November 9, 2022

Depegging Disasters

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It is normal to encounter individuals with huge resistances in entering the cryptocurrency ecosystem. It is known to be an abode of fraudulent schemes and of absurd volatility that may result in losing as much as  90% of your invested capital. Many protocols have brought both high hopes and nightmares in crypto - including stablecoins.

Reading this article will enlighten you on the major stablecoin carnages during the year 2022, along with their brief post-mortem analysis, and how to keep safe in stablecoin investments.

Disaster 1: UST

On May 9th, 2022, a disaster struck the Defi community. Do Kwon’s brainchild, TerraUSD (UST), lost its peg to the dollar. Prior to this day, system loopholes were identified by a group of individuals, who were able to successfully exploit the system on the 9th. The death spiral allegedly started when roughly $84 million worth of UST were withdrawn from the protocol, which algorithmically increased the token supply of its sister token, Terra Luna (LUNA). This then created a negative flywheel - evaporating both LUNA and UST into smoke.

On May 11th, Anchor Protocol proposed to restore UST back to its peg by adjusting their interest rates and deposit rates. Unfortunately, UST never came back to its former glory.

Disaster 2: MIM

Following the UST disaster, an inevitable fear took over. People anticipated more disasters to happen. True enough, several stablecoins follow suit, including the one developed by Danielle Sesta’s Abracadabra, the Magic Internet Money (MIM). Allegedly, the treasury of Abracadabra was buried in $12 million of bad debt as a result of Terra Luna’s fall. This allegation, however, was denied by Danielle. The team issued an announcement to let users repay their outstanding loan to help in mitigating the issue. Fortunately, MIM was able to regain its health back to $1 and continues to live on today.

Disaster 3: fUSD

One of Fantom’s biggest lending protocols, Scream Protocol, has also established their own stablecoin called Fantom USD (fUSD). This stablecoin is built to be overcollateralized by the Fantom token (FTM). The depegging issue was construed to be from a bad debt issue brought by a faulty liquidation mechanism - users with underwater debts in the protocol weren’t liquidated, resulting in a lack of funds to retain the peg of fUSD.

The Scream Protocol team quickly addressed this problem by partnering up with the Fantom Foundation in running a liquidation bot as they announced in the tweet, “We are currently working on a solution to the fUSD bad debt issue. The Fantom Foundation has agreed to run a liquidation bot that will liquidate any underwater positions that use fUSD as collateral.

Disaster 4: HUSD

The depegging disaster has also reached centralized exchanges, Huobi in this case. On August 18, the Huobi team detected unusual price fluctuations and immediately contacted the stablecoin issuer, Stable Universe Limited, to execute contingency plans. They were able to recover the price back to $1 within just 12 hours. Afterwards, Huobi issued a statement explaining the root of the issue. They stated that it was a result of a liquidity problem that was from the closure of some market maker accounts in compliance with regulations.

However, this happened again on October 28. HUSD was delisted from its platform as Justin Sun, along with Tron, took the ownership of HUSD. The acquisition did not just shake up the management structure of Huobi but also the price of HUSD. As of this writing, HUSD remains to be roughly 75% below a dollar.

Staying Stable with Stablecoins

A lesson that can be learned from these four disaster scenarios is that stablecoins may lose their stability due to security and liquidity issues. Both collateralized and algorithmic stablecoins may fall prey to these risks.

As digitally native currencies, code and smart contracts are the real gauge for security. However, for the general population not well versed with solidity and technicalities of smart contracts, smart contract audits may suffice in filtering out the strong from the weakly built cryptocurrencies. Audited smart contracts may prevent casualties from faulty mechanisms like that of fUSD.

Liquidity issues, on the other hand, may stem from poor tokenomics - having a flawed mint & burn mechanism or a poorly risk-managed treasury. Unlike in traditional finance where investors can just sleep in on their deposits, folks in decentralized finance have to take extra measures to stay prudent. It is crucial to stay up-to-date with the stablecoin issuer’s movements. Regularly peeking the collateralization ratio of the treasury or monitoring the supply of the tokens could take one’s risk management to the next level.

High risk, high reward. Cliche as this sounds, it still applies when holding stablecoins. Merely holding or depositing stablecoins could reap yields that cannot be seen in banks. As the space expands and evolves, incredible innovations would always be accompanied by unforeseen drawbacks. This also means that risk management should always be at the forefront of an investor’s priorities.