Will DAI go the way of Terra USD? Vitalik Buterin thinks not and explains why

Will DAI go the way of Terra USD?  Vitalik Buterin thinks not and explains why

Key facts:
  • For Buterin, a stablecoin that generates a 20% annual return looks like a Ponzi.

  • Just because a stablecoin passes some tests doesn’t mean it’s safe, says Buterin.

The cryptocurrency world was shaken by the recent drop in terraUSD (UST). This was a Terra network token designed to be a stablecoin and always trade at USD 1. Many wonder if the same could happen with other cryptocurrencies not collateralized by fiat money, such as DAI, on the Ethereum network.

The co-creator of the network, Vitalik Buterin, believes that this will not be the case and on his personal blog explain the reasons. It is worth clarifying that exemplifies it, not with DAI but with RAI, a stablecoin backed only by ether (ETH). DAI has multiple collaterals, not just ETH.

Despite this, the ideas conveyed by the Russian-Canadian programmer are perfectly applicable to DAI as well, which is a much more widely used stablecoin. “DAI is a hybrid system backed by both centralized and decentralized collateral, which is a reasonable choice for your product, but makes the analysis more complicated,” Buterin writes.

Before continuing with the explanation of the co-creator of Ethereum, it is necessary to understand how UST managed to maintain its parity with the US dollar. CriptoNoticias, in the article “Where does the Luna Foundation get the money to buy bitcoin?” he explains it in detail.

In summary, to issue UST it was necessary to burn (destroy) the dollar equivalent of the cryptocurrency terra (LUNA). And the same goes in reverse: if UST is burned, then an equivalent amount of LUNA is emitted.

Through a seigniorage mechanism, the market itself was encouraged to expand or reduce the UST in circulation, in order to maintain its price at USD 1. As could be seen, this was not sustainable and the prices of both cryptocurrencies ended up falling, UST and LUNA.

What happens if the activity [en la red Terra] falls to almost zero?” Buterin wonders and he himself gives the answer: “volatile coin market capitalization becomes quite small relative to stablecoin.” When that happens, explains the specialist, the system becomes “extremely fragile”:

Just a small downward shock to demand for the stablecoin could cause the targeting mechanism to print too much of the volatile coin, causing that coin to hyperinflate, at which point the stablecoin also loses its value.

Vitalik Buterin, co-creator of Ethereum.

Differences between RAI (or DAI) and terra USD

In contrast, in RAI (also applicable to DAI, although its collateral is not just ETH) the mechanism is different. A lender deposits ETH as collateral in a smart contract (the “vault”). You can then withdraw up to a certain amount of RAI (less than the collateral deposited) and you can get your ETH back when you pay off the debt.

The motivations for doing this are usually two:

  • To leverage on ETH and trade on longif you believe that the price of that volatile asset is going to rise.
  • To make arbitration, if an investment is found that increases its price. That is, you can borrow RAI and make a profit on the difference.

As Buterin explains, if the demand for RAI dropped considerably, even if there was only one incumbent left, it would not be a problem. The redemption rate would skyrocket until all lenders’ vaults are liquidated. The remaining holder could buy the vault at the liquidation auction, use their RAI to pay off their debt, and withdraw the ETH.

For this reason, the leader etherean he is convinced that RAI (and similarly functioning currencies) “is much more robust than a Terra-style system.”

“There is no genuine investment that can come close to a 20% annual return”

On the other hand, although he does not mention it explicitly, Buterin seems to be criticizing what was the Terra network’s favorite platform, Anchor Protocol. As reported by CriptoNoticias, this decentralized finance (DeFi) application paid annual returns close to 20% per year in the UST stablecoin.

Obviously, there is no genuine investment that can come close to a 20% annual return.

Vitalik Buterin, co-creator of Ethereum.

According to the 28-year-old computer billionaire, there are only two ways for a stablecoin to offer such a rate of return.

The first of these is that some type of negative interest rate is charged to some currency holders to balance the positive interest rate paid to others.

Will DAI go the way of Terra USD? Vitalik Buterin thinks not and explains why
Anchor Protocol paid 20% annual interest to those who deposited UST on the platform. Source: CryptoFuture – YouTube.

The second of these, says Buterin, is that it is a Ponzi scheme “that gives stablecoin holders incredible returns for some time until one day it suddenly collapses with a bang.”

What can be learned from what happened with Terra USD and LUNA?

After mentioning these things, the developer reflects on what can be learned from the situation that the cryptocurrency industry has experienced in the last month.

“The cryptocurrency space needs to move away from the attitude that it is okay to achieve safety by relying on endless growth,” Buterin argues. He adds: “It is certainly not acceptable to maintain that attitude saying that ‘the fiat world works the same way’, because the fiat world does not try to offer anyone returns that go up much faster than the regular economy.

Also, Buterin encourages testing various developments in extreme situations. it even says that if they pass the tests, it doesn’t mean they’re secure, because “they could still be brittle for other reasons or have governance bugs.”

For what has been said, at the user level, it is worth distrusting everything that promises returns that are too good to be true. In relation to stablecoins, in case of using them, the risks and benefits of each of them must be evaluated, in order to make a good decision.

For the latter, CriptoNoticias has prepared the text “What is a stablecoin?” that can serve as a guide for personal research on the subject.

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