I'm seeing alot of newcomers, this 🧵 is for you! It will cover:
1. Everything you need to know about stablecoins
2. How $UST works
3. The relationship between $UST and $LUNA
1. Everything you need to know about stablecoins
2. How $UST works
3. The relationship between $UST and $LUNA
If you're in the crypto market, you're guaranteed to have interacted with stablecoins. They account for almost 80% of trading volume and have a total market cap surpassing $150B.
The top 6 stablecoins being:
1. $USDT
2. $USDC
3. $BUSD
4. $DAI
5. $UST
6. $MIM
The top 6 stablecoins being:
1. $USDT
2. $USDC
3. $BUSD
4. $DAI
5. $UST
6. $MIM
These are all pegged 1:1 to the US Dollar, however, their pegging mechanisms vary significantly from one another. There are 3 main types of stablecoins:
- Fiat-backed
- Crypto-backed
- Algorithmic
- Fiat-backed
- Crypto-backed
- Algorithmic
Fiat-backed is by far the most common, consisting of $USDT, $USDC, and $BUSD. They are supposedly 100% backed by fiat collateral, this means that for every 1 $USDT, there should be 1 US Dollar sitting in a bank account somewhere in the Fiat world.
Sounds relatively simple right?
Yes, it does, but it comes with significant risks. The main two being:
- Counterparty risk.
The centralised party behind the fiat-backed stablecoin doesn't actually back their stablecoins with the said reserves.
Yes, it does, but it comes with significant risks. The main two being:
- Counterparty risk.
The centralised party behind the fiat-backed stablecoin doesn't actually back their stablecoins with the said reserves.
- Regulatory risk.
Due to the fact that these stablecoins are controlled by a centralised company, regulators could freeze the assets that back the stablecoins, resulting in these 'fiat-backed' cryptocurrencies actually being worthless.
Due to the fact that these stablecoins are controlled by a centralised company, regulators could freeze the assets that back the stablecoins, resulting in these 'fiat-backed' cryptocurrencies actually being worthless.
- Overall risky backing.
The reserves of both $USDT and $USDC have been under regulatory scrutiny, due to the asset types being used to back their stablecoins. The most common backing is actually commercial paper, which is really just company debt, this is risky.
The reserves of both $USDT and $USDC have been under regulatory scrutiny, due to the asset types being used to back their stablecoins. The most common backing is actually commercial paper, which is really just company debt, this is risky.
Okay, what about crypto-backed stablecoins?
Due to their nature, these are also known as collateralised debt position (CDP) stablecoins and include both $DAI and $MIM.
Due to their nature, these are also known as collateralised debt position (CDP) stablecoins and include both $DAI and $MIM.
To mint one of these CDP stablecoins, the user would need to deposit a collateral asset, this could be $ETH, $USDT or any other crypto asset accepted by the respective protocol.
For example, to mint 1 $DAI (worth $1), a user must deposit a minimum collateral of $1.50
For example, to mint 1 $DAI (worth $1), a user must deposit a minimum collateral of $1.50
For example to mint 1 $DAI (worth $1), a user would need to maintain a collateral level above $1.50. If they initially deposited $2 of $ETH and $ETH then dropped to $1.50, liquidation would occur. The collateral deposited ($ETH) would then be sold to buy and burn $DAI.
There are two main downsides to this CDP structure:
- It's inefficient due to being over-collateralised
- Requires market participants to want leverage, hence it's hard to scale
- It's inefficient due to being over-collateralised
- Requires market participants to want leverage, hence it's hard to scale
But it also faces regulatory risk which is passed on from their collateral assets.
Both $DAI and $MIM can be minted with $USDT or $USDC as collateral.
$DAI has approximately 30% of its collateral in the form of $USDC.
Both $DAI and $MIM can be minted with $USDT or $USDC as collateral.
$DAI has approximately 30% of its collateral in the form of $USDC.
