The risks of algorithmic stable coins and who wants them to collapse!

"UST stable coin veers wildly from dollar peg. Life savings lost." These are the headlines that shocked many. If you are confused about what's going on, I invite you to dive into what happened to UST and who benefits from it.

Overview:
1. What is a stable coin?
2. How does an algorithmic stable coin work?
3. What went wrong?
4. What happened to UST and LUNA?
5. Who profits?
6. Is there a future for UST?
7. Is this the fate of HBD?

1. What is a stable coin?

Stable coins are pegged to the fiat currency, such as a US dollar. In contrast to volatile cryptocurrencies such as Bitcoin or Etherium, stable coins are supposedly stable and should always be fixed or very close to the value of fiat currency. Think of them as fiat-like assets on the blockchain. There are two major types of stable coins: stable coins that are backed by collateral such as fiat, crypto, commodities or other assets, and algorithmic stable coins. An algorithmic stable coin is not backed by any assets; instead, there is an algorithm in place that incentivizes market players to maintain the coin price.

2. How does algorithmic stable coin work?

Let me show you how algorithmic stable coins work with an example of an algorithmic stable coin called UST.

UST is supposed to be pegged to the US dollar in a ratio of 1:1. The peg is maintained by pairing UST with a sister cryptocurrency Luna in an algorithm. Within the algorithm, one can swap one dollar worth of Luna for one dollar worth of UST and vice versa.

The algorithm is designed to incentivize people to arbitrage when UST's price deviates from 1 dollar to maintain the UST peg. Arbitrage is a practice of taking profit from small discrepancies in price.
People are incentivized to keep the price of UST in check by swapping LUNA for UST when UST is worth more than $1 and swapping UST for LUNA when the price of UST is below $1.

• For example, when the UST is worth more than 1$, let’s say 1.03$, arbitrageurs can buy 100$ worth of LUNA and convert it to 100 UST worth 103$, which they can sell to realize 3 dollars in profit. When they convert LUNA to UST, the supply of UST increases, and the price should, in theory, return to 1$.
• When the price of UST falls below 1$, let’s say $0.98, traders can then buy 100 UST that is worth 98$ and sell it for $100 worth of LUNA, making 2 dollars in profit. In doing so, the UST supply is reduced, and the price should, in theory, return to 1$.

All algorithmic stable coins have a similar mechanism, although every coin has a different ecosystem and slightly different staking and unstacking procedures.

3. So what went wrong?

In June 2021, an algorithmic coin called IRON collapsed, and this made the headlines at that time. IRON was supposed to be pegged to 1 dollar and was maintained through pairing with a sister cryptocurrency TITAN, the same way UST is paired with LUNA.

At one point, as the price of Titan was surging, some large players started to realize the gains, and this started a chain reaction of panic selling. In two days, the price of Titan fell from around 52 dollars to near zero. Such a sudden drop caused the stable coin IRON to lose its peg to 1 dollar and fall below 94 cents.

Why did it drop? Shouldn’t the algorithm provide incentives to return the stable coin to its pegged value?
The problem here was that because the fall of Titan price was so rapid, the arbitraging that was supposed to maintain the stable coin’s peg was unprofitable. Even though Iron was below 1$ and traders were supposed to buy IRON, that was 94 cents and sell it for 1$ worth of Titan, this didn’t happen because Titan was falling rapidly in price, and arbitraging was unprofitable. As a result lack of incentives and arbitrage, IRON couldn’t return to the peg value of 1 dollar. This made many investors, including a famous Shark Tank investor, Mark Cuban, upset and angry because IRON is supposed to be a stable and safe coin. You can read more about IRON here.

As of August 2021, IRON has regained its peg and is trading around 1$, but TITAN never regained confidence and is still slightly higher than zero.

The takeaway is that the algorithmic stable coin lost its peg because the algorithm and incentive model behind it failed when there was a huge panic sell of the paired cryptocurrency.

4. What happened to UST and LUNA?

Let’s now come back to UST and Luna, that’s been haunting everybody in the market these days.
At the beginning of July 2021, Luna was around 7$; since then, it steadily grew and reached over 100$ at its peak (in March 2022), even when the rest of the crypto market was falling. Luna was in the top ten cryptocurrencies, and UST was in the top three stable coins.

Suddenly, over the past few days, we have seen a great fall of Luna from around 86$ to 1$ in three days.

Like the Iron stable coin, UST lost its peg and is still very volatile these days, with the lowest price reaching around 25 cents.

This has caused an extreme panic among holders of UST, especially the ones who put lifesaving into it, as everybody relied on UST as a safe and stable fiat-like asset. What caused UST to lose its peg? Again, it is a failure in the incentive mechanism that was caused by the sudden and dramatic fall of UST’s paired cryptocurrency, Luna.

As I already described, UST is not the first algorithmic coin that failed to hold its peg. The story repeats again and again; the algorithmic coin’s Achilles heel is a “bank run” situation and panic sell. In my opinion, this makes it a great resource for coordinated attacks and manipulation from the big players until this vulnerability is resolved.

5. Who profits from the fall of algorithmic stable coins?

First, it’s everyone who makes money on it, which are usually large entities that can afford to short, even when the market goes against them.
But most importantly, it is the ones in power who have the sole right to the emission of US dollars. Why would they want anyone else to create dollars from thin air? I believe that after making people distrust decentralized stable coins, they can introduce “stable” and “safe” CBDCs.

6. Is there a future for UST?

There is news that Terraform labs, the organization behind UST, has voted to take a loan collateralized by $750 million in Bitcoin to buy UST and return the peg. However, as the price of Bitcoin falls amidst falling markets – it’s a dangerous game. Anyways, only time will tell whether or not Luna and UST will fall to 0 or close to it.
Overall, if UST won’t regain the peg, the damage to the ecosystem, developers and community will be huge.

7. Is this a fate of HBD?

Now I want to hear your thoughts. Do you agree with my analysis? What are your thoughts on algorithmic stable coins? Do you think this is an inevitable fate for all algorithmic coins, including HBD?

Let me know in the comments👇

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