BitMEX Founder Discusses Stablecoin Categories, Believes Perfection is Impossible, Market Will Continue to Explore

The founder of BitMEX, Arthur Hayes, who is known for sharing his views during market turbulence, did not miss out on the recent unpegging event of UST this week. In his latest article, he discussed various categories of stablecoins, including those backed by fiat reserves, overcollateralized ones, Bitcoin-backed stablecoins, and the recent market star algorithmic stablecoins. He also cautioned investors on what to watch out for in the current market environment.

This article provides a summary of the key points. For any doubts, please refer to the original article.

Legal Tender Pegged Stablecoins

When users transfer assets in banks, it usually takes time and money as costs. The emergence of the Bitcoin blockchain has created a competitive peer-to-peer payment system that significantly reduces these costs. However, compared to fiat currencies and commodities like a barrel of crude oil, Bitcoin's volatility is extreme. To address this issue, Tether introduced the first stablecoin pegged to the US dollar, USDT.

USDT is backed 1:1 by fiat assets held by banking institutions, known as fiat reserve stablecoins. Following USDT and USDC, various types of fiat reserve stablecoins have emerged.

Arthur Hayes believes the biggest issue with these stablecoins is the need for banks willing to hold the fiat assets supporting the token. Even though USDT generates high trading volume daily, these banks do not earn any transaction fees but must bear the cost of holding large amounts of fiat assets.

It is strange to Arthur Hayes that banks are expected to provide custody services for stablecoins backed by fiat assets without charging any fees, as this strategy will be unsustainable on a larger scale. Handling several billion dollars may be manageable, but expecting commercial banks to allow the custody of stablecoin assets in the trillions is foolish, not to mention becoming a payment solution for Web3 or a truly decentralized global economy.

Crypto-Collateralized Over-Collateralized Stablecoins

In short, stablecoins pegged to fiat currencies can be minted by using crypto assets as collateral. The most well-known protocol for this is MakerDAO.

By providing high market cap coins like BTC, ETH as collateral, DAI can be minted where 1 DAI = 1 USD. However, if the value of the collateral drops due to a price decrease, there is a risk of liquidation to meet the borrowing value of DAI.

The situation of DAI being pegged to the USD is quite healthy, but over-collateralization is its biggest issue, reducing liquidity in the crypto capital market in exchange for stability with fiat assets.

Additionally, Arthur Hayes suggests that MKR token holders can introduce risk into their business model by lending out idle collateral assets for more income. In this case, MakerDAO will have credit risk as it cannot be certain if these borrowers paying interest in cryptocurrencies are reliable, if the collateral is reasonable, and if it belongs to native assets. Arthur Hayes mentions that MKR token holders can introduce high-risk coins as collateral through governance proposals.

The advantage of traditional banking businesses is that the system can grow exponentially without depleting all currency collateral. These over-collateralized stablecoins fill a very important niche market, but due to the aforementioned fundamental reasons, they always remain niche markets.

Algorithmic Stablecoins

Algorithmic stablecoins aim to peg assets without a reserve of less than 1:1 fiat assets or crypto reserves and typically do not use external collateral to back stablecoins.

Given the topic at hand, it is necessary to use LUNA and UST as examples to explain how their mechanisms work. LUNA is the governance token of the Terra ecosystem. UST is a stablecoin pegged to the USD, with its underlying assets consisting only of circulating LUNA.

Here is how it operates:

UST Premium: If 1 UST = 1.01 USD, UST is overvalued compared to its pegged value. In this scenario, the protocol allows LUNA holders to exchange $1 worth of LUNA for 1 UST. LUNA is burned or taken out of circulation, while UST is minted or added to circulation. Assuming 1 UST = 1.01 USD, traders can earn a profit of $0.01.

UST Discount Current Situation: If 1 UST = 0.99 USD, UST is undervalued relative to its pegged exchange rate. In this case, the protocol allows UST holders to exchange 1 UST for $1 worth of LUNA. It can be thought of as purchasing 1 UST for $0.99 and exchanging it for $1 worth of LUNA, making a profit of $0.01. UST is burned, while LUNA is minted.

Arthur Hayes states that in the case of UST discount, the circulating supply of LUNA continues to increase. The current major issue is that investors with newly minted LUNA may choose to sell it immediately rather than hold, anticipating it to rise. This is why when UST significantly discounts from its peg, there is continuous selling pressure on LUNA.

