The aftershocks that followed the collapse of the Terra (LUNA) ecosystem are still being felt throughout the crypto world. The sudden meltdown of a top 10 coin raised a lot of questions, and some worry whether other cryptos and stablecoins — especially algorithmic stablecoins — could also disintegrate.
Most recently, Vitalik Buterin, crypto guru and the brains behind Ethereum (ETH), has waded into the debate. He published a thought piece arguing you can’t tar all stablecoins with the same brush. Buterin points out that some algorithmic stablecoin models are feasible and sets out his thinking as to why.
Buterin’s thoughts on stablecoins
An algorithmic stablecoin is often supported by another crypto and uses baked-in formulas to regulate the price. This is different from, for example, USDC, which is a fiat-backed stablecoin supported by real dollars in the bank. The big challenge for all dollar-pegged stablecoins is finding ways to maintain their peg.
Terra used a system that relied on a symbiotic relationship between LUNA and the Terra USD (UST) stablecoin. The system essentially burned or minted the two tokens to maintain the value of UST. It’s a bit of an oversimplification, but when the value of LUNA fell dramatically, the UST stablecoin became unsustainable, triggering a death spiral.
Another issue was that Terra’s Anchor protocol promised a 20% APY on UST. Some investors converted their savings into UST to earn the high APY without fully understanding the risks involved. This is one reason Buterin welcomes the greater level of scrutiny on decentralized finance (DeFi).
The well-known developer says when stablecoins attempt to generate these types of returns, they can instead turn into Ponzi schemes. “Obviously, there is no genuine investment that can get anywhere close to 20% returns per year,” he says. “In general, the crypto space needs to move away from the attitude that it’s okay to achieve safety by relying on endless growth.”
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But just because Terra’s experiment failed, it does not mean that algorithmic stablecoins can’t work. Buterin focused on an Ethereum-based stablecoin called RAI, created by Reflexer Labs. It isn’t pegged to the dollar, and aims to become a stable global reserve that isn’t tied to any individual fiat currency. RAI is collateralized using ETH through a system of lending, and Buterin sets out how RAI will maintain a stable value even in the face of dramatic volatility.
Crypto is not magic
DeFi takes the middleman out of many traditional banking transactions. It can reduce fees and generate higher returns, but it also brings additional risks. You don’t get the same consumer protections in DeFi as you would with a traditional bank. Some schemes are poorly thought out and others are outright scams.
There’s sometimes a tendency to believe incredible returns are possible in decentralized finance because, well, it’s crypto. What Buterin is pointing out is that we should question these systems and understand how they work.
When it comes to stablecoins, he gives the following pointers:
- Look at whether they are reliant on constantly attracting new money in order to maintain their rates — if so, the projects are heading into Ponzi territory.
- Look at what would happen under extreme conditions. Terra couldn’t hold up in the face of extreme volatility. Buterin points out that once the collapse seemed likely, it became a self-fulfilling prophecy. It only took a small shock to make the system so fragile, it triggered a meltdown.
- Finally, look at what happens if the stablecoin starts to fail. Can it wind down safely? Or will it suddenly collapse dramatically? If a project can’t draw to a close without burning investors, this should be a red flag.
Terra’s collapse showed us all that crypto is still at a very experimental stage and even projects that appear convincing can fail. However, it also highlights the importance of thinking critically about specific projects. Last year, when the crypto industry was on an extraordinary bull run, it felt as if nothing could go wrong. Now as economic tightening squeezes crypto prices, we’re starting to see the cracks. Make sure you understand the cryptos you buy, especially if they promise high returns.
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The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.Emma Newbery has positions in Ethereum and Terra. The Motley Fool has positions in and recommends Ethereum and Terra. The Motley Fool has a disclosure policy.
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