The Kingstons continued their conversation on stablecoins, especially on algorithmic stablecoins, the purest form of truly decentralized stablecoin that, in its extreme case like TerraUSD, may have nothing tangible to back it up in case of breaking the peg.
Kimberly: We haven’t talked about algorithmic stablecoins yet, and I feel we have to because they are more in troubles these days, like the Terra Luna stablecoin.
Greg: You are right. But first thing first, not all algorithmic stablecoins were born equal. I know many people are talking about TerraUSD and using that as a convenient case against all stablecoins. I recently went to an investment conference and one speaker there brushed away all stablecoins as “failed experiment” citing the Terra case. But Terra, or more accurately “UST” as the stablecoin in the Terra ecosystem is called, is an exception because it relies on smart contract algorithm, very little on full or excess backup reserve.
Kimberly: So does it mean having solid backup reserve is the key for the success of stablecoins?
Greg: I would say so at this early stage of stablecoins, which have yet to establish widely accepted trust or even broad awareness. But reserve matters even with public trust because trust does not fall from the sky but must grow up from the ground. Reserve provides the rich soil for trust to grow. To see it from a crisis prevention perspective, there is an article in Investopedia that says it well: Reserves are an antidote to panic.
Joy: The recent story with Tether proves how important reserve is. According to an article from blockworks.co, after the crash of UST, Tether investors rushed to redeem or to get rid of more than $16.3 billion worth of Tether token or “USDT” as the largest stablecoin is called. They either switched to dollars or to rival stablecoins like the second largest stablecoin USD Coin or “USDC.”
Emily: These names are confusing sometimes. But I guess they all start with USD, which stands for “US dollars”, right?
Joy: Right. The last letter tends to separate them. The “T” in USDT stands for Tether, “C” in USDC means Circle, the issuance entity for the USD Coin or USDC, while “T” in UST stands for Terra. BUSD is an exception because it uses the first letter of “B” to indicate the issuer of Binance.
Greg: The two stablecoin giants, number one ranked USDT by Tether and number two ranked USDC by Circle, clearly understand how important reserve is for getting public trust. After the crash of UST, these two stablecoins both tried to convince the public that they are financially fine with reserves. Circle announced they would publish weekly reserve report from now on, and Tether released an assurance report on its reserves by an auditing company MHA Cayman.
Joy: It’s interesting that Tether could only get a Cayman Island based auditing firm to write the report, not by a US based auditor. Its reserve composition is also less transparent than USDC is. I was worried that USDT would lose its crown as the top stablecoin. But in the end, although it experienced the largest “run” away that forced Tether to “burn” 20% of USDT token, Tether managed to keep its dollar peg and also the title of the largest stablecoin.
Greg: I wasn’t too concerned because USDT is centrally controlled and far better reserved than UST. During times of uncertainty, people always look for things they are familiar with, and having central control and backup reserve are the comforting factors.
Kimberly: Mom says USDT “burned” tokens, what does it mean?
Greg: “Burning” and “minting” are the two basic operations for changing the market supply of digital token or coin. I use “tokens” and “coins” interchangeably because digital coins are nothing but tokens. When they are “burned,” it means to send them to addresses or digital wallets that can only receive — never release or return — the token, as if they were dollar bills burned to ashes. Burned coins have been removed permanently from market circulation and the total coin supply is reduced.
Kimberly: But why do we want to do that? Are we having too many coins in circulation than needed?
Lily: Let me guess: The “law of scarcity” applies. When the USDT price drops below the peg, say one USDT only buys $0.989 instead of $1.00, it signals that the demand for USDT is lower than its supply, as more investors would keep dollars than USDT. Tether must “burn” some USDT tokens to take them out of circulation to push the value of USDT up to $1.00, all because things in short supply have higher value, other things equal.
Joy: And in the opposite scenario Tether must “mint” USDT when its price rises above the peg. Say one USDT coin can sell at $1.015, which means more investors want USDT than dollar. “Minting” USDT then increases the coin supply to push the price down to $1.00 peg.
Lily: So the story says “when USDT price drops, burn, when it rises, mint!”
Greg: To “burn” is to decrease USDT supply or equivalently to increase its scarcity; to “mint” is to increase USDT supply or decrease its scarcity. Think of the price of watermelons: In the summer more watermelons are available, and we can get one for just $4.99 even in the Bay Area. In the winter the supply of watermelons is decreased, so we must pay a higher price like $8.99. Now, if supermarkets want to keep the same price, say $6.99 throughout the year, they will put some watermelons into storage in the summer and release them from storage in the winter — assume a watermelon can be stored for months. Burning USDT is like putting watermelons into storage in the summer to raise its price from $4.99 to $6.99, while minting USDT is like releasing watermelons in the winter to lower its price from $8.99 to $6.99.