As LUNA is perceived to be more valuable, the more use cases UST has in the decentralized Web3 economy, this minting and burning mechanism will function properly. However, if UST cannot maintain its downward trend, a death spiral may start from perpetual minting of LUNA in an attempt to re-peg UST.

The aforementioned issue is a common problem for all algorithmic stablecoins – how to regain user support to re-peg when the stablecoin price deviates. Once a death spiral starts, algorithmic stablecoins will fail and lose market trust, making it very difficult and costly to regain market confidence.

Arthur Hayes believes that theoretically, this model can be expanded to meet the needs of the decentralized Web3 economy, but it requires near-perfect design and execution.

Hayes's Version of Bitcoin-Backed Stablecoins

Arthur Hayes believes that the only commendable aspect of stablecoins is that they allow fiat currencies to exist on public chains. He argues that using Bitcoin as a reserve to create an unbreakable 1:1 USD stablecoin is inherently flawed. However, it can be achieved by creating a "Bitcoin" and "reverse derivative contract" to create the value of one USD.

He suggests that in the form of a foundation, Bitcoin can be used as collateral on multiple top exchanges, and reverse derivative contracts can be employed to create synthetic USD sUSD. For example, if 1 BTC is worth $100, and you want to create 100 synthetic USD, you can prepare 1 BTC as collateral along with 100 contracts for 1 USD worth of bitcoin shorts.

The intention is to create a one-dollar value, where when Bitcoin rises, the losses from the short position in Bitcoin will offset the excess value of one dollar per Bitcoin; and when Bitcoin falls, the profits from the short position will compensate for the Bitcoin being less than one dollar in value. This model will only break if the value of Bitcoin goes to zero or drops too quickly.

Creation can be done by providing Bitcoin to the foundation, opening a short position, and receiving synthetic USD; redemption can be done by repaying synthetic USD and retrieving the collateral. Each creation and redemption should incur fees as a source of income. He also believes that the funding rate for shorts will be positive in the long run, meaning long positions must pay shorts. Therefore, the more synthetic USD backed by Bitcoin circulating in the market, the more bitcoin shorts will generate funding rate returns, which will be another source of income for the foundation.

Perfection is Impossible

Arthur Hayes believes that without compromise, it is impossible to create a stablecoin pegged to fiat currencies on public chains. Among the four options presented, he prefers stablecoins backed by Bitcoin and derivatives, followed by over-collateralized stablecoins.

However, regardless of the option, the issue lies in the need for assets to move between parties on these public networks to generate transaction fees for maintaining the payment network. Therefore, in the long run, holding these coins will incur wear and tear.

Can Terra / UST Survive?

Terra is currently at the deepest point of the death spiral. Arthur Hayes believes that when the market cap of UST equals the market cap of LUNA, the spiral will stop. However, with their current mechanism, when there are still billions of dollars of LUNA being dumped in the market, who would want to take over LUNA when UST < 1 USD?

The chart above shows the market value of UST-LUNA, where a value >0 means UST must be burned and LUNA issued to re-peg UST.

Arthur Hayes believes that algorithmic stablecoins and fiat debt reserve stablecoins are not much different, except for one critical factor. Terra cannot force anyone to use UST at any cost. They must make the market believe that the governance token supporting the protocol, LUNA, has a non-zero value and that its value will grow faster than the quantity of UST over time.

Unless some genius protocol changes are made, Arthur Hayes does not think they can survive, but he also admits he can't think of a good solution.

It's Time to Rest

This week's crash was exacerbated by the Luna Foundation selling BTC to re-peg UST to the USD. This occurred just a week after the Fed raised interest rates by 50 basis points, indicating that the market cannot handle continuously rising nominal interest rates.

Furthermore, the US CPI in April increased by 8.3% year-on-year, which is still unacceptably high and the Fed is expected to raise rates by another 50 basis points in June to combat inflation, further disrupting long-term risk assets.

Therefore, Arthur Hayes has a few reminders for investors:

• Crypto capital markets must pay attention to the overexposure of Terra-related assets
• Any service related to this event that offers above-average returns will experience a capital outflow
• Most people do not seriously understand how protocols work and tend to sell directly during stressful events, causing all crypto asset investors to lose confidence and prefer holding fiat
• After a major bloodbath in the market, it takes time to recover, and trying to understand reasonable prices now is futile

"I will be a buyer at $20,000 for Bitcoin and $1,300 for Ethereum, roughly corresponding to the historical highs of each asset during the 2017/18 bull market. Stay away from the buy and sell buttons until the dust settles." Arthur Hayes said.