Risks and Benefits of Algorithmic vs Fiat Backed Stablecoins

Introduction

The emergence of Stablecoins in combination with decentralized price oracles may revolutionize ownership and trade in our global economy by functioning as a railroad for transporting information to digital assets from the real world. Decentralized web3 applications for which users own and monetize personal information will then replace freemium models utilized by centralized cash apps, debit cards, exchanges and social media platforms.

Stablecoins are crypto tokens pegged 1 to 1 with fiat currencies and are a dream for the transformation of our society into a digital economy, as the human brain desires stability. The part of our brains responsible for planning the future is the prefrontal cortex. To feel calm and prevent anxiety, our prefrontal cortex needs at least illusionary certainty. As a result, mankind created stable fiat currencies backed by central banks where long-term inflation is sacrificed for illusionary short-term price stability. Like magic, equity analysts, consumers and businesses can then discount future values to the present and consider opportunity costs satisfying the needs of the prefrontal cortex.

In fact, currency stability is so treasured by our society today that many people consider crypto maximalism as a sacrilegious act against the church of stability. In addition to enhancing criminality and climate change according too many politicians, bitcoin’s price volatility violates Newton’s first law of prefrontal cortex science.

How can any industry win against politics, religion and science?

While Proof of Stake and transparent immutable database blockchains successfully is overcoming the numerous criminal and climate arguments against the crypto space, Stablecoin and decentralized price oracle inventions is satisfying the summed stability needs of global prefrontal cortexes christening crypto.

Decentralized oracles apply open source algorithms to transfer the price of goods and services from the real economy into a blockchain meaning no government or corporate board has the power to influence or change that on-chain price. The blockchain will therefore always reflect real world prices whether we like it or not.

The Truflation oracle is a great example of a pricing mechanism with decentralized governance measuring true cost of living based on real world prices of goods and services. Soon, flatcoins pegged to the Truflation index will allow maintaining constant purchasing parity against goods and services included in the Truflation basket.

If you question Web3, check out Metamask, Terra, FTX, Bravo, Fleek and DeSo to name a few. There really are so many Web3 Dapps now.

Oracle purpose

Stablecoins

Without short-term price fluctuations in the crypto space, Stablecoins serve as a medium of exchange, unit of account, store of value and method for discounting the value of future digital currency projects.

Unlike transactions made in fiat currency, Stablecoin equivalents are secured and cleared by blockchain technology rather than expensive banking and third party intermediaries. These intermediaries are known to charge high fees for custody and facilitation of transactions. For example, with Stablecoins there are no extra fees for immediate settlement of international cross-border payments if both counterparties own digital wallets.

The perhaps main purpose of Stablecoins other than just providing stability in a volatile crypto space is enhancing blockchain developments for Decentralized applications (Dapps) by simplifying access to asset raising and liquidity provisioning.

To connect with the real economy, most Stablecoins are pegged 1 to 1 with the largest fiat currencies in the world like USD, EUR, GBP and Yen. These Stablecoins maintain their peg by collateralization similar to how banks collateralize mortgages with underlying houses.

Stablecoins are generally collateralized by storing exchanged fiat currency used for minting/creating new Stablecoins in a vault like Tether or by holding cryptocurrencies and commodities in a treasury like Terra and PaxosGold.

The Price Paid For Stable Currencies

A single US dollar is worth around 0.01 grams of gold. However, back in 1971, that same dollar could be exchanged for slightly less than 1 gram of gold. The purchasing power of the dollar against gold has therefore declined by 100x over the past 50 years. In terms of real value, a 1971 dollar is worth around 0.14 dollars in 2022. The US dollar’s cumulative inflation of 600% over the past 50 years follows the historical pattern for world reserve currencies, as the price paid for a country to enjoy a dominant stable currency to exchange goods and services is a function of stimulatory monetary and fiscal policy.

If central banks and governments are willing to sacrifice short-term pain for long-term gain by tightening and avoiding printing in periods of strength and uncertainty respectively, then cumulative inflation of fiat currency lessens. For example, if FED’s 2% long-term inflation target was achieved, the 1971 dollar would only have experienced 269% instead of the current 600% in cumulative inflation.