Kimberly: That makes sense. Do other stablecoins work the same as Tether’s USDT?
Greg: Yes and no. All stablecoins have the “burn” and “mint” operations but they do that somewhat differently. The two largest stablecoins, Tether’s USDT and Circle’s USDC, are both centrally controlled, which means they rely on a central authority to determine when to “burn” and when to “mint.” Algorithmic stablecoins are smarter as they rely on smart contract to automatically control burning or minting.
Kimberly: Speaking of algorithmic stablecoins, what about the most famous one, the UST? Does it use burning and minting as well?
Greg: Of course but in its own unique way. Basically it played a “seesaw” game using the stablecoin UST and a governance coin called “LUNA.”
Emily: What’s a governance coin?
Greg: It’s a coin that offers voting right to its owner, like stockholders voting for company issues. For our purpose it’s better to think of LUNA as a “sister” or a “utility” coin because it’s used as a tool or incentive to help UST maintain its peg with dollar.
Kimberly: How do the two work out together?
Greg: At the first glance you may think the design is clever. The Terra ecosystem has a special deal for trading between LUNA and UST. It says whenever investors swap LUNA token for UST or sell UST to buy LUNA, they can do that at a guaranteed fixed price of $1 — even though the prices of UST and LUNA are subject to market fluctuation. We can think of LUNA and UST as “identical twins” and if a LUNA owner wants to buy UST, or a UST owner wants to buy LUNA, the price will always be fixed at $1.00. This part of transaction sounds simple. But here is what gets complicated: The prices of LUNA and UST will both vary on the open market. This creates an opportunity for arbitrage.
Kimberly: It’s complicated indeed. Please give an example and explain what arbitrage is.
Greg: Let’s say in the stablecoin open market the UST is currently priced at $1.02, meaning one UST token or coin can sell for $1.02, 2 cents above the $1.00 peg. Meanwhile, say the current price of LUNA token is $0.50. I’m making it up because the real price of LUNA now is around $0.0001. If UST and LUNA were not “identical twins” with a price guarantee, LUNA owner will have to pay $1.02/$0.5 = 2.04 tokens to get 1 UST coin. With the price guarantee, whoever holding LUNA tokens will only pay $1.00/$0.5 = 2 LUNA tokens, not 2.04. Meanwhile everyone else without LUNA token have to pay $1.02 to get one UST coin. The saving of 2 cents is not much but comes risk-free because Terra system sets up that way. In addition, if I own one a lots of LUNA tokens and use them all to buy UST coins, the profit adds up quickly. This is how arbitrage works, which is nothing but legitimate ways to make money by taking advantage of price differences.
Kimberly: So Terra knew there would be price breaking away from the peg and designed the seesaw game to encourage arbitrage as a way to bring UST price back to the peg, right?
Greg: Yes. Now what would happen when investors all rush to get UST using every LUNA token they have? The price of UST will go down while LUNA price will go up. Why? Two ways to understand it. The first is to think about watermelons again: When all supermarkets are flooded with watermelons in the summer, they will lower the price for quick sale. This works the same for UST. When investors are buying UST, the market will be flooded with UST tokens, just like the watermelons in the summer. The UST price will go down. The other way to look at it is to think of the “burning” and “minting” operations. When investors are buying UST, new UST tokens must be minted, and the spent LUNA tokens will be burned. This also leads to a lower price of UST and a higher price of LUNA.
Kimberly: You just described the scenario when UST goes above the $1.00 peg. How about UST price going below the peg, which is more likely to happen as we all know?
Greg: It works the same way as a seesaw game. Say one UST coin only sells at $0.985 rather than $1.00 in the open stablecoin market, but within the Terra system one UST coin can still sell $1.00 worth of LUNA, which is 2 tokens. Guess what investors will do? Everyone will sell UST at $1.00 to buy 2 LUNA tokens, because in the open market one UST coin only gets you the equivalent of $0.985 in LUNA, which is $0.985/$0.5 = 1.97 tokens. From there the watermelon story repeats itself, in the sense that LUNA price goes down and UST price goes up. Again, arbitrage helps bring UST closer to the peg.
