globally, and enables access to crypto’s efficient capital markets.

Problem: Most stablecoins have opaque reserve management, unreliable offshore auditors, and expensive / difficult to access liquidity.

Solution: USDC’s fully liquid reserves are held at leading financial institutions, verified monthly by a Big Four accounting firm, and offer instant and fee-free liquidity via Circle Mint.

While these features primarily position USDC as a digital dollar alternative for businesses (already boasting clients such as Visa, BlackRock, and Stripe), individuals like you and I can leverage it in crypto’s capital markets. I use USDC in a few ways:

1. As a safe haven during volatility - traders can retain purchasing power (in crypto) when markets shift bearish

2. As DeFi collateral - lenders face (close to) zero risk of liquidation

3. As a bank account - 5.15% APY on Coinbase (better than most HYSAs)

Terra Luna

While fiat-collateralized stablecoins are far safer than proposed alternatives, decentralization maximalists would argue that they rely too heavily on traditional finance. As crypto is intended to entirely replace the monetary system imposed by central governments, our core infrastructure needs to be independent of external pegs such as the US dollar. However, crypto-backed reserves are risky and perhaps too reliant / optimistic on market performance. Algorithmic stables attempt to find the middle ground, generally operating without liquid collateral and instead via incentive mechanisms.

Although newer entrants show promise (ENA), the rise and fall of Terra Luna is an unavoidable barrier to understanding algorithmic stablecoins.

Launched in 2018 by the now-infamous Do Kwon, Terra stood as it’s own blockchain, similar to Ethereum or Solana. The network itself was underpinned by a dual-mechanism between LUNA (their native token) and UST (an algorithmic stablecoin). Users could burn x$ of LUNA to create / receive x$ of UST; and vice versa. The peg itself was maintained by the forces of arbitrage:

• if UST <$1, traders could buy 1 UST, burn and mint $1 of LUNA, then sell in profit

• if UST >$1, traders could buy $1 of LUNA, burn and mint 1 UST, then sell in profit

The fatal flaw in this model is that LUNA had intrinsic value apart from just maintaining UST’s stability. Like most projects, much of this was speculative upon the ecosystem’s continued success - utilities included staking / governance participation, paying fees for confirming transactions, and generating yields via native lending protocols.

Riding the momentum of the 2021-22 bull hysteria, major VC firms poured capital into what they imagined to be a ‘revolutionary, new DeFi ecosystem’. Anchor, one of Terra’s leading protocols, further attracted retail investors by offering up to 19.5% APY for UST depositors. Consequently, LUNA’s valuation soared while UST issuance rapidly increased.

By April 2022, LUNA had become a top 10 cryptocurrency with a market capitalization of over $40b (ATH of ~$119). However, as volume skyrocketed, Anchor’s yield quietly required increasingly unsustainable subsidy levels (at the time, UST deposits occupied more than 50% of Terra’s TVL). Come early May, the broader crypto market began seeing sell-offs amidst worsening macro.

Contemporary with these developments, several large depositors withdrew over $2b in UST from Anchor, hundreds of millions of which was quickly liquidated. De-pegging UST from $1, this triggered a ‘death spiral’ of smaller investors to similarly offload their holdings. As a result, LUNA’s supply became hyper-inflationary while it’s collateral-backing got simultaneously eviscerated.

Within the span of a few days, LUNA and UST’s valuations were entirely wiped out - causing an additional ~$300b loss across the industry. Voyager and Celsius filed for bankruptcy, Three Arrows Capital was forced to liquidate, and millions of ordinary users lost their deposits.

Terra’s collapse can ultimately be attributed to its unsustainable and self-reinforcing network design:

1. UST relied on “normal” market conditions - trust that there would always be demand

2. UST demand was boosted through unrealistic yield offerings - infinite deposits, infinite subsidies

In Sum

While I’ve ended this rather negatively, stablecoins are and will continue to be relevant. In their current state, fiat-collateralized stables show the most promise with real-world pegs and transparent reserves. Unsurprisingly, they’ve also seen the most development, attention, and funding. However, I am somewhat of the belief that a reliance on traditional financial instruments undermines the ethos of crypto. UST is obviously a poor example of the alternative, but the answer is likely somewhere in the space of algorithmic stablecoins (or perhaps a hybrid of that with fiat). Terra Luna’s model was unsuccessful, but that doesn’t mean all will be. In fact, its flaws can better inform future challengers. Ethena (ENA & USDe), catches my eye in this regard. Let’s just hope they don’t make the same mistakes.