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What is a Stablecoin

What is a Stablecoin

An automated stablecoin is a system that has the following properties:

– Issues a stablecoin, which tries to target a particular price index. Normally, the goal is 1 USD, but there are other options as well. There is some targeting mechanism that works continuously to push the price towards the index if it deviates in any direction. This makes ETH and BTC non-stablecoins (duh).

– The guidance mechanism is completely decentralized, and free of protocol-level dependencies on specific trusted actors. In particular, it should not rely on asset custodians. This makes USDT and USDC not stablecoins.

In practice, (2) means that the targeting mechanism must be some kind of smart contract that manages some reserve of crypto-assets, and uses those crypto-assets to prop up the price if it falls.

Can the stablecoin, even in theory, be safely “reduced” to zero users?

In the real, non-crypto world, nothing lasts forever. Companies shut down all the time, either because they never manage to find enough users in the first place, or because the once strong demand for their product no longer exists, or because they are displaced by a superior competitor. Sometimes, partial collapses occur, which cause it to move from mainstream to niche status (for example, MySpace). These things have to happen to make room for new products. But in the non-crypto world, when a product closes or declines, customers generally aren’t as hurt. Certainly, there are some cases of people falling into the trap, but in general the closures are orderly and the problem is manageable.

But what about automated stablecoins? What if we consider a stablecoin from the bold and radical perspective that the system’s ability to avoid the collapse and loss of huge amounts of user funds should not depend on a constant influx of new users?

Can Terra be liquidated?

In Terra, the price of the volcoin (LUNA) comes from the expectation of the rates of future activity in the system. So what happens if expected future activity drops to near zero? The market capitalization of the volcoin falls until it becomes quite small relative to the stablecoin. At that point, the system becomes extremely fragile: only a small downward shock in stablecoin demand could lead the selection mechanism to print piles of volcoins, causing hyperinflation of the volcoin, at which point the stablecoin also loses its value.

The collapse of the system may even become a self-fulfilling prophecy: if it appears that a collapse is likely, this reduces the expectation of future rates that is the basis of the volcoin’s value, pushing the market capitalization of the volcoin downward, making the system even more fragile and potentially triggering that same collapse – exactly as we saw happened with Terra in May.

Can Terra finish?

In Terra, the price of the volcoin (LUNA) comes from the expectation of the rates of future activity in the system. So what happens if expected future activity falls to near zero? The market capitalization of the volcoin falls until it becomes quite small relative to the stablecoin. At that point, the system becomes extremely fragile: only a small downward shock in stablecoin demand could lead the selection mechanism to print piles of volcoins, causing hyperinflation of the volcoin, at which point the stablecoin also loses its value.

The collapse of the system may even become a self-fulfilling prophecy: if it appears that a collapse is likely, this reduces the expectation of future rates that is the basis of the volcoin’s value, pushing the market capitalization of the volcoin downward, making the system even more fragile and potentially triggering that same collapse – exactly as we saw happened with Terra in May.

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