The Past and Future of DeFi Stablecoins: Reflections after the Terra UST Collapse
This article is written by the team at XREX exchange: Wayne Huang-Yaowen, Chen Anzu, You Zhiwei, Aditya Gupta
Whether it's TerraUSD UST, which collapsed recently, or other DeFi stablecoins that have withstood the market's test of liquidity, such as DAI, FRAX, FEI, or early failures like Basis Cash (BAC), Ampleforth, all can be traced back to the dual coin model proposed by cryptocurrency economist Robert Sams in 2014 in his paper "A Note on Cryptocurrency Stabilisation: Seigniorage Shares."
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Robert Sams' Dual Token Model: The Contradiction Between "Transaction" and "Speculation"
Robert Sams, who designed the theoretical foundation for DeFi stablecoins, believes that the reason why Bitcoin's price fluctuates wildly and cannot become a stable unit of account is due to the existence of two conflicting demands - "transaction" and "speculation."
1. Demand for Transactions
As Bitcoin gains more acceptance and is used as a medium of exchange, the demand for Bitcoin will inevitably increase, and users will hope for the price of Bitcoin to stabilize, facilitating transactions.
2. Demand for Speculation
However, as the demand for transactions increases, more speculators will predict the future increase in demand, leading to buying and hoarding Bitcoin for HODL. This will inevitably cause the price of Bitcoin to rise. Whether it is updates on current demand awareness or changes in future demand predictions, they will drive fluctuations in the price of Bitcoin, conflicting with its role as a stable unit of account.
Based on this assumption, Robert Sams proposes that the issuance and design of cryptocurrencies should have tokens that can satisfy these two demands separately:
1. Stablecoin: A unit of account and medium of exchange with a stable price to meet the demand for transactions.
2. Seigniorage Token: Seigniorage, also known as the money tax, is the revenue that currency issuers can earn. When a currency is widely used and recognized, as its usage increases, so does the revenue. Therefore, the value of this "seigniorage token" will increase. Since speculators will hoard this "seigniorage" token, meeting their speculative demand, it will not affect the price of the "stablecoin," allowing it to continue to serve as a good unit of account.
For example, in the case of USDC, if the market is optimistic about the future demand for USDC, they would not hoard USDC but would instead acquire a large amount of shares of the issuer, Circle.
At the same time, seigniorage tokens also play a role in absorbing stablecoin price fluctuations and supporting stablecoin market value.
Many existing DeFi stablecoin projects can be seen as concrete implementations of Sams' dual-token model.
The Transparency of Blockchain is a Double-edged Sword: A Lifesaver for DeFi Stablecoins in a Death Spiral
Compared to the fully exogenous reserve-backed CeFi stablecoins like USDT and USDC, algorithmic stablecoins in DeFi, such as UST, BAC, and ESD, optimize reserve fund efficiency as their main goal. They treat the "seigniorage token" as the "primary" support behind the stablecoin. While this significantly improves the efficiency of their reserves, it also makes the price trend of the "seigniorage token" another important signal reflecting the current demand situation or future trends of the stablecoin. This can make the price stabilization mechanism more fragile in times of crisis and make it more difficult to recover. The recent collapse of UST is the most vivid example of this.
When UST faces a shock from large holders selling off, causing a liquidity crisis and a significant drop in UST demand, the top priority is to maintain the price of UST pegged to the US dollar and avoid exacerbating the crisis. The main task is to make participants feel that the decrease in UST demand is not significant and to ensure that market panic is controlled to prevent confidence from collapsing. This is why we advocate that liquidity is the first line of defense in stablecoin design.
As long as there is sufficient liquidity to stabilize market prices, market participants will not perceive a significant decrease in demand for UST as long as prices do not continue to plummet. This can prevent subsequent chain reactions. This logic is effective for reserve-backed CeFi stablecoins denominated in US dollars or US dollar-like assets, such as USDT issued by Tether, but has limited effectiveness for DeFi stablecoins like UST issued by Terra. Why?
Because even though the Luna Foundation Guard LFG, along with market makers, worked to maintain adequate liquidity in the market, stabilizing the price of UST, if the price of LUNA, the native token of Terra, significantly drops, it becomes difficult to resolve the crisis surrounding UST. Why?
