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Bitcoin has become a reserve asset for the UST cryptocurrency of the Terra blockchain network. What does this portend for the $186 billion stablecoin market?
The use of Bitcoin as a stablecoin reserve asset is a watershed moment in the stablecoin segment that has huge implications for the entire digital asset industry. Bitcoin is gaining additional utility as a reserve asset for the Terra stablecoin (UST) under the Luna Foundation Guard initiative as it diversifies UST-backed collateral. This is the first major stablecoin to take such a step, but it certainly won’t be the last. Using bitcoin as a reserve would certainly have a positive effect on the stability of UST during periods of increased market volatility, but this is not the only consequence of such a move.
Using bitcoin as a reserve asset to back stablecoins resolves some of the regulatory issues associated with the reserves of other leading stablecoins. In addition, it embeds bitcoin in the wider digital asset ecosystem as a pristine collateral that supports decentralized finance, the metaverse economy, and its nascent yet-to-be-explored ecosystem.
Before delving deeper into the analysis, it is necessary to draw a parallel between what is happening in the stablecoin sector and the changes that could potentially occur in global monetary rules of engagement, in particular, an increase in demand for bearer reserve assets.
Bretton Woods III: increased demand for “foreign money”
Money Markets and Rates Strategist at Credit Suisse Zoltan Pozar recently published a study. He suggested that as a result of the sanctions imposed on Russia, the so-called “internal money” would be replaced by “external money” to secure the value of fiat currency. Domestic money is a monetary instrument that exists as a liability on the balance sheet of another entity, such as government bonds. External money is not a liability on the balance sheet of another organization. These are bearer assets such as gold and bitcoin.
BitMEX co-founder Arthur Hayes, unsurprisingly, took it one step further in his recent analysis, adding that the current Petrodollar/Eurodollar monetary system officially ended with the confiscation of the Russian central bank’s foreign exchange reserves by the US and the European Union, and the exclusion of some Russian banks from the system. SWIFT. Hayes argues that aside from the moral considerations associated with the imposed sanctions, the confiscation of the sovereign government’s foreign exchange savings forever changed the monetary rules of interaction.
It is not clear what this new system will look like, but both analysts agree that from the gold-backed Bretton Woods era to domestic money-backed Bretton Woods II, we now arrive at foreign-money-backed Bretton Woods III. (gold and other goods).
This does not necessarily mean that major central banks will start holding bitcoin as a reserve asset anytime soon, but it does revive interest in this use case for bitcoin amid the first real large-scale use of bitcoin in a stablecoin reserve.
And while financial policy in Pozar and Hayes’ analysis has little to do with the regulatory framework being developed for stablecoins, it highlights the general direction that cryptocurrencies might take. The concept of internal/external money is a valuable framework, and the need for bearer assets as reserve currencies is indeed very real, and for other reasons.
Rethinking how stablecoins are created
To create a successful stablecoin, two things are needed: the demand for this cryptocurrency and the reserves that provide it. The latter is solved in several ways: leading stablecoins such as USDT and USDC hold a basket of assets in reserve, usually cash, government or commercial debt bonds (Domestic Money). But this model is currently facing regulatory uncertainty as financial regulators increasingly acknowledge that stablecoins are subject to the same vulnerabilities as money market funds due to a lack of transparency around reserve assets.
Simply put, stablecoins need liquid reserves so that users can be sure that the tokens can be exchanged for fiat currency. A loss of user confidence could trigger a run on the stablecoin, leading to large-scale redemption requests. For a stablecoin like USDT, the underlying assets pegged to the traditional financial ecosystem will experience the same downward pressure.
How much of an impact this might have on traditional markets depends on the size of the stablecoin in question, some of which, according to Fitch Ratings, have already reached asset values comparable to money market funds based in Europe. In addition, there is often not enough information about the composition of the reserve assets backing a stablecoin to fully assess its potential risks. USDT Tether is the largest stablecoin by any measure and a prime example of this. Tether has never disclosed details of the portfolio structure backing its USDT stablecoin. Cash and bank deposits are known to back it, while commercial bonds and certificates of deposit, which account for almost half of the collateral, are not disclosed.
The rapidly growing stablecoin sector and its ties to the traditional financial system have prompted financial regulators to take a closer look and figure out how to implement controls and oversight in this area. But it is not yet clear how to do this, and one of the reasons for this is that there is still debate about how stablecoins should be classified. Bank deposits, securities, treasury bonds, etc. are regulated by various bodies and structures.
