Leveraging Stablecoin Seigniorage with Terra and Luna
In order to peg a stablecoin to a fixed fiat price, it needs to be collateralized in one way or another. While the established methods for issuing stablecoins have some disadvantages, Terra uses a dual-token approach that both guarantees collateralization and liquidity.
One to One Collateralization
The most widely used stablecoins use this method. Among the largest of these are Tether and Coinbase’s USDC. These stablecoins rely on fiat funds being held as collateral by centralized service providers. As centralized stablecoins, their success stands and falls with the reliability of their issuers.
They are under constant pressure to prove that their stablecoins are indeed backed one to one with fiat currency. An example for this is the ongoing controversy surrounding Tether’s backing. Since there were corresponding statements from Tether’s legal team, we know that Tether has lost its full backing at least temporarily. By now, Tether claims to have restored its one to one collateralization, but whether this is really the case is still open for debate.
As soon as there is credible speculation that a bank run may leave the holders of a stablecoin empty-handed, the coin will inevitably lose its peg. This is exactly what happened to Tether when, at the height of its controversy, its market price dropped as low as $0.91.
What could potentially become another stablecoin is Mark Zuckerberg’s brainchild Libra. The way Libra has been conceived was not to peg its value against one certain fiat currency, but rather against a basket of various fiat currencies and government bonds. For this reason, Libra has been likened to an exchange-traded fund (ETF) rather than a stablecoin, among others, by members of the US congress.
Additionally, the Libra Association plans to give its blockchain smart contract capabilities. This way, Libra would combine many features of blockchain technology into a single solution. Its ETF-like nature comes with some problems, however. First of all, government bonds are less stable than hard currencies. If an important bond or a series of bonds held as collateral by the Libra Association face an impending default or debt restructuring, Libra would drop in value as a result.
While, in comparison to an ETF, the Libra Association could hold some interest-bearing assets as collateral, they have no intention to pass this interest on to Libra holders. While the interest earned on Libra’s collateral is meant to cover the costs of operating the blockchain, thus subsidizing transaction fees, those fees should be very low anyway on a permissioned consortium blockchain, compared to a public blockchain.
Finally, Libra faces a lot of resistance from regulators, as a stablecoin on this enormous scale could seriously threaten the sovereignty of national banks. While this is exactly what a lot of cryptocurrency visionaries are rooting for, they likely don’t envision to transfer this economic power to, of all companies in the world, Facebook. Due to this heavy resistance, it is doubtful whether Libra will ever come to life.
Over-collateralization with Cryptocurrency
With their collateralized debt positions, MakerDAO’s DAI was the first decentralized stablecoin on the market. MakerDAO users can mint DAI by locking down cryptocurrency in a smart contract called Collateralised Debt Position (CDP). They can later release their locked cryptocurrency by paying back the same amount they have borrowed. Thus, the locked-down cryptocurrency collateralizes DAI.
In order to peg DAI to the US-Dollar, the cryptocurrency that collateralizes a CDP is liquidated and auctioned off if its value in USD should drop below the amount of DAI borrowed. Since this is similar to margin call, MakerDAO can be likened to a decentralized margin trading platform. As such the main use case for borrowing DAI is to increase the leverage on one’s crypto holdings.
Since the amount of people who want to increase their leverage is limited, so is the liquidity of overcollateralized stablecoins. Not only does this limit the potential usefulness of these stablecoins as global payment currencies. Since the pegging mechanism relies on the work of arbitrageurs, they are less stable compared to centralized stablecoins, especially when their liquidity is low.
For example, the price of single collateral DAI with a market cap consistently over $50 million has mostly been hovering in a corridor of about $0.02 to either side of its $1.00 peg. In comparison, DAI’s competitor sUSD has a market cap of only a few million US-Dollars. Due to its low liquidity on exchanges, sUSD has much larger price fluctuations and has been trading at a significantly lower price than one US-Dollar most of the time.
Circular Collateralization with Terra and Luna
The Korean project Terra uses a novel approach for stablecoin collateralization. Their Proof of Stake blockchain is secured using Luna staking tokens. At any time, any user can mint Terra stablecoins by paying Luna tokens to an automated market maker. In the reverse case, users can pay Terra to the market maker in order to receive Luna.
The market maker pegs Terra to fiat currency by applying the corresponding amount rate between Luna’s market price and the fiat currency. In order to act as a counter-party for issuing and buying back Terra, the market maker burns Luna (when Terra is minted), or mints Luna (when Terra is bought back and subsequently burned). While Terra’s flagship currency, TerraSDR, is pegged to Special Drawing Rights, Terra offers various other sub-currencies including TerraUSD, TerraEUR, and TerraJPY.
This ties in with the concept of seigniorage. Seigniorage is the difference between the value of one unit of currency and the costs to issue one unit. For centralized stablecoins, the seigniorage is zero, as one unit of fiat always needs to be put down as collateral in order to issue one unit of the stablecoin. Over-collateralized stablecoins are even worse in terms of seigniorage, since minters have to lock more money into a CDP than they receive in stablecoins.
In contrast, there are zero costs associated with issuing Terra. From the side of the person who wants to mint Terra, this is simply a swap in exchange for Luna tokens. The Luna tokens then get burned, distributing the seigniorage to Luna holders. The potential liquidity of Terra is therefore virtually unlimited.
Besides its function in securing the PoS blockchain, Luna collateralizes Terra with its market cap. This is needed, as users who want to return Terra cause the market maker to mint Luna. In order to maintain a healthy market cap and thus ensure full collateralization, there is a small transaction fee that gets applied to all Terra transactions. Those transaction fees, in addition to a minor spread between the market makers bid and ask prices, are distributed as staking rewards who stake their Luna tokens on the PoS blockchain.
This means that the relationship between the various Terra sub-currencies and Luna is circular in nature. When more Terra units get issued, this, of course, means that a higher market cap is needed as collateralization. On the one hand, Luna tokens get burned in the same process, which creates upward price pressure on the remaining tokens. On the other hand, when there is a larger amount of Terra in circulation, this transfers to larger staking rewards and subsequently a higher market valuation of Luna. Thus, the amount of Terra in circulation and the market cap of Luna expand and contract jointly, which both ensures collateralization and liquidity of the Terra stablecoin.
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