Because the price of LUNA serves as another important signal for observing changes in UST demand. If the price of UST stabilizes but the price of LUNA drops, the market will interpret this as a decrease in demand for UST, as there are two possible interpretations:
1. The drop in LUNA is due to users reducing their demand for UST, burning UST, minting LUNA, and selling it, causing LUNA to drop in price.
2. The drop in LUNA is due to speculators revising their future demand expectations for UST significantly.
Regardless of the first or second interpretation, market participants will turn pessimistic about the current or future demand for UST, even though the price of UST has not decoupled. This pessimistic sentiment will trigger two selling pressures on LUNA:
1. UST users, fearing that the drop in LUNA prices weakens UST support, will burn UST to mint LUNA and sell it.
2. LUNA holders will sell LUNA due to their bearish outlook on future UST demand.
The first selling pressure is the most dangerous because according to UST's smart contract logic, as the price of LUNA drops, each UST burned will mint more LUNA, creating greater selling pressure. These two selling pressures will amplify each other, rapidly consolidating the decline in LUNA prices into market consensus, triggering a chain reaction and leading UST into a death spiral.
Opacity is a Natural Characteristic of the Currency Market: Symmetric Ignorance Benefits Liquidity
From the perspective of token economics, UST already needs to defend two additional market signals - price stability (anchored to the US dollar) and circulation volume (market capitalization). However, due to its core design, UST still needs to defend the market capitalization of LUNA, a third market signal.
This contradicts Nobel laureate in economics Bengt Holmström's discussion of market liquidity, where he said, "I argue that 'no questions asked' is the ultimate goal of market liquidity... Opacity is a natural feature of the currency market that can enhance liquidity." He also stated, "People often think that liquidity must be built on transparency, but this is a misconception."
Following Holmström's theory, we can analyze several currencies we are familiar with: TWD, USDT, UST
TWD: There is no real-time transparency in the circulation volume, and there are no "seigniorage" stocks for market speculation, making it easier for the market to enter a state of "symmetric ignorance," making it easier to defend.
Tether USDT: Due to its on-chain issuance, the circulation volume (market capitalization) is immediately transparent, increasing the market's interpretation signals. While it is challenging to defend, because its financial reports and reserve information are still managed centrally, it can still achieve a state of "symmetric ignorance."
Terra UST: The dual-token mechanism creates three points of transparency - real-time circulation of UST, real-time circulation and price of the "seigniorage token" LUNA, and the market's clear understanding that LUNA is the sole support behind UST. These three points prevent users of all UST and speculators of LUNA from constantly peeking at the price fluctuations of LUNA, speculating on the market's future demand attitude towards UST, preventing them from entering a state of "symmetric ignorance." The LFG must defend not only the anchoring and circulation of UST but also the price of LUNA, making the defense line too long and difficult to defend.
The Dual Token Model is Not Suitable for Endogenous Support
Although the dual-token model itself is more difficult to defend, MakerDAO's stablecoin DAI, which also adopts a dual-token mechanism, has performed relatively well in this storm compared to the collapse of Terra UST. DAI, which is backed by over 150% of external collateral assets, has two major features: excess collateral and external asset collateral.
Central banks lowering interest rates to stimulate the economy during the pandemic made the "DeFi summer" of 2020 shine even more brightly. During that time, the DeFi industry discovered the competitive advantages of decentralized finance, including maximizing fund efficiency and generating high-interest rates. Compared to the traditional finance sector's interest rates at the time, the interest rates generated by DeFi were very attractive. Stablecoins like FEI, FRAX, and the later Terra UST emphasized fund efficiency and utilization.
Unlike Terra UST, FEI and FRAX can be considered "Holmström-style" stablecoins. They are familiar with liquidity operations. While their reserves are not as solid as DAI, they focus mainly on constructing liquidity, creating a solid first line of defense. Their reserve assets are mostly external variables, significantly reducing the market's sensitivity to fluctuations in the price of the "seigniorage token." Both efforts help create and maintain a state of "symmetric ignorance," an approach that helps them navigate through crises.
However, the weaknesses and mistakes of Terra UST in this collapse are:
- The dual-token design is inherently more challenging to defend, especially when using an internal variable like the "seigniorage token" LUNA as the primary support, making it prone to triggering a death spiral.
