Algorithmic, fiat-backed or crypto-backed: What’s the best stablecoin type?

The third spot on the market capitalization list was taken by TerraUSD (UST), who flipped BinanceUSD (BUSD). It didn’t last very long. The once-mighty stablecoin, which powers Terra’s ecosystem, is now reduced to tweets that “Terra more than UST”. Although no one knows if LUNA will make a comeback or not, UST will be remembered as an algorithmic stablecoin that was destroyed in the same way as Basis Cash (which Terra creator Do Kwon is alleged to have been a part) and Mark Cuban-backed Iron Finance.

The failure of UST raises the question: Are algorithmic stablecoins doomed? Is it fiat-backed stabilitycoin or crypto-backed stablecoin that investors have the best way to protect themselves from volatility in the crypto market?

Different stablecoins: The pros and cons

By now, most are aware of the types of stablecoins such as fiat-backed stablecoins, crypto-collateralized stablecoins and algorithmic stablecoins. Although there are other stablecoins, such as commodity-backed or seigniorage. The most widely used are the three listed above.

Each user has their own reasons for choosing one type of stablecoin over the other. Some prefer algo stablecoins due to their decentralized narrative. Some would prefer fiat-backed cryptocurrency like Tether (USDT), and USD Coin (USDC), even if they are centralized due to the private companies that hold the equivalent fiat reserves for each token. However, fiat-backed coins have the advantage of having an actual asset backing them.

As long as fiat reserves are available, Tether’s peg will be stable. The most likely risk is a bank collapse scenario. This could be a problem for Tether as it is heavily exposed to commercial papers. Large corporations issue commercial papers, which are an unsecured type of debt with a maturity of up to 270 days. Tether can become insolvent if there are too many redemptions. This is why the company has reduced its commercial paper holdings in the past six months.

Crypto-collateralized stablecoins like Dai (DAI), on the other hand, are backed by an excess supply of another cryptocurrency, in this case, Ether (ETH). DAI requires a minimum 150% collateralization rate. This means that the DAI borrowed must be equal to 1.5 times the amount of ETH deposited into a smart contract. To borrow $1,000 worth DAI, a user must lock in $1,500 worth of Ether. If Ether’s market price drops below the minimum collateralization ratio, the collateral will be paid back to the smart contract in order to liquidate the position.

The case of UST

Stablecoins have a tendency to keep their value at their peg. However, the events that occurred to UST were astonishing and threatened the collapse the entire market. UST is a hybrid between an algo stablecoin and a crypto-collateralized stablecoin. Users are encouraged to use $1 worth of LUNA to buy UST at a profit when the price of UST rises above the dollar peg. Users can exchange UST for a discounted LUNA if UST falls below its dollar peg. As a contingency plan, the Luna Foundation Guard had large amounts of Bitcoin (BTC), collateral. This made it crypto-backed. As it turned out, this was ineffective and the remaining BTC and assets were given to smallholders for compensation.

The large withdrawals from Anchor Protocol on May 8th were the catalyst for Terra’s demise. Millions of UST were quickly removed from the protocol and sold to create a downward spiral. The result was panic. The algorithm couldn’t react quickly enough and began to burn LUNA in response to the rapid fall of UST’s price.

The evidence is obvious in hindsight since Terra’s Anchor Protocol was the only source of primary demand for UST. The low trading volume for UST indicates that users are more interested keeping it in the protocol rather than using it for trading.

DAI holding steady

DAI had actually remained stable despite panic and Tether losing its peg against the United States dollar for a brief time. DAI rose to $1.001 while USDT fell to $0.994 at one point. DAI was recently hailed as “the” decentralized stablecoin.

DAI, which has been around since 2017, has been able to withstand many of the most extreme market conditions. This is something that no other stablecoin has ever done. There is never a shortage risk in crypto markets.

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