TerraUSD’s stability mechanism stopped working this week when investors lost faith in Luna, amid a broader downturn in cryptocurrency markets. TerraUSD’s price crashed to as low as 30 cents. In theory, asset-backed stablecoins should hold firm despite this. But Tether also broke away from its dollar peg for the first time since 2020 on Thursday, dropping to as low as 95 cents.
Generally, cryptocurrencies have a major problem with price volatility, but one sub-category of coins designed to maintain a constant value is called Stablecoins. In theory, as cryptocurrency prices plummeted this week, with bitcoin losing around a third of its value in just eight days, stablecoins were supposed to be isolated from the chaos. But interestingly an unexpected collapse in the 4th-largest stable coin TerraUSD, which broke from its 1:1-dollar peg, has brought the asset class under renewed attention.
Now before we dive deeper we need to get our head around Stable Coins.
Stable coins are cryptocurrencies designed to be protected from the wild volatility that makes it difficult to use digital assets for payments or as a store of value. They attempt to maintain a constant exchange rate with fiat currencies, for example through a 1:1 U.S. dollar peg.
Talking of the significance and popularity of stablecoins, these have a market cap of around $170 billion, making them a relatively small part of the overall cryptocurrency market, which is currently worth around $1.2 trillion, according to CoinMarketCap data.
But they have surged in popularity in recent years. The largest stablecoin, Tether, has a market cap of around $80 billion, having surged from just $4.1 billion at the start of 2020. The No.2 stablecoin, USD Coin, has a market cap of $49 billion, according to CoinMarketCap data.
While data on the specific uses of stablecoins is hard to come by, they play a crucial role for cryptocurrency traders, allowing them to hedge against spikes in bitcoin’s price or to store idle cash without transferring it back into fiat currency.
Also, Read What is CryptoCurrency?
Working mechanism of Stablecoins
There are two main types of stablecoin:
1. Those which are backed by reserves comprising assets, such as fiat currency, bonds, commercial paper, or even other crypto tokens.
Stablecoins such as Tether, USD Coin, and Binance USD are reserve-backed: they say that they hold enough dollar-denominated assets to maintain an exchange rate of 1:1. The companies say that one of their stablecoins can always be exchanged for one dollar. Asset-backed stablecoins have come under pressure in recent years to be transparent about what is in their reserves and whether they have sufficient dollars to back up all the digital coins in circulation.
Just for an example-: Report says that Tether held $34.5 billion in Treasury bills and $4.2 billion in cash and bank deposits, as of Dec. 31. That combination of reserves represented nearly 50% of Tether’s outstanding tokens, up from 38% at the end of September. Tether also bolstered its percentage of money-market funds to 3.8% of total reserves. Its percentage of commercial paper and certificates of deposits fell to 31% from 44%.
Tether’s other reserves include $4.2 billion in secured loans that it says are made to unaffiliated entities; $3.6 billion in “corporate bonds, funds, and precious metals,” and $5 billion in “other investments, including digital tokens.” Those latter three categories add up to 16% of Tether’s total reserves, and there isn’t any detail about what they are. Tether didn’t provide footnotes disclosing details about its secured loans, funds, or precious metal holdings.
2. Those which are algorithmic, or “decentralized”.
Meanwhile, TerraUSD is an algorithmic stablecoin. This means it does not have reserves. Instead, its value was supposed to be maintained by a complex mechanism involving swapping TerraUSD coins with a free-floating cryptocurrency called Luna to control supply.
Stablecoins – What are the regulator’s concerns?
While regulators globally are trying to establish rules for the cryptocurrency market, some have highlighted stablecoins as a particular risk to financial stability e.g. if too many people tried to cash out their stablecoins at once.
In its stability report, the Fed warned that stablecoins are vulnerable to investor runs because they are backed by assets that can lose value or become illiquid in times of market stress. A run on the stablecoin could therefore spill over into the traditional financial system by creating stress on these underlying assets, it said.
In theory, stablecoins are designed to combat the volatility of conventional cryptocurrencies by fixing their value to that of a fiat (traditional) currency like the US dollar or a physical asset like gold. As long as the value of the asset a stablecoin is tied to remains stable, that coin will also remain stable. Tether (USDT) for example, is tied to the US dollar and thus has remained relatively steady in value. As of this writing, one USDT is valued at one US dollar.
That said, this approach means stablecoins sacrifice some of the independence of other cryptocurrencies. The faith in the asset that makes it stable comes from the fact that one entity—the US government for the US dollar, for instance—controls the majority of the supply and acts as custodians for the reserve assets.
But the problem is a lack of transparency and trustworthiness about the details of reserves, which these stable- coins claim to maintain.
Also just Just because they’re called ‘stablecoins’, doesn’t mean they’ll stay reliable forever. Take for instance the recent case of UST, the stablecoin against which the recently crashed Terra cryptocurrency had been valued against. TerraUSD’s stability mechanism stopped working this week when investors lost faith in Luna, amid a broader downturn in cryptocurrency markets. TerraUSD’s price crashed to as low as 30 cents. In theory, asset-backed stablecoins should hold firm despite this. But Tether also broke away from its dollar peg for the first time since 2020 on Thursday, dropping to as low as 95 cents.
Tether sought to reassure investors, saying on its website that holders were still able to redeem their tokens at the 1:1 rate.
Stablecoins, despite only existing on the blockchain, are also prone to real-world events. For example, if the vaults of Tether’s real-world collateral reserves were robbed and emptied, that would bring the price of the virtual currency crashing down.
