Very stable geniuses: The race to build regulation-proof stablecoins

There’s a new breed of stablecoin in crypto markets. They are pegged to the US dollar. They seek to maintain that peg “algorithmically” through a minting mechanism designed to tickle the fancy of arbitrageurs. Yet they are amassing colossal backing, à la older stablecoins, in case that mechanism fails. 

In two of the most prominent cases — Terra’s UST and TRON’s USDD — the target size of these reserves is $10 billion.  In sum, they are here to ensure that stablecoins — the lifeblood of crypto markets — cannot be interfered with by regulators. 

“Regulatory pressure is going to hit the core protocol teams of decentralized stablecoins and centralized stablecoins alike,” says Do Kwon, founder of the blockchain Terra. “The key difference here is that the natural law is different. Even if I wanted to, let’s say, freeze accounts holding UST, I wouldn’t be able to do it.”

TRON founder Justin Sun’s thinking is similar. “We can’t make the most important part of crypto super centralized and vulnerable to basically everyone,” he says. “We need to make the stablecoin in the industry just as decentralized as bitcoin, so no one can touch it.”

The two share other similarities besides their views. Not only are they both trying to amass $10 billion in reserves for their stablecoins, but they have also both had run-ins with regulators. 

Kwon is involved in an ongoing standoff with the Securities and Exchange Commission, the US watchdog, over its attempts to subpoena him. Sun’s TRON raised $70 million in 2017 through an initial coin offering just before a blanket ban was enforced by Chinese regulators.  

They are, however, at very different stages in their stablecoin journeys. And they are not alone. 

Taking on Tether

Terra’s UST is the pioneer among protocol-native stablecoins. As shown in the chart below, courtesy of The Block Research, total issuance for UST has already topped $18 billion. It began circulating as recently as November 2020. That compares to around $83 billion in Tether’s USDT, and $44 billion in Circle’s USDC. 

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UST has already surpassed Binance’s BUSD and MakerDAO’s DAI in total issuance. 

Yeou Jie Goh of DeFiance Capital, the token investment firm, says this demonstrates the faith investors have developed in algorithmic stablecoins — which remain a far from tried and tested commodity. “Despite the market downturn and volatility, UST has also kept its peg. It seems that the market is not too fearful of UST’s stability as compared to before,” he says. 

The success of UST has spurred the emergence of two noteworthy imitators in recent months. Sun announced his project — a stablecoin native to the TRON blockchain named USDD — on April 21. It will begin circulating on May 5. 

Shortly after Sun’s announcement, NEAR Protocol announced the launch of a decentralized stablecoin named USN, confirming earlier reporting by The Block. 

Like Terra, both NEAR and TRON will use an arbitrage system to try to keep the price of their stablecoins in line with that of the US dollar, yet both also spoke of amassing reserves. 

How do algorithmic stablecoins work? 

Established stablecoins like Tether’s USDT and Circle’s USDC maintain their peg to the US dollar by managing a reserve of cash and assets. The management and makeup of these reserves has drawn heavy scrutiny from regulators, journalists and the wider industry.

DAI, which is issued via an Ethereum-based smart contract, is collateralized by cryptocurrency. MakerDAO determines the currencies that are accepted for collateral, the collateralization ratio required to mint Dai, and imposes an interest rate, called a stability fee, which it uses to control the number of Dai in circulation and maintain its peg.

Algorithmic stablecoins differ from established ones in that, at their core, they maintain their peg to the dollar without the use of collateral. Instead, they rely on market incentives. 

In the case of Terra, users can mint one UST by burning one dollar’s worth of LUNA, Terra’s native token. Conversely, they can sell one UST for one dollar’s worth of LUNA. The protocol is designed to incentivize burning and minting in a way that is supposed to ensure $1 worth of LUNA can always be traded for 1 UST, and vice versa.

“When the demand for Terra is high and the supply is limited, the price of Terra increases. When the demand for Terra is low and the supply is too large, the price of Terra decreases,” Terra’s website explains. “The protocol ensures the supply and demand of Terra is always balanced, leading to a stable price.”

USN and USDD mirror that design, except that NEAR and TRX tokens, respectively, will be used instead of LUNA. 

Terra also introduced the concept of a reserve as a backstop to algorithmic stablecoins. In theory, these reserves can be drawn on for stability in the event that sharp selloffs in crypto markets erode the incentives that underpin algorithmic stablecoins. 

In February, The Block revealed that an entity named the Luna Foundation Guard (LFG) — a Terra-boosting non-profit based in Singapore — had raised $1 billion through an over-the-counter sale of LUNA to establish a bitcoin-denominated reserve for UST. 

By late March, the reserve had already grown to $2.2 billion, and Kwon — who is outspoken on social media, if more reserved in person — tweeted that his long-term goal is to establish a reserve of $10 billion. But the numbers appear flexible.

“When I put out a number, $10 billion, I just mean that the incoming seigniorage coming from Terra is going to constantly allow the growth of the reserve,” Kwon says. “That number, we think, is going to just keep increasing over time.” 

By ‘seigniorage,’ Kwon appears to be referring to profits derived from issuing UST. It is a term ordinarily used in the context of governments, but it is fitting given Kwon’s thoughts on the nature of blockchain technology. “Most of this is easier to understand if we’re speaking the language of nations. I think of these blockchains as very similar to countries,” he says.