Lily: It just came to me that the seesaw game played by UST works much like the central bank: Fed sells government securities to banks to reduce the money supply in order to raise the interest rate; Fed buys government securities from banks to increase money supply in order to lower the interest rate. Fed has a goal of keeping the inflation rate at 2%, just like stablecoins have a goal of $1.00 peg with the dollar. Fed manipulates government securities just like UST relies on arbitrage with LUNA to stay on peg.
Kimberly: If so, why has UST failed so miserably while the Fed has been playing the same seesaw game for decades or centuries and it works fine.
Greg: It goes back to the backup reserve that we’ve been talking about. Fed has the deepest pocket that Terra can never match. Nobody will worry about Fed default because it has all the cash they want to buy securities. Terra on the other hand was severely under-reserved. An article published by Coindesk.com tells us that before its collapse in May 2022, UST had a market capitalization of $18 billion, but its reserve was less than $4 billion.
Joy: The way I see it, we also have a mindset problem. In other words, there is more to stablecoin than scarcity. We need to understand social psychology to be successful in major innovations. Understanding public mindsets allows us to foresee things before price changes or more importantly before crisis hits. The sustainability and value stability of stablecoins demand more than scarcity. Meanwhile, many in the crypto world, from Satoshi to the Terra co-founder Do Kwon, only focus on scarcity. Satoshi and his followers believed controlling the total supply of Bitcoin to 21 million is enough to control inflation. Do Kwon believed playing a seesaw game between two coins of UST and LUNA is enough to keep the value of stablecoin stable. Reality has proven them wrong. Bitcoin has been a lousy “inflation hedge,” while UST had a free fall in value. It’s the willingness to adopt that plays a more important role.
Greg: Sounds interesting. How does the “willingness to adopt” works?
Joy: It’s about convincing as many people as possible, not just the current investors in UST or LUNA. To do that, we have to understand what public hidden concerns are and offer insurance or assurance. I want to cite the example of FDIC for bank deposits. FDIC works its wonder since 1933 not because it sits there waiting for scarcity to show up. Instead, it preemptively offers a signal of assurance to all depositors by promising a coverage of up to $250,000 to boost public confidence.
Emily: What is FDIC?
Joy: Its full name is “Federal Deposit Insurance Corporation”. It’s a great way to ensure the safety and security of funds for all depositors. FDIC was founded in 1933 and ever since then it claims that not a single depositor has lost one penny of the deposited funds under its coverage.
Greg: Good point. I wish the Terra folks understood this before betting everything on UST and LUNA. It’s easy to ignore the big picture and single out scarcity and technicality — it’s easy to be penny smart and pound foolish. Many things done by central banks are not replicable by an entity because behind the Fed is the silent but almighty “Uncle Sam” who holds a unique and exclusive power of collecting taxes from every taxpayer. Fed should always issue a warning before making a policy move that says “Danger, do not try it at home!”
Emily: I want to go back to bank runs. Mom says investors were running away from Tether and redeemed $16 billion USDT for dollars, is that the same as bank runs?
Joy: Running away from a stablecoin is not the same as running away from a bank. The biggest difference still comes down to backup reserve. They also have different business models. With banks nobody can ask them to hold all the deposit, because banks make money by lending the deposits out or by investing the deposits in something else. To ask banks keeping all deposited money in their vaults is asking for bankruptcy.
Emily: Why is that?
Joy: Let’s say Bank of America receives $100 million from depositors in a month, if the Fed asks it to keep 10% of the deposits, Bank of America will lend $90 million out to earn higher interest to keep its door open. The Fed will never ask the bank to keep 100% of deposit.
Kimberly: But what if all depositors rushed to get their money out, no bank can pay them all and will be forced to shut down, right?
Joy: That’s where FDIC comes into play. Also, Tether has limited itself to institutional or large investors as it demands a minimum fiat withdrawal or deposits of $100,000. Clearly it is not for general public.
Kimberly: Now we know how banks make money, what’s the business model for stablecoins? I mean how do they make money?
Greg: There is an article on the website Binzinga.com that talks about that. There are several ways. They can charge issuance and redemption fees. When an investor pays dollar or other collateral to get stablecoin, she’ll be charged “issuance fee.” When the investor wants to get rid of the stablecoin and get dollar or other collateral back, she’ll be charged “redemption fee.”
Joy: Centralized stablecoins makes money mainly through short term lending and investing. One example is Tether loaned $1 billion to Celsius Network in October 2021. The latter would pay Tether an interest rate of 5% to 6% per year, which means Tether received between $50 to $60 million dollars per year.
