On May 9, the ‘stablecoin’ TeraUSD dropped from a high of $119 to around 20 cents. Its digital coin counterpart Luna also fell near zero. Unlike other cryptocurrencies such as bitcoin, which can grow wildly in value, stablecoins are pegged to the fiat currency of the country. In most cases, this is the US dollar, and attempts are made to keep the value of the stablecoin at $1. Stablecoins are important to the crypto world as they are used by traders as a means of maintaining value without leaving the digital asset ecosystem. Investors turn to them during periods of crypto volatility.
For a stablecoin to function properly, it needs sufficient collateral. Broadly speaking, there are three ways to collateralize a stablecoin.
The first is to make collateral by fiat; This means that coins are reserved by real assets; For each stablecoin, the real currency must be equal to the asset.
The second is to make collateral with a cryptocurrency, although price volatility is an issue here. Therefore, stablecoin providers try to solve this by ‘over-collateralization’; For example, to hedge the volatility of the underlying crypto, $1 of a stablecoin is tied with $2 worth of crypto. It aims to create the benefits of decentralization for stablecoins while mainline crypto reserves absorb the effects of market volatility.
Third and technically most difficult is to go for decentralized collateral using algorithms, like TeraUSD did. Here, stablecoins are not tied to any kind of reserve, but instead use smart contracts to monitor price fluctuations and schedule and issue and buy cryptocurrencies accordingly. A ‘smart contract’ is a decentralized application or program that executes business logic in response to external events. TeraUSD uses algorithms to set underlying triggers for the buying and selling of the underlying crypto in order to keep its value stable.
After last week’s free fall, questions have arisen as to whether collateralizing stablecoins via algorithms is appropriate. Better known stablecoins such as Tether and USDC rely on the ability to redeem tokens from holdings that are collateralized by fiat currency. There has been doubt about what proportion of reserves are available for fiat-backed stablecoins, but that is a topic for another day.
The algorithmic method of creating stablecoins is part of a trend called decentralized finance (DeFi). This includes apps that create financial instruments using underlying cryptocurrencies such as bitcoin and ethereum.
Thanks to the recent explosion in DeFi apps, crypto is no longer just about the ‘new gold’ or new types of money, it represents a way of structuring sophisticated transactions. It seems that each new app that starts in the world of DeFi creates new pieces of the entire financial system.
Some of the more popular D-Fi apps include such as PoolTogether, which has “loss-free” lotteries that use Ethereum’s smart contract layer to publish decentralized applications with unlimited functionality to developers anywhere in the world. Amazingly, this tool is quick to provide value to the gambling industry. The best way to describe a loss-free lottery in India would be to compare it to a chit fund, which randomly sells a pot monthly, instead of using an auction mechanism to determine the taker of the month. chooses the winner. Pot. Like chit funds, these apps constitute an alternative banking system to savings and loans, but they are based entirely on a cryptocurrency and are not legal tender of a country. And, like chit funds, they are not insured by any country’s deposit insurance mechanism.
In a separate incident last month, there was another stablecoin sensational fraud, which appears to be a ‘legal’ set of tactics (or at least legal because the space is unregulated). In April, a cryptocurrency named Beanstalk was defrauded to the tune of more than $180 million. The attack featured an unusual strategy in which the attacker used borrowed funds to accumulate voting rights, which were necessary to transfer all the money to his (or his) account. The robbery was reported on 18 April.
While Beanstalk itself is a network through which digital currency transfers take place, its blockchain system provides users with crypto units called ‘beans’, which are the platform’s official tokens. Those who make deposits on its network are referred to as “bean farmers”, those who lead to “farms”, and their accounts (wallets) are referred to as “silos”. Beanstalk effectively operates as a bank.
Apparently, some of Beanstalk’s bean farmers have been forced to deposit cryptocurrencies such as ether into ‘silos’ to build up reserves of stablecoins in exchange for voting rights over the organization’s operations through ‘decentralized autonomous organizations’ (DAOs). was encouraged to. The purpose of a DAO is to act like a company in the crypto world, controlled directly by its shareholders, with no governance structure such as a board and/or executive management panel.
Last month, a DAO vote in Beanstalk resulted in the bank’s entire silo being moved out of it at once. The attacker borrowed $80 million in cryptocurrency and deposited it in the DAO Project’s silos, gaining enough voting rights in this “bean bank” to be able to pass any resolution immediately. With that power, the attacker voted to transfer the contents of the Treasury. to him/herself, then in the process of withdrawing the money, returned the voting rights, and subsequently repaid the loan. It was all done in a matter of seconds. This would have been both impossible and illegal in all sorts of cases in the real world. Be careful!
Siddharth Pai is the co-founder of Sienna Capital and the author of Takeproof Me: The Art of Mastering Ever-Changing Technology.