Now onto algorithmic stablecoins, the largest being $UST.
These stablecoins are backed by a reserve asset, in $UST's case, this is $LUNA. To maintain peg, the supply of stablecoins in circulation will be altered to meet demand.
These stablecoins are backed by a reserve asset, in $UST's case, this is $LUNA. To maintain peg, the supply of stablecoins in circulation will be altered to meet demand.
So, how is this done?
It's done through a simple burning and minting mechanism between $UST and $LUNA.
1 $UST can always be exchanged for $1 worth or $LUNA.
It's done through a simple burning and minting mechanism between $UST and $LUNA.
1 $UST can always be exchanged for $1 worth or $LUNA.
Let's work through a couple of examples:
$UST is at $0.95 (below peg)
In this case, anyone can buy $UST at $0.95 and burn it to receive $1 worth of $LUNA, this will result in $UST reapproaching it's peg and the user receiving a $0.05 risk-free profit.
$UST is at $0.95 (below peg)
In this case, anyone can buy $UST at $0.95 and burn it to receive $1 worth of $LUNA, this will result in $UST reapproaching it's peg and the user receiving a $0.05 risk-free profit.
$UST is at $1.05 (above peg)
In this case, users could buy $1 worth of $LUNA and burn it to receive 1 $UST (worth $1.05), also resulting in $UST regaining peg with the user receiving a $0.05 risk-free profit.
In this case, users could buy $1 worth of $LUNA and burn it to receive 1 $UST (worth $1.05), also resulting in $UST regaining peg with the user receiving a $0.05 risk-free profit.
This algorithmic model removes the:
- Counterparty risks
- Regulatory risks
- Over collateralisation issue
- Scaling issue
- Counterparty risks
- Regulatory risks
- Over collateralisation issue
- Scaling issue
So what are the risks?
Bank run/death spiral:
In the face of $UST dropping below peg for long periods of time, it'd be profitable to:
1. Burn $UST for $LUNA
2. Sell $LUNA at a profit
3. Repeat
Bank run/death spiral:
In the face of $UST dropping below peg for long periods of time, it'd be profitable to:
1. Burn $UST for $LUNA
2. Sell $LUNA at a profit
3. Repeat
This would supposedly result in $LUNA's price crashing, and $UST's reserve asset being worthless, leaving $UST unbacked.
However, in May, $UST dropped below peg (as all stablecoins did) and this 'death spiral' people speak about, never occurred.
However, in May, $UST dropped below peg (as all stablecoins did) and this 'death spiral' people speak about, never occurred.
So, how does this relationship between $UST and $LUNA work? and how does it affect $LUNA's price?
As $UST is minted, $LUNA is burned. In other words, as the demand for $UST goes up, the supply of $LUNA goes down.
Of course, this also works in the other direction.
As $UST is minted, $LUNA is burned. In other words, as the demand for $UST goes up, the supply of $LUNA goes down.
Of course, this also works in the other direction.
As for the price.
In the short-term, a decrease in the supply of $LUNA shouldn't have any direct effect on $LUNA's price. $LUNA's price will fluctuate the same as all volatile assets.
In the short-term, a decrease in the supply of $LUNA shouldn't have any direct effect on $LUNA's price. $LUNA's price will fluctuate the same as all volatile assets.
In the long-term, this decrease in $LUNA supply makes $LUNA a scarcer asset. Scarcity increases price.
For example (Market cap = $100M):
1. $LUNA supply = 100M
$LUNA price = $1
2. $LUNA supply = 90M (scarcer)
$LUNA price = $1.11
For example (Market cap = $100M):
1. $LUNA supply = 100M
$LUNA price = $1
2. $LUNA supply = 90M (scarcer)
$LUNA price = $1.11
Again, this was much longer than intended, let me know if you prefer shorter or longer 🧵's.
Hope you enjoyed 🤝
Hope you enjoyed 🤝
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