High risk brings high rewards: Risk assessment of UST and other stablecoins

Some call them "the best of both worlds", and some "the trader's safe haven". While both statements do have some truth to them, there is much more to be said about stablecoins.

Before investing in any asset, be it a stablecoin or something else, it is your responsibility to educate yourself about it. Only this way can you truly mitigate risk and reap all the associated benefits.

Knowing that education requires plenty of research, we decided to help you cut down the research time and effort by providing this article. In it, we discuss the risks of investing in stablecoins, with a special focus on UST - one of the latest assets listed in the SwissBorg app with an impressive yield rate of up to 19.5%.

A brief explanation of stablecoins

Somewhat of a perfect blend between crypto and fiat, stablecoins offer much-needed privacy, security, and rapid processing while not being volatile.

Pegged to reserve assets, stablecoins can maintain a fixed value and give their holders the luxury of not worrying about price swings common with even the biggest crypto players like Bitcoin and Ethereum.

This now poses the question, "Is the grass that much greener on this side of crypto?". The simple answer is no, and here is why.

In comparison to other cryptocurrencies, stablecoins are indeed low-risk. Still, it's important to note that every stablecoin bears some of the typical crypto risks along with stablecoin-specific risks.

The latter varies from stablecoin to stablecoin but is generally divided into four categories:

• Tech risk
• Counterparty risk
• Market risk
• Systemic risk

We will cover each risk category in detail for some of the biggest stablecoins around, like UST, USDC, and USDT.

But before jumping into all of that, here are some pointers on what to keep in mind before investing in the stablecoin of your choice:

• Proper management and auditing of centralised/decentralised reserves - Completely decentralised coins with synthetic real-world assets can be safe and auditable. Be sure to examine what is the case with the coin you are considering. This is vital in case of any potential involvement of regulators with the coin.
• Diversified reserves - A stablecoin with a tangible real-world assets reserve backing provides much more safety and stability than other crypto assets. If the reserve backing the stablecoin is also diversified and low in volatility, the stablecoin itself becomes safer.
• Technical due diligence - Blockchain and smart contract failures do happen. It's important to know how big is the technical risk of the stablecoin you are considering.

UST: The rising star in the stablecoin space 

UST is a stablecoin pegged to the US Dollar. It is also one of the most notable algorithmic stablecoins (more on that in our Stablecoins 101 article).

UST belongs to the Terra-Luna ecosystem, a Cosmos-based blockchain protocol that uses fiat-pegged stablecoins to power price-stable global payments systems. 

Due to its not-so-original naming, some people might confuse UST with USDT or even USDC. So, what is the main difference?

Both USDT and USDC are backed by collateral, which is not the case for UST. Instead, to maintain its peg through an algorithmic incentive mechanism, UST uses LUNA - the governance and staking token of the Terra blockchain. 

What does this mean for UST holders? It means that the future of UST highly depends on the future of LUNA, as users can burn $1 of LUNA to mint 1 UST or burn 1 UST to redeem $1 worth of LUNA on the Terra blockchain.

UST risks

By now, it's safe to say you understand that UST is not an asset with zero risk.

For those of you interested in an in-depth analysis of the risks of UST, SwissBorg's DeFi risk analyst, Matteo Bonato, wrote a great risk report titled "TerraLuna & UST - Risk Assessment".

To offer you a short yet valuable UST risks overview, we will go briefly over each of the previously mentioned risk categories.

Tech risk - medium/high

Due to it being fairly new to the stablecoin space, it's not yet possible to fully evaluate UST's technical capability, leading to a medium to low high tech risk.

Counterparty risk - high

As mentioned earlier, there is no real collateral backing UST. Instead, an active network of validators and the action of market participants protect its peg by arbitraging any deviation from parity.

UST is also seen as a liability for the Terra ecosystem as one can redeem 1 UST for a 1 USD value of LUNA (and vice versa). In case UST becomes highly volatile, the Luna Foundation Guard has started accumulating BTC, which would serve as additional support for UST.

Along with fears of a possible UST-TerraLuna "death spiral", this stablecoin raises one more concern related to Anchor Protocol - a lending and borrowing protocol in the Terra ecosystem.

Close to 50% of UST in circulation is locked in the Anchor Protocol, which offers a lending rate of over 19% on UST deposits. However, although very high and appealing, this may not be a sustainable rate. So, if there is a decrease in offered UST rates, UST positions could be deleveraged, and stress could be put on UST's peg and the price of LUNA.

Taking into consideration the unsustainability of Anchor Protocol rates and the lack of real collateral backing UST, it's safe to say that it has very significant counterparty risk.