In any case, the goal of regulators is to prevent stablecoins from becoming “too big to fail” markets that could pose a systemic risk to the traditional financial ecosystem. The established supervisory structures, using the traditional “inside money” approach to reserve assets, could well limit the growth of the stablecoin market.
But not all stablecoins are the same. Some are using a completely different mechanism to support the currency and contain risk in the digital asset economy, effectively addressing some of the concerns raised by financial regulators.
Algorithmic stablecoins: decentralized reserve assets using smart contracts
Algorithmic stablecoins use smart contracts to automatically and programmatically maintain a peg, usually with digital assets as collateral. The digital asset industry has long been waiting for the perfect algorithmic stablecoin to replace all others. If we build a system that works reliably in the face of intense market volatility, it can be infinitely scalable to whatever size the digital asset economy requires.
There have been many experiments with this type of stablecoin in the past, and most of them failed many years ago. But the algorithmic stablecoin is back in earnest with tokens like UXD, which is built on Solana and backed by delta-neutral positions; FEI, an ERC20 stablecoin using a bonding curve, and UST, pegged to LUNA Terra.
UST currently ranks fourth in terms of market capitalization in the stablecoin category, ahead of DAI and on the heels of Binance USD. The Terra blockchain is currently the second largest blockchain with a total value of over $27 billion locked, of which about 50% is dedicated to the Anchor protocol, a clear sign of demand for UST. (Terra is an investor in Hex Trust, which provides customers with connectivity to Terra and Anchor.)
A quick guide to how UST works. Instead of relying on fiat reserves, UST uses Terra’s native LUNA token as an asset that absorbs short-term volatility. The peg mechanism is designed to ensure that the minting value of UST is always equal to the minting value of the stablecoin LUNA. To mint one UST, you need to burn LUNA for only 1 US dollar. When UST falls below or above the $1 mark, LUNA holders can exchange their tokens for the equivalent dollar amount in UST, which creates arbitrage opportunities that in turn control the price of UST.
But that was Phase 1, and Phase 2 has just begun.
UST Phase 2: Bitcoin becomes a reserve asset
One common criticism of algorithmic stablecoins is that in times of high volatility, arbitrage incentives are not attractive enough to maintain a peg. Addressing this potential shortcoming, Terra and the Luna Foundation Guard, a non-profit organization created to support the Terra network, recently announced a $1 billion sale of LUNA tokens to create a $10 billion Bitcoin reserve as part of the UST Foreign Exchange Reserve.
This is an initiative to provide a broader level of support using resources not directly linked to the Terra ecosystem. The strategy is to buy bitcoin first, with plans to include other major digital assets in the near future. Now that Bitcoin functions as an independent reserve cryptocurrency backing UST, the UST currency reserve acts as an additional way to maintain the peg during long market sell-offs, reducing the algorithmic stablecoin’s reflexivity.
As a reserve structure, this form of collateral is the equivalent of the digital assets that Possar and Hayes predict central banks will use in establishing the new Bretton Woods III monetary system, shifting from domestic money (securities) to foreign money in holding reserves ( bitcoin). This could potentially have a huge positive impact on the wider stablecoin sector as well. The digital asset industry is relentless in innovating, which means that UST will likely not be the last stablecoin to follow this path. Altcoins didn’t stop at Ethereum. DeFi didn’t stop at Compound. Non-fungible tokens (NFTs) didn’t stop at CryptoPunks. Stablecoins using bitcoin as a reserve asset will not stop at UST.
The launch of decentralized finance after the crypto winter has seen the market capitalization of stablecoins rise from $5.75 billion in early 2020 to $186.4 billion today. We may see another exponential move upward as algorithmic stablecoins backed by the world’s premier decentralized bearer asset may be trustworthy enough to support the next phase of the exponential growth of the digital asset industry. As DeFi, Web 3.0, and the metaverse come together to form a single layered financial network, we will need decentralized stablecoins that can keep the entire system stable, whether in times of calm or volatile markets.
The use of bitcoin is expanding
Bitcoin as a reserve asset for decentralized stablecoins expands the meaning of the “Bitcoin is gold” statement, which goes beyond common features such as real ownership, fungibility and fixed supply. In a modern interpretation of Bretton Woods, bitcoin becomes true digital gold, embedded in the broader digital asset industry as secure collateral for stablecoins in the era of Bretton Woods III, which favors outside money.
This is yet another example of how the crypto industry is actively creating new types of financial institutions, decentralized autonomous organizations, infrastructure and technology providers, financial instruments, products and assets – led by Bitcoin, the world’s first digital decentralized bearer asset, as a collateral asset for this new world.
Author: Elvir, Analyst at Freedman Сlub Crypto News
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