- There are not enough use cases; out of the $18 billion issuance of UST, $11 billion is staked in Anchor, an excessively concentrated and unrealized value application scenario, accelerating UST users' decisions to sell in times of crisis, with no incentives for any market participants to buy in.
- The $3 billion BTC reserve is insufficient to protect the $18 billion UST issuance (only 17%).
- Although Terra later added BTC as an additional reserve, it was not the best choice. Terra should have chosen a stronger defense like USDC, USDT, etc., as the first line of defense. Just like the first line of defense for any central bank is its foreign exchange reserves, not gold reserves.
- When UST was being sold off by large holders and starting to decouple, the issuer was too inexperienced and hasty in liquidity operations, missing the golden opportunity to defend. Both UST and Luna collapsed within a week, evaporating over $50 billion in market value.
The Future of Algorithmic Stablecoins
Terra UST will not be the last algorithmic stablecoin. The history of cryptocurrencies will see more experiments and setbacks to lead humanity to find the best mechanisms and methods. When evaluating and designing the next generation of DeFi stablecoins, we must consider three coexisting and complementary supports:
1. High-quality Reserves and Risk-segmented Reserves
They must be exogenous, and the higher the quality of reserves, the lower the market's attention and sensitivity. Assets that are not linked to the market are preferred, ideally those that will be "forgotten," to achieve a state of "symmetric ignorance."
Reserves can be divided into:
- Collateral assets: Designs like DAI's, with excess collateral and collateral assets that can be redeemed by the collateral holder.
- Reserve assets: Designs like FRAX and FEI, with excess reserves that entirely belong to the protocol and cannot be redeemed.
2. Strong Liquidity Defense
Stablecoin designs must not only consider reserves but also focus on defense speed and liquidity. Strengthening liquidity between themselves and other mainstream stablecoins can absorb market sell-offs and stabilize market confidence, making it worthwhile for DeFi stablecoin DAO organizations to invest resources in building. Curve will remain an important liquidity infrastructure in the coming years. Stablecoin DAOs should focus on establishing additional defense budgets beyond reserves, similar to the foreign exchange reserves of central banks. This part of the budget should belong entirely to the protocol.
The defense budget should be calculated proportionally based on the stablecoin's circulation outside, and should at least refer to the foreign exchange reserve ratio of various central banks.
3. Inherent Demands
Today's market cannot do without USDT because USDT trading pairs have the best depth and spreads, and the liquidity and trade in emerging markets heavily rely on USDT. This is why in early 2019, when BitFinex (a Tether-related company) froze $850 million in a Panamanian bank, the industry raised $1 billion in funding within ten days. Because USDT is crucial to the entire market, the industry must protect Tether and BitFinex.
USDC has also gradually built up demand: reserves and trading in the DeFi ecosystem. This type of "inherent demand" helps resist market consensus pessimism-induced selling pressure.
The diversity of use cases will prompt market participants to enter and buy during a crisis due to different applications and demands for the stablecoin. During the brief decoupling of USDT caused by the UST collapse, we observed this phenomenon on the XREX exchange, where many users bought USDT at a lower price. Traditional currencies also exhibit similar behaviors; for example, when the Japanese yen depreciates, many people have a demand for traveling to Japan or importing products, prompting them to buy in.
As Hemingway once said, "In a calm sea, every man is a sailor." Therefore, we also believe that every crisis or bear market is a battlefield for stablecoins, and each crisis is an opportunity to shape safety and reputation. In the recent Terra UST collapse storm, DAI's stable anchoring and USDT's successful handling of market pressures exceeding $10 billion will help them accumulate experience and reputation.
By going through the tragedy of Terra UST together, we understand that continuously improving the community's understanding and evaluation capabilities of DeFi stablecoins is crucial to expect the industry to continue innovating and creating more stable and user-friendly stablecoin protocols. We also hope to remind the community that the most crucial value of stablecoins is not the efficiency of reserve funds but the liquidity and security as a "unit of account" and "medium of exchange."
This is why in April this year, regarding the stablecoin legislation drafted by the US authorities, Deputy Secretary of the U.S. Treasury, Lenny Liang, emphasized during the hearing that stablecoin regulation not only requires quality reserves but also demands resilience in extreme market conditions and liquidity and ease of conversion between different stablecoins.
Users choose stablecoins for their price or value "stability," and DeFi designers should focus on "stability" as the primary appeal of a stablecoin.
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