For a stablecoin to work properly, it needs sufficient collateral. Broadly, there are three ways to collateralize a stablecoin.
The first is to collateralize by fiat; this means the coins are backed by real assets in reserve; for every stablecoin, there should be the equivalent in real currency assets.
The second is to collateralize with cryptocurrency, although price volatility is an issue here. So, stablecoin providers try to solve this by ‘over-collateralization’; for example, $1 of stablecoin is linked with $2 worth of crypto, to hedge the underlying crypto’s volatility. The aim of this is to create the benefits of decentralization for stablecoins while mainline crypto reserves absorb the impact of market volatility.
The third and technically the most difficult is to go for decentralized collateralization using algorithms, like TerraUSD did. Here, stablecoins are not linked to any kind of reserve, but instead use smart contracts to monitor price fluctuations and programmes to issue and buy cryptocurrencies accordingly. A ‘smart contract’ is a decentralized application or programme that executes business logic in response to external events. TerraUSD used algorithms to set underlying triggers for the buying and selling of underlying crypto to keep its value constant.
After last week’s free fall, questions have arisen over whether collateralizing stablecoins via algorithms is tenable. Better known stablecoins such as Tether and USDC rely on the ability to redeem tokens from holdings that are collateralized by fiat currency. There have been doubts about what proportion of reserves are available to fiat-backed stablecoins, but that’s a topic for another day.
The algorithmic way of creating stablecoins is part of a trend called Decentralized Finance (DeFi). It involves apps that create financial instruments using underlying cryptocurrencies such as Bitcoin and Ethereum.
Thanks to a recent explosion in DeFi apps, crypto is no longer just about a ‘new gold’ or a new kind of money, it represents a way to structure sophisticated transactions. Each new app that debuts in the DeFi world seems to cook up new pieces of an entire financial system.
Some of the more popular De-Fi apps include projects such as PoolTogether which have “loss-less" lotteries that use Ethereum’s smart contract layer to let developers anywhere in the world publish decentralized applications with limitless functionality. Unsurprisingly, this tool has been quick to provide value to the gambling industry. The best way to describe a loss-less lottery in India would be to liken it to a chit fund that randomly picks a monthly winner of a pot, rather than using an auction mechanism to determine the month’s taker of the pot. Like chit funds, these apps have formed an alternate banking system for savings and loans, but they are based solely on a cryptocurrency and not any country’s legal tender. And, like chit funds, they are not insured by any country’s deposit insurance mechanisms.
In a separate incident last month, there was the sensational defrauding of another stable-coin through what appears to be a ‘legal’ set of tactics (or at least legal since the space is unregulated). In April, a cryptocurrency named Beanstalk was defrauded of more than $180 million. The attack featured unusual tactics in which the attacker used borrowed funds to accumulate the voting rights necessary to transfer all the money into his (or her) own account. This heist was reported on 18 April.
While Beanstalk itself is a network through which digital currency transfers occur, its blockchain system provides users with crypto units called ‘beans’, which are the official tokens of this platform. Those who make deposits on its network are referred to as “bean farmers" tending to “fields", and their accounts (wallets) are referred to as “silos". Beanstalk effectively operated as a bank.
Apparently, some of Beanstalk’s bean farmers were encouraged to deposit cryptocurrencies such as Ether into a ‘silo’ to build up the stablecoin’s reserves in exchange for voting rights over the operation of the organisation through a ‘decentralized autonomous organization’ (DAO). The point of a DAO is to act like a company in the crypto world, one that is controlled directly by its shareholders with no governance structures such as a board and/or executive management panel.
Last month, a DAO vote at Beanstalk resulted in the bank’s entire silo being transferred out of it in one go. The attacker had borrowed $80 million in cryptocurrency and deposited it in the DAO project’s silo, gaining enough voting rights to be able to instantly pass any proposal at this “bean bank". With that power, the attacker voted to transfer the contents of the treasury to him/herself, then returned the voting rights in the process of withdrawing the money, and subsequently repaid the loan. All of this was done in a mere matter of seconds. It would have been both impossible and illegal on all sorts of counts in the real world. Be wary!
Siddharth Pai is co-founder of Siana Capital, and the author of ‘Techproof Me: The Art of Mastering Ever-changing Technology’.