Inflationary yet stable currencies allow businesses and consumers to plan for the future. In addition, the human brain’s prefrontal cortex is the future planner and the prefrontal cortex needs illusionary certainty to feel calm for the world to function. As a result, the instrument used by businesses and consumers as medium of exchange, unit of account and store of value must be stable. Currency stability is a religion so powerful that when Cryptopunks argue that Bitcoin equals money a majority of the world’s western prefrontal cortexes simultaneously breaks as Bitcoins price volatility violates the law of stability.

The truth is that short-term stability is a powerful but necessary illusion, which is difficult for Bitcoin to solve without a FED printer. In a perfect world, merchants should have access to liquidity when currency volatility explodes, but instead society chooses to exchange short-term volatility for long-term inflation (volatility), which is the cost of transacting using a government backed stable fiat currency.

Fiat stability is why the crypto developers are solving crypto volatility problems by creating Stablecoins using the four different forms of underlying collateralization such as USDC, Tether and Terra.

Current inflation and how the average American household with 61KUSD in annual income would experience inflation with a 3% salary bump over next two years

The First Stablecoin

The first widely adopted Stablecoin was Tether created in 2014 by a Hong Kong based team. Tether is a fiat collateralized crypto token (USDT) with an objective to remove cryptocurrency volatility and serve as a bridge between traditional and digital markets. Each Tether was first pegged 1 to 1 with USD, which means that in theory for every Tether in circulation there should be an equivalent amount of fiat in the Tether treasury.

Tether is a business and the parent company generates profits from fees on deposits and investments. For example, a minimum deposit of 100,000 USD is needed to interact directly with Tether’s treasury and withdrawing balances from Tether costs at minimum a 1000 USD. When depositing fiat directly into Tether there is also a 150$ account verification fee. Finally, instead of just holding cash in the treasury, Tether lends out money to companies (risky).

In 2019, the Tether team updated the financial disclosure statements no longer claiming a 1:1 USD deposit backing. These cash equivalent reserves held are instead high quality yield generating papers with low risk, but anything that generates a return still involves risk.

The updated financial disclosures therefore imply that Tether’s peg might break if the value of Tether’s treasury reserves drop. Given the volatility of the crypto market as a whole, it is not surprising that a lot of shady decisions have been made to keep Tether alive, like preventing customers from withdrawing Tether in 2017[1].

Despite controversy, Tether is the third largest crypto token in the world with over 80 billion USD in market cap benefitting mostly from the 2017 bull crypto bull run when there were no stable coin alternatives. In 2017, a stable coin explosion took place, and other Stablecoins like Terra were created. Sharing some history about the Terra project is important before demonstrating in detail how Terra maintains a fixed 1:1 price to fiat with algorithms and cryptos rather than a fiat reserve treasury like USDT.

Tether logo

A Different Kind Stablecoin

Terraform Labs was founded in 2018 by Korean computer scientists Do Kwon and Daniel Shim to compete with traditional and other crypto payment systems[2]. As of March 23 2022, The combined market value for the Terra ecosystem which includes Luna, Terra and now also some Bitcoin is over USD 48 billion.

Rather than the Ethereum or Bitcoin approach, Kwon and Shim began with creating a Stablecoin to promote stability over volatility to underpin the Terra ecosystem. In the now legendary Terra White paper, Kwon and Shim outlined their vision of scaling a practical blockchain payment network to generate user adoption.

The Terra Stablecoin bet paid off, as there are now more than 100 projects built on Terra platforms across DeFi, NFT and Web3. Unlike fiat backed Tethers, Terra Stablecoins are algorithmically pegged to fiat currencies including USD, EUR and KWR and uses a system of arbitrage incentives, open market operations and dynamic protocol levers to maintain peg stability.

The algorithm controlling the Terra system is designed to destroy/burn and create/mint the collateral coin Luna to prevent peg deviations against fiat currencies.

Minting or burning in crypto speak is the process of creating or deleting tokens algorithmically through a smart contract to increase or decrease the value of the tokens already circulating in the open market.

These Luna tokens are held in the Terra Treasury similar to how a traditional bank puts collateral in a bank vault to enforce repayment when lending out money to borrowers. Since Luna tokens are either burned or minted to maintain Terra price stability, the supply of Luna is elastic and volatility is pushed from the Terra Stablecoin to the price of Luna.