Bitcoin, in the case of Terra and others, appears to be the reserve asset of choice — although it isn’t the only asset. LFG has also topped up its coffers with considerable sums of Avalanche’s native token AVAX. It is as yet unclear how USDD’s reserve will take shape.

Why focus on bitcoin and other decentralized cryptocurrencies, instead of dollars and traditional asset classes? Again, it comes back to blunting the tools of watchdogs. 

Sun believes that stablecoins backed by centralized currencies face an inevitable crackdown. “I predict that today’s stablecoins will be super centralized in the next five years,” he says. “It won’t be much different to banks basically. In the future, I think for owning stablecoin you’ll probably need to open like a bank account first.”

Once more, Sun and Kwon are singing from the same hymn sheet. “I think the likely outcome of how crypto is going to play out is that anything that can be regulated will be,” says Kwon. 

Both spy deliverance in the form of decentralized stablecoins, with emergency backing in similarly decentralized assets. They see Circle, Tether and others as centralized issuers, and thus vulnerable to the whims of regulators. 

Kwon highlighted the heavy use of so-called centralized stablecoins within Ethereum apps. “What is the point of building on the right consensus mechanism when the single point of failure is in the money supply of Ethereum?” he asks. 

The limits of decentralization 

The logic that decentralized operations are immune to interference is, at its heart, simple: it goes that no entity within the network in question has the power to enforce anything — freezing accounts, for instance — unilaterally, and so the demands of authorities become irrelevant. 

A common criticism of decentralized models, however, is that they throw open the doors to criminals. That is hardly surprising when founders like Kwon and Sun speak so brazenly of their plans to build regulation-proof technologies.

Yet Sun says his motivation is not to avoid regulators, but rather to buy time. “We just don’t want to design an infrastructure so that all law enforcement has a say on it and will eventually destroy the infrastructure itself,” he says. TRON is against money laundering, he adds, but also against freezing people’s assets as a remedy to it. 

Sun’s solution for this apparent catch-22 is to work closely with blockchain forensics companies like Chainalysis and Elliptic to trace and stamp out criminal activity, such that “the bad guys or the criminals can’t escape from their liabilities.” TRON has faced money-laundering allegations in the past, which Sun denied at the time. 

A smart match

There may be more to protocol-native stablecoins than simply dodging regulators, however. 

Steven Zheng, director of research at The Block, says the benefits of blockchain-native stablecoins are similar to those driving the construction of native token bridges. In both cases, operators get more control and compatibility with other blockchains, he says. 

“For example, instead of waiting for Tether to integrate USDT to your own chain or being forced to turn USDT into wrapped USDT just to make it usable, you launch L1USD immediately compatible with all the native apps and functionalities of your chain,” Zheng adds.   

There are also security considerations. Carl Vogel, partner and head of research at 6^th Man Ventures, a venture capital firm, says that protocol stablecoins present “less attack vectors and fewer intermediaries” to hackers. 

“Networks with native stablecoins more directly inherit the network’s trust versus stablecoins that derive it from other protocols built on top,” he says. “In addition, it eliminates a core threat vector which is when the network upgrades and application layer protocols don’t adopt the change quickly enough, creating a vulnerability.”

Established stablecoin players are not blind to these benefits. In emailed statements, Paolo Ardoino, CTO of the crypto exchange Bitfinex, welcomed the emergence of protocol native stablecoins. Tether and Bitfinex share the parent company iFinex Inc. 

“We don’t see this as a threat, rather we see this as a validation of our model and what we have started,” he says. “It remains to be seen how these new products can, in effect, differentiate themselves and scale up to be an $80 billion+ market cap stablecoin.”

What Terra has already achieved with UST has, however, moved Tether to action.

Ardoino says the company is now “exploring some of these new blockchains to natively issue Tether official stablecoins on their layers.” He did not go into detail on how USDT could ever be considered native to a blockchain that is not its own. 

“As an example, Tether is actively funding and helping develop L2 native solutions based on the Lightning Network protocol,” adds Ardoino. 

Tether remains the dominant stablecoin in crypto at present. It serves as a crucial go-between for a range of blockchains: Ethereum, Solana, Algorand, EOS, Liquid Network, Omni, TRON, Kusama and Bitcoin Cash’s Standard Ledger Protocol. 

In time, it is possible that USDT will contend with UST and other decentralized stablecoins in those ecosystems. Sun says USDD is “chain-agnostic” and will be compatible with TRON, Ethereum, BNB Chain and BitTorrent from the start. UST, according to Kwon, has already been bridged over to Ethereum, Solana and a number of other layer-1 blockchains and layer-2 platforms including zkSync. 

But the key question in these new stablecoin wars is whether developers will follow Terra’s lead, and in turn whether most if not all blockchains eventually come equipped with a native stablecoin.  

In Kwon’s mind, it’s a no-brainer. He looks to NEAR by way of example. “If the economy on NEAR grows, as that economy grows there’s going to be more USN printed, and that will create a positive flywheel which will consume more and more of the base NEAR asset which benefits the NEAR economy.” 

Circle and NEAR Protocol declined to speak to The Block for this article.