A crazy week in the financial markets. There has been arguably the most significant transfer of value in less time in history. Nearly $50B has left the Terra ecosystem in just a couple of days. Lehman Brothers was a $60B market cap company to see the order of magnitude.
This has sent panic through the equity markets in general and the cryptocurrency market in particular. Within cryptocurrencies, there has been one market that has been hit hard, and that is stablecoins.
Throughout this week, I have read many comments about what could happen with other stablecoins such as USDT, USDC, or DAI. And I have to say that USDT has nothing to do with UST, nor UST with DAI.
Each one uses its own economic mechanism to maintain its peg, i.e., its 1:1 parity with the dollar. As we have always said, there are two main groups: 1) those that are collateralized by another asset (usually FIAT money) and 2) the algorithmic ones.
What we see over all these years is that algorithmic have failed in 99% of the cases, and 1% are close to failure. Instead of having reserves, they look for a model in which they try to maintain the peg based on economic incentives through arbitrage and market makers, as has been the case with UST.
The main problem with algorithms is that their mechanisms are not antifragile. It isn’t easy to innovate in financial mechanisms. For example, Maker copied the gold standard model: I issue coins, and I have a guarantee behind it.
In the case of UST, terra’s stablecoin, they had a system whereby when they issued UST, they burned LUNA. This makes that when a lot of UST is issued, the price of LUNA goes up a lot, as happened. The arbitrage mechanism was based on the fact that if you wanted to sell 1 UST, they would give you 1 dollar in LUNA.
On top of that, there was the Anchor protocol, where if you deposited USTs, you were paid 19.5% per annum. All the interest came either from the loans or from reserves that had been put in from Terra.
In this protocol, up to 80% of the UST issue was held. So the systemic risk was very high. But this performance and the investment thesis gave this protocol give a fictitious sense of security. Obviously, we knew the risks involved, which could be losing 100% of that portion of the portfolio.
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