While the Terra Stable coin remains pegged to fiat, the Luna token has increased by over 600% in 2021.

The Terra ecosystem founders wanted their flagship token to have a stable price so that developers on the Terra blockchain could focus on creating Decentralized applications (Dapps) without questioning the future value of the native Stablecoin.

The main benefit of algorithmically backed Stablecoins like Terra over traditionally cash backed Stablecoins like Tether is that peg and collateral governance is handled by immutable open source code rather than key man decisions of a board or CEO. For example, the Tether team decided to hold commercial paper in the treasury rather than full cash reserves to back Tether. These key man biases may violate Stablecoin stability in the long-term, which are avoided when stability is instead maintained by algorithms.

Terra logo

How Terra is Stable

After reading the entire White Paper on Terra, my first reaction is that Terra’s minting process is complex and perhaps not simple enough to understand for people with a normal life, but I love challenges so let us try breaking down the Terra White Paper[3].

Basically, Terra outlines how growth generation is centered around incentivizing network effects by effective algorithmic monetary and fiscal policy to maximize stability and utility.

While a government incentivizes adoption by enforcing taxes payable in the government currency, Stablecoin adoption is generated by edge provisioning. Simply put, merchants and friends will use Terra if a noticeable edge over fiat and competing Stablecoins exists.

Terra has already achieved adoption by luring in the largest payment processor in South Korea, Chai, to accept Terra Stablecoins. The Chai-Terra partnership is probably behind the 2022 increase in market value of Terra despite that crypto is in bear market territory.

Terra’s edge over competitors is seamless transactions across borders at low fees and a giant ecosystem spanning DeFi, gaming, borrowing, lending and the metaverse. In addition, a maximum of 1% in transaction fee is charged to merchants.

Seamless cross border transactions remove time consuming bank settlements from days to seconds and low fees provide merchants with greater revenue as the maximum fee charged by using the Terra ecosystem is much lower than the 2-3% typically charged by Visa or Mastercard.

Lower merchant fees are made possible by utilizing the Terra blockchain algorithm, which is a combination of elastic monetary policy to create a stable yet censorship resistant currency and efficient fiscal policy in which multiple Dapps compete for financing from the Terra Treasury.

The main Terra peg is not to the USD or EUR, but to the international monetary fund special drawing note, (IMF SDR), which is a weighted-basket of major international currencies.

The Terra SDR allows for all underlying Terra currency pegs to enjoy shared liquidity in order to maintain individual peg stability to all pegged currencies simultaneously.

Shared liquidity also allows for the atomic swap function. For example, if user B wants to receive Terra EUR from user A holding Terra USD, the Terra Swap function allows user B to receive Terra EUR at the prevailing USD/EUR exchange rate although user A is sending the payment to user B in Terra USD. Exchanging Terra pegged to different currencies is therefore as seamless as a Venmo payment.

Terra Arbitrage Model

Understanding Terra monetary policy

Terra is a family of Stablecoins pegged to major fiat currencies and collateralized by native cryptocurrency Luna to create a stable yet censorship resistant method of exchange compared to bitcoin and other volatile cryptocurrencies.

The hope is that currency stability incentivizes adoption of Terra, which in turn accelerates demand increasing both transactions and value of the Terra ecosystem.

More demand imbalances the Terra SDR and IMF SDR peg, which is unacceptable for a Stablecoin. In response to imbalance, the Terra system rebalances the peg by varying transaction fees and supply of Luna according to a predetermined and transparent algorithm.

Mining Profit = Luna rewards/Luna supply – unit minting cost

In a Terra expansion, the price of Terra SDR is likely pushed below 1 against the IMF SDR. Note that 1 Terra SDR can always translate into 1 Luna SDR by transacting with the Terra Treasury. When 1 Terra SDR purchases more than 1 IMF SDR, traders will exchange 1 Luna SDR for a higher valued 1 Terra SDR from the Terra Treasury, which equals risk free money!

In return for aggregating and verifying all transactions on Terra’s Proof of Stake blockchain, Luna holders or so called miners stake Luna tokens to earn extra yield from all transaction fees generated by interactions between users of Terra.