Market risk - medium

Both UST and LUNA enjoy a lot of popularity that doesn't show signs of dying down. But, given that USDT - another popular stablecoin - lost its peg shortly in May 2021, we can say that UST has a somewhat significant market risk.

Systemic risk - medium (with a negative outlook)

Even with a daily trading volume of just 500M USD, UST is still the fourth largest stablecoin in terms of market capitalisation. The Terra ecosystem is consistently gaining market share, and the growth of LUNA and UST seems to be unstoppable. This uncontrolled growth (together with the ongoing accumulation of BTC) could pose a serious threat to the DeFi and crypto space in terms of systemic risk. Thus, UST's assigned systemic risk grade is medium (with a negative outlook).

The best ways to mitigate risk related to UST

1. Keep an eye on UST positions/yield investments in terms of de-peg probability and the health status of the Terra ecosystem. The latter can be assessed by looking at TVL in the Anchor Protocol.
2. Look for signs indicating reduced demand for Terra stablecoins as well as LUNA.
3. Stay up-to-date with the secondary market - the Terra primary market cannot support large amounts of redemptions, so the secondary market needs to be active, liquid, and with good trading volumes.
4. Set exit limits to start unwinding position on time.

The risks of other stablecoins: USDT and USDC

Given that all stablecoins bear a certain amount of risk, we decided to provide you with brief risk assessments of USDT and USDC as well, in hopes of helping you decide which stablecoin(s) and associated risks are you willing to take on.

USDT risks

USDT, better known as Tether, is a cryptocurrency pegged to the US Dollar, meaning that an equivalent amount of USD backs the circulating supply of Tether. Tether tokens, which trade under the USDT symbol, are generated by Tether Limited and then issued by Bitfinex following fiat currency deposits into its reserves.

Tech risk - low

Since its November 2014 launch as the first stablecoin in operation, USDT has accumulated 143M transactions. 

USDT moved to the Ethereum network in November 2017 and now holds third place in market capitalisation. This stablecoin is, in fact, the most used one and bears a low tech risk.

Counterparty risk - medium/high

Despite its large popularity, USDT has had its fair share of controversies:

• Alleged hack costing 31M USDT
• Findings that the audit ensuring maintenance of the real-world reserve was never conducted
• Accusation against iFinex Inc., stating that a loss of 850M USD in client and corporate funds had been hidden from investors
• Accusation stating the illegal manipulation of BTC with non-backed USDT

Looking back at all the controversies surrounding USDT, it's fair to say that it has a medium to high counterparty risk.

Market risk - low

Thanks to its wide adoption and availability on almost every crypto exchange, this stablecoin enjoys a low market risk.

Systemic risk - high

At the time of writing this article, USDT has a market capitalisation of 82B USD and a similar daily trading volume. As the most traded cryptocurrency, USDT has a high impact on the market (44% of the USD stablecoin market cap and 85% of volume) and thus a high systemic risk.

USDC risks

When it comes to stablecoins in the DeFi space, USDC reigns supreme along with DAI. USDC is supported by the Centre Consortium and promoted by Coinbase, which provides liquidity to projects.

Tech risk - low

Since its 2018 launch, USDC has registered over 37M transactions, solidifying the fact that it has a low tech risk.

Counterparty risk - medium

Considered centralised by many, USDC has high-quality reserve assets backing it, including the US Dollar.

The technology which enables USDC to hold the backing USD value and be minted is based on a legal framework. Centre Consortium - a trusted entity in the ecosystem - is responsible for the maintenance and Grant Thornton for the monthly auditing.

But, regardless of being the first regulated cryptocurrency, USDC has an Ethereum-based infrastructure that regulators have little power over. This leads us to believe that the counterparty risk is medium.

Market risk - low

As mentioned earlier, USDC is very present in the DeFi space, specifically as collateral and principal on multiple DeFi platforms. It is also low in volatility, allowing it to boast a low market risk.

Systemic risk - medium/high

Ranking fifth on the list of largest cryptocurrencies, USDC has a market capitalisation of 51B USD (27% of the USD stablecoin market) and a daily trading volume exceeding 4B USD (5% of the market). 

As is the case with USDT, any failure of USDC could have severely negative impacts on the stability of the crypto market, giving its systemic risk a medium to high rating.

Conclusion

We hope that with this article, we have made you more aware of the potential risks you could face when investing in stablecoins. Remember, every investment comes with a risk, so it is up to you to find an asset worth investing in that meets your risk preferences.

At SwissBorg, we do our best to give you plenty of options to grow your wealth but also educate you on how to invest in crypto the smart way. So make sure to check out our app equipped with the best investment tools and our blog, where we publish educational content regularly.