Kimberly: So this works just like banks.
Joy: Except the required amount in reserve is usually higher — much higher — for stablecoins than for banks because FDIC does not cover stablecoins.
Greg: Lending is not the only way stablecoins make money. The other way is investment. Stablecoins are backed by assets, but not necessarily all by cash. For example, in July 2021, 61% of USDC reserves were in cash or cash equivalents while the rest was invested in a variety of assets such as Certificates of Deposit, corporate bonds, municipal bonds, U.S. Treasuries and commercial paper. They can invest in money market funds like commercial papers and better yet, treasury bill.
Emily: What is treasury bill?
Joy: It’s called “T-bill” for short. It’s short term debt issued by the Treasury Department to borrow money from the public. Its term ranges from 4 to 52 weeks, meaning an investor can buy T-bill today and the Treasury Department will pay her money back no later than the 52nd week. Because of the short time, T-bill will not pay interest, but investors can buy at a discount price from the par value.
Emily: What’s par value?
Joy: Par value is the face value of the T-bill. It’s the amount of money that the Treasury Department promises to pay the investor back when the bond reaches the maturity date. For example, say I bought a T-bill of $1,000 that is mature in 4 weeks. If the T-bill is discounted at 20%, I will only pay $800 today to receive the bond and after 4 weeks, the Treasury Department will pay me $1,000 to get the bond back.
Greg: Tether is not the only stablecoin doing the lending business. The second largest stablecoin, USDC, also does that. Jason, please check the market caps for top stablecoins from www.coinmarketcap.com.
Jason: It stays USDT ranks number three overall but the largest stablecoin by market cap. Its price is $0.9991. USDC is right behind Tether, with a price of $1.00.
Kimberley: How is USDC doing better than Tether in pegging?
Joy: According to an article by gemini.com, USDC has central control just like Tether does. Also like Tether, USDC is fully backed by reserve. What sets USDC apart is that its reserve is held at regulated US financial institutions, just like commercial banks do in the traditional finance. Furthermore, it’s audited by a U.S. accounting firm that issues monthly report on the reserves backing USDC.
Kimberly: If I remember correctly, Tether holds its reserve to itself, not to outsiders, right?
Joy: That’s right, and that may explain why the article from blockworks.co says only Tether knows what exactly its backup reserve is made up of. This also made it harder for Tether to obtain a creditable auditor willing to issue public reports about its reserve.
Lily: So the real lesson is that people are willing to invest in crypto and use stablecoins as long as (1) they are fully reserved, preferably in stable fiat; and (2) their reserve information is transparent and verifiable.
Joy: I would add another lesson: it’s a good thing that we have different stablecoins at the same time, because it helps speed up the learning process. Think of it, if we only had Tether, we’d have to wait to see how it performs during bad times before trying anything else. Now we can compare different models of stablecoins and pick up the best.
Lily: Following your logic, having price ups and downs is also a good thing, because it provides a good testing environment for different stablecoins.
Greg: The article on blockworks.co has an informative chart showing prices of top four stablecoins since May 1st: Tether or USDT, USD Coin or USDC, Dai and Binance USD or BUSD. We know one thing for sure: the demise of UST or TerraUSD has more negative impact on USDT than on anything else. Binance USD even has price higher than the peg, reaching a peak price of $1.07 on June 19, 2022.
Kimberly: Why is BUSD priced higher in the event of UST crash?
Joy: I wonder to what extent has that been caused by having a governmental agency in New York offering authorization of BUSD stablecoin, not just by fiat backup and auditing report.
Greg: I see what you mean. It also helps that the New York State Department of Financial Services or NYDFS authorized Paxos Trust Company LLC to offer a gold-backed virtual currency, the first such virtual currency. Keep in mind that Paxos is in a partnership with Binance to launch BUSD.
Lily: I find it funny that Crypto is supposed to be a game changer to traditional finance; yet in reality, its creditability and reliability still depend so much on traditional finance, like having fiat backup or setting up account in banks.
Kimberly: I agree. Bitcoin and other cryptocurrencies were designed to be unregulated, and they call for disintermediation; yet having a governmental approval helps Binance USD or BUSD succeed.
Joy: Bear in mind though that stablecoins are designed to be the bridge connecting digital currency with fiat, which means they have a naturally strong tie with traditional finance. Non-stablecoins may not have such a feature. But you are right, stablecoins works much like fiat: The more regulated and the closer the link with fiat, the safer it is perceived and the stabler during the time of uncertainties.