Miners holding larger Luna stakes are more likely to become validators responsible for ensuring transaction accuracy and timeliness, which means larger stakes earn more yield!

In our example, a demand shock pushes the Terra SDR below 1 so observant Terra ecosystem traders will therefore send 1 Luna SDR to the system and receive back 1 Terra SDR, which generates a small arbitrage profit for traders as 1 Terra SDR is valued more than 1 IMF SDR by the open market. In return, the Terra SDR peg value is brought back to 1.

The holders of Luna are also happy because the Terra ecosystem burns/destroys a part of the Luna SDR upon receipt. Fewer Luna tokens increases the value of Luna in a growing Terra ecosystem as market forces drive up the price for each individual Luna.

Note that the Terra SDR will experience economic contractions pushing the exchange rate above 1 IMF SDR in the future so the Terra ecosystem monetary policy algorithm is continuously smoothing mining profits across both good and bad times.

To maintain stable long-term mining profits, the change in the rate of Luna burn and Terra transaction fees therefore decreases with accelerating demand.

Luna logo

Issues With Stablecoins and Cryptos in General

Money laundering is a common problem cited frequently with regulators because of laxed third-party monitoring in the crypto space. Regulators argue third-parties like banks are beneficial because of KYC or know your customer checks.

Although KYC in theory prevents money laundering, the USD is undoubtedly the largest currency used for nefarious activities; just ask the infamous Pablo Escobar who, rather than hiding money, used billions of dollars in profit as firewood.

In the end, KYC is an educational challenge that the crypto and stable coin community must overcome for regulators to feel comfortable with peer-peer transactions.

My hope is that with education regulators will hopefully understand that a permissionless blockchain is essentially an immutable database that records all transactions on the network.

I would therefore suggest future Escobars to not launder money on a permissionless blockchain.

Note that even if blockchain based Stablecoins is a great tool against money laundering, irresponsible monetary and fiscal policy by central banks and governments generally remain problematic as long as the Stablecoin is pegged to fiat.

We should also investigate the price paid for the pleasure to transact in a stable algorithmic currency.

Terra and Algorithmic Stablecoin Dangers

Trust in fiat currency pegs by Stablecoins depend on the value of the underlying collateral stored in treasury and on the system/bank/vault/treasury holding the collateral.

For Stablecoins like Tether maintaining a fiat peg is relatively straightforward as each Tether is backed by an equivalent dollar securely held in the Tether Treasury. The main risk is that the collateral custodian is devious.

For example, if Tether’s Treasury is not holding a proportional collateral amount of Tether’s total market value in its vault, the Tether Treasury may suffer a bank run.

Algorithmic Stablecoins like Terra can also suffer bank runs. Unlike people, however, transparent immutable software cannot be manipulated.

A potential Terra bank run scenario is if merchants stop accepting Terra Stablecoin payments and if Terra users then respond by switching payment method and selling Terra, which in turn leads to a rapid contraction of Terra money supply.

As a result, the value of the Terra SDR may rapidly decrease below 1 to the dollar, which puts enormous pressure on the Terra algorithm to stabilize all fiat currency pegs.

Remember that if the value of Luna is 0, then Terra is no longer able to maintain currency pegs, which actually happened to Terra’s Stablecoin competitor Iron Finance.

On June 16 2021, Iron Finance suffered a coding design flaw and Iron USD lost its soft peg to the dollar. The design flaw allowed the value of the collateral backing the governance token Titan, which is equivalent to Luna, to drop to 0.

Although some people believe Iron Finance was a scam, Ivan Kuznetsov wrote a paper arguing that the design flaw in Iron Finance stabilizing mechanism failed to appropriately incentivize arbitrageurs to protect Iron USD’s peg during a swift drop (bank run)[4]. The same could happen for Terra.

Titan to 0

Difference Between Iron Finance and Terra

Iron Stablecoins was backed by USDC and Titan rather than just Luna, which makes Terra and Iron a bit different.

