Cryptocurrency continues to make headlines, just not in the way we have become familiar with in the last year. As volatility in crypto assets has shown no signs of abating, crypto investors looked for other avenues to have exposure to a digital currency that could be more stable… enter Stablecoins. A stablecoin is supposed to offer a combination of traditional-asset stability with digital asset flexibly, which has proven to be a popular idea, with billions of dollars flowing into stablecoins in recent years. So, what is a stablecoin, how do they work, and why have they suddenly been in the news just as much as other cryptocurrencies?
Stablecoin basics
Stablecoins were created to address a need in the cryptocurrency space. While cryptocurrencies are supposed to be used as currency, with the properties of a store of value, most of them have the volatility characteristics of more speculative asset classes. While the significant volatility has allowed investors to make money by holding cryptocurrencies such as Bitcoin and Ethereum, it has also restricted their adoption as a usable currency. For example, no one wants to use their bitcoin to buy a $50,000 car, when a week later that same amount of bitcoin could be worth $75,000.
Stablecoins are meant to be just what the name suggests, a blockchain based cryptocurrency that is stable in price. This allows holders to do two things;
- Use a stablecoin to exit the cryptocurrency market and hold their assets in a coin that will retain its value, then reinvest in cryptocurrency when they want to. The same function as a cash balance in a brokerage account.
- Have a cryptocurrency that investors are more willing to use in a transaction than other cryptocurrencies that are significantly more volatile.
Some users compare stablecoin to a savings account; however, it is important to note that there are still some risks associated with these investments and they are not protected by FDIC insurance like an actual bank account.
How do Stablecoins work?
There are two main types of stablecoin, each has a different process that attempts to reduce volatility and ensure a stable price.
Collateralization (Pegged): A coin backed by something of value, either a fiat currency (U.S. Dollar or the Euro) or Gold.
– This works as long as the investors who hold the collateralized stablecoin believe that the “producer” actually has enough reserves of the asset that backs the coin, to produce the necessary amount.
– For example, if a stablecoin is backed by the USD, and there are 10,000 of a stablecoin in the market, there needs to be $10,000 in the dedicated bank account. This way, if everyone wants to turn in their stablecoin at once, they all get the promised $1.
– Now say that instead of the necessary $10,000, the stablecoin is only backed by $8,000. Theoretically, each holder of the stablecoin would get $0.80, not the full amount but not catastrophic. However, that only works in theory. Realistically, the first people to turn in their stablecoin get $1, and the last get nothing, creating incentive to turn in your stablecoin first. This is how panic selling occurs, essentially a 21st century cryptocurrency version of Great Depression era bank runs.
Algorithmically Pegged: Stablecoins that are not backed by actual assets. Instead, they are regulated by a smart contract and market activity that manipulates the supply of coins available to offset changes in price.
– If the stablecoin begins to appreciate, the algorithm creates more, this increases supply and decreases price, returning it to its target value.
– The reverse is true, if the stablecoin begins to fall in value, the algorithm decreases supply, increasing the price and restoring equilibrium.
Most algorithmically pegged currencies operate with a “sister token” that trades on exchanges. The value of this token can be volatile, but the standing “peg” is that a stablecoin can always be exchanged for a set amount of the sister token.
This relationship works as long as the algorithm functions properly, there are enough willing buyers, and there is enough market value in the sister token to provide the necessary liquidity to back the stablecoin.
The case of Terra:
The Terra network is a blockchain-based ecosystem that runs on the TerraUSD (UST) and LUNA tokens. The Terra blockchain allows developers to create customized blockchains and applications. As of March 2022, there were over 100 such projects.
TerraUSD (UST) is the stablecoin of the Terra network, it is linked to LUNA which is free to fluctuate in price. TerraUSD is designed to have a set value of 1 UST = $1. It uses an algorithmic peg, with the promise that 1 UST can always be exchanged for $1 worth of LUNA. The algorithm works on the arbitrage principal of:
– If UST appreciates to $1.01, traders can exchange $1 worth of LUNA for 1 UST (worth $1.01). This process removes $1 worth of LUNA and creates 1 new UST. This increases supply of UST and will cause the price of UST to fall back to $1. The trader who executed this process has made $0.01 with no risk.
– If UST depreciates to $0.99, traders can exchange 1 UST (worth $0.99) for $1 worth of LUNA. This process removes 1 UST and creates $1 worth of LUNA. This decreases the supply of UST and will cause the price of UST to increase back to $1. The trader who executed this process has again made $0.01 with no risk.
The system works as long as there is enough value in both UST and Luna, and enough willing buyers to execute the arbitrage trades. The operators of the system also had a backup account with other cryptocurrencies (mostly Bitcoin) to backstop the value of UST and Luna.
It worked…….until it didn’t
The Terra ecosystem was firing on all cylinders in the beginning of 2022, UST was stable and the increase in the use of the Terra blockchain caused significant appreciation in LUNA as well. The Washington Nationals baseball team had even entered into a deal to work towards accepting UST as a payment option in the future.
The downfall of Terra started in early May, when several large sell orders of UST were entered. The arbitrage system could not keep up and the peg was lost.
Once UST lost its peg, instead of buying the devalued token, investors started panic selling UST. At the same time LUNA also began to sell off. This was due to the fact that in order to decrease the supply (raise the price) of UST to restore the $1 peg, the corresponding trades would increase the supply of LUNA, driving down its cost. This caused investors to rapidly sell both UST and LUNA. The algorithm failed, there were no buyers, and even the reserve account of bitcoin could not hold up the system.
As you can see in the charts below, initially UST was stable while LUNA was allowed to appreciate. When disaster hit in May, they both sold off in a panic-induced death spiral that left both of them practically worthless. An estimated $40 Billion was wiped away in the crash.
| UST: | LUNA: |
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What’s Next
As of now, the dramatic downfall of UST/LUNA has not spread to other stablecoins, and the Terra network is working on plans to try to reboot its blockchain. These events have led to increased calls for regulation of the stablecoin market, from both politicians and financial experts. While the final chapters of this story have yet to be written, it can already be viewed as an important lesson; that every investment has potential risks that investors must consider before putting their hard-earned money on the line.
How We Can Help
As with any investment, it is important to weigh the risk against the potential returns. If you are interested in finding out if investing in a stablecoin is right for you, or if you would simply like to learn more, contact us online or at 410-685-9685.
