One word sums up this past week: a bloodbath. After the TerraUSD (or UST) algorithmic stablecoin and Luna collapsed, the market lost around $270 billion in a cryptocurrency sell-off.
Luna’s value is now zero and at one point it was worth more than $100. Luna’s was created to maintain the UST peg. UST was supposed to be one-to-one with the US dollar. When Luna crashed, UST lost its peg. When I checked today UST was around 17 cents.
Ilias Louis Hatzis is the founder and CEO of Kryptonio wallet.
So what happened this week?
Well, UST is not fully backed by collateral like some stablecoins. Also, UST did not only rely on the supply and demand economics of its algorithmic relationship with Luna. The Terra ecosystem had purchased significant reserves in bitcoin.
Here comes the good part… When the crash happened it sold all its bitcoin holdings (42,530 BTC, around $1.3 billion) to maintain its peg, causing the price of bitcoin to drop and reach a 16-month low.
Bitcoin dropped below $26,000 and its volatility was at its highest in two years. It goes without saying that every altcoin suffered the same fate this week.
What are stablecoins?
Stablecoins have been around since BitShares launched in 2014 and became popular with the use of Tether on the Omni network.
Stablecoins are supposed to remain stable. Stablecoins are cryptocurrencies that are typically pegged to a fiat currency and aren’t supposed to fluctuate in value. In theory, one stablecoin always equals one dollar.
About 80% of transactions on major cryptocurrency trading and lending platforms involve stablecoins. Stablecoins are used to trade digital assets and serve as an onramp from fiat currency to digital assets.
How do they work?
There are two types of stablecoins: fully backed and algorithmic. There are also stablecoins that are hybrids and use both collateralized and algorithmic peg mechanisms.
Fully backed stablecoins have a fully reserved backing of the money in a bank (like USDC, Binance USD, TrueUSD, and Paxos Dollar). That is, for every $1 of the stablecoin that exists, $1 is in the bank.
Algorithmic stablecoins, like UST, are pretty complicated beasts that have a mechanism to change the price of the currency so the currency follows the dollar. Algorithmic stablecoins use automated smart contracts to maintain the peg, by buying and selling the stablecoin against an associated governance token.
What are the risks?
Stablecoins are more or less centralized and this poses several risks.
If the stablecoin is backed by dollars in a bank, the bank account may be seized because of a number of reasons, including AML/KYC requirements or other government actions.
Some stablecoins are unregulated. There’s no law that requires stablecoins to keep reserves in trusted assets or prove that they even have what they say they have in reserves. You have to trust that the custodians of the stablecoin are legit. In 2021, Tether settled a lawsuit over misleading claims about its reserves.
Pegs may experience instability or design flaws that lead to de-pegging. Last year Fei, an algorithmic stablecoin, was briefly de-pegged after its launch in April 2021. The failed Iron stablecoin used elements from both mechanisms, as its peg was partially backed by USDC stablecoin (a reserve-backed stablecoin), and Titan, the token for the Iron Finance protocol.
Stablecoin regulation is coming fast
Regulators were already concerned about stablecoins and potentially the problems that could arise from the systemic failure of top stablecoins. President Biden’s executive order, spurring federal agencies to look closer at crypto’s risks and benefits, signals exactly this concern.
The collapse of UST triggered a “regulation moment.” There’s already talk about the launch of a joint global body to better coordinate cryptocurrency rules.
Stablecoin regulation could mark the first wave of rules for the crypto markets, but different types of digital assets could be regulated in different ways. For example, the rules governing USDC may not necessarily be the same as those for Ethereum.
Conclusion
Stablecoins are a solution to one of the most serious problems in crypto: volatility.
While stablecoins offer a lot of potential in terms of addressing the volatility problem, the truth is that all stablecoins are not created equal, and as we found out this week, they can be just as volatile as other cryptocurrencies.
Dante Disparte (Chief Strategy Officer at Circle) offers some great insights in a recent post: “Trust is the sum of the parts and not the sum of promissory statements and complex arrangements that only amplify risk, opacity, and correlations, rather than abating them.”
There is no denying the fact that cryptocurrencies and stablecoins are here to stay. But, it all boils down to trust and how you go about achieving it. For any of them to become the future they must earn the trust of the users, the governments, and the world at large.
Subscribe by email to join the other Fintech leaders who read our research daily to stay ahead of the curve. Check out our advisory services (how we pay for this free original research.