Also, in response to a scenario putting downward pressure on Terra similar to that experienced by Iron Finance, Terra’s algorithm will rapidly offer Luna SDR for Terra SDR at huge discounts, which incentivizes arbitrage traders to buy 1 Luna SDR for around 0.9 Terra SDR’s until the Luna-Terra ratio and pegs are back to 1 again.

In addition, the Terra System will increase transaction fees and burn of Luna collateral to further remove supply of Luna.

Higher fees and burn rates increase the marginal value of each Luna held by validators as they receive more rewards for validating transactions in a now smaller Terra ecosystem.

The Terra treasury has also implemented a nuclear stability option by using bitcoin as collateral. In March 2022, the Terra Treasury started purchasing bitcoin with the goal of amassing a total of 10 billion dollars in BTC to back Terra Stablecoin stability.

Unlike Iron Finance, Terra is therefore becoming the first stable or fiat currency in history that is using the bitcoin standard. The best part of Terra is not necessarily the Stablecoin itself, but the protocol's objective to create long-term value through algorithmic investing in decentralized applications, which will hopefully assist in creating the best Stablecoin possible as well.

Terra Fiscal Policy

Like validators of the Terra blockchain, the Terra treasury earns a portion of the seigniorage/profits generated by Luna burn and transaction fees. The Terra treasury then uses those profits in combination with an algorithmic and decentralized approach based on economic activity to invest in new Terra Dapp projects.

Investing in Dapps, means that the Terra treasury functions like a Venture Capital arm of its blockchain like a normal investor allocating resources. Terra’s investment in Dapps is achieved through a mathematical equation optimizing funds sent to Dapps based on both current and future Dapp economic activity.

Investing in decentralized application platforms that create practical solutions for social media, borrowing/lending, gambling and more aims to create future growth of the Terra Ecosystem.

The more economic activity that a Terra Dapp is generating, the more fiscal stimulus that Dapp will receive from the Terra Treasury.

Efficiency of funding is measured by comparing current economic activity with previous periods economic activity. Accelerating economic activity will lead to more funding from the Terra treasury. For the math behind the proportion of funding received by a specific Dapp, I will delegate to the white paper[5].

However, by using a programmatic approach to funding Dapps based on past success, the Terra treasury aims to without bias create the best possible Dapps to grow the Terra ecosystem more than competing blockchains.

Terra Found Do Kwon

Conclusion

Unlike Government currencies enforced by taxes, Stablecoin adoption is generated by providing users with an edge. Stablecoin emergence started with Tether, which was backed directly by fiat in the Tether treasury.

Tether is still the largest Stablecoin in the world, but the risk associated with key man decisions has forced many people to turn to alternatives.

A range of collateralized Stablecoins like MakerDao, PaxosGold and Terra therefore emerged as competitors too Tether.

Perhaps the most exciting of these alternatives is the Algorithmic Stablecoin, Terra, which uses a system of arbitrage incentives, open market operations and dynamic protocol levers collateralized by the native cryptocurrency Luna and Bitcoin to maintain peg stability.

The biggest risk associated with Terra is a bank run, which could cause fiat pegs to deviate similar to the Iron Finance Stablecoin debacle.

The bank run risk is most likely why Terra purchased Bitcoin to maintain price stability in times of emergency.

However, there are a lot of benefits with Terra and that is why more than 100 Dapps have been built on top of the now 48 billion dollar Terra and Luna ecosystem.

The atomic swap function for cross-border payments, the low fees charged to merchants for transactions and the Dapps built on Terra is why Terra might become the number one blockchain in the future, while the bank run risk might become its downfall.

[1] https://productmint.com/tether-business-model-how-does-tether-make-money/#:~:text=Tether%20is%20a%20cryptocurrency%20that,as%20well%20as%20through%20investments. [2]https://messari.io/asset/terra/profile#:~:text=Terra%20was%20created%20in%20January,the%20world's%20major%20fiat%20currencies. [3] https://assets.website-files.com/611153e7af981472d8da199c/618b02d13e938ae1f8ad1e45_Terra_White_paper.pdf https://www.sofi.com/what-is-terra-luna/ [4] https://jeiwan.net/posts/analysis-titan-fall/ [5] https://assets.website-files.com/611153e7af981472d8da199c/618b02d13e938ae1f8ad1e45_Terra_White_paper.pdf