As popular assets in the cryptocurrency space such as Bitcoin see their values rapidly eroding, the decline of a particular stablecoin is drawing the attention of observers as a possible red flag for the market.
That’s fundamentally at odds with the pitch of UST and other stablecoins, which are supposed to maintain a steady value, usually equivalent to the U.S. dollar.
So what’s gone wrong with this stablecoin, and what will it mean for the crypto market? Here’s what you need to know.
What is a stablecoin?
Stablecoins are a particular kind of cryptocurrency that are pegged to the value of an existing asset, often the U.S. dollar.
While popular digital currencies such as Bitcoin and Ethereum are known for occasionally volatile swings in value, the steady promise of a stablecoin is meant to offset these fluctuations. It can make the cryptocurrencies attractive as hedges against Bitcoin or as an alternative store for funds if someone doesn’t want to keep their money in cash.
Alex Tapscott, managing director of the Digital Asset Group at Ninepoint Partners, says stablecoins have emerged as one of crypto’s “killer apps.”
Because cryptocurrencies such as Bitcoin have unsteady values, stablecoins — Tether and USDC are a couple of popular options — are often used as a middle step for exchanges between digital assets.
Stablecoins also have a clear use case in international money transfers, with individuals and businesses able to send funds using a stablecoin without paying costly wire fees, Tapscott says.
“They are a much more efficient and seamless way to move money around the world.… That is a hugely important innovation.”
What happened to TerraUSD and Luna?
There’s a useful metaphor in traditional finance to describe the collapse of TerraUSD, Tapscott says: a run on the bank.
“In many respects, the collapse of UST is basically an old-fashioned bank run for the digital currency era, which makes it kind of fascinating that we’re replaying some of the kinds of crises that we’ve had in the traditional analog financial world in the digital world,” he says.
When a bank holds your money, it only keeps a small percentage of those funds in reserves and uses most of it to finance loans and other transactions. In the normal course of business, that’s usually not a problem, as money is coming in and going out in manageable proportions with a solid base maintained for clients to withdraw cash at their leisure.
But if everyone decides they want their cash today — say, because they believe the bank will default — the institution might not have enough reserves to meet demands. A run on the bank driven by panicked clients only increases the odds that the bank itself will fail.
In the case of TerraUSD, some massive withdrawals of the coin from a crypto exchange earlier this week prompted speculation of a run on the coin, and traders appeared to flee from the asset amid those fears.
With the supply-demand balance upset, TerraUSD broke from its dollar peg. Its sister coin Luna has also seen its value plummet.
Tapscott says there is some speculation in the crypto space that an anonymous trader prompted the run in an “attack” of sorts on the stablecoin. The company behind UST briefly halted trading on the Terra blockchain Thursday to prevent “governance attacks.”
But he also says the coin’s collapse could be a reflection of what happens to unproven assets when market conditions worsen, something he turns to a popular quote from investing magnate Warren Buffett to describe: “When the tide goes out, you see who’s swimming naked.”
What impact will this have on the crypto market?
It remains to be seen whether efforts to boost UST back to its previous highs will be successful.
Before the collapse, TerraUSD was the third-largest stablecoin in the world with a market cap around US$18 billion, making it worth only a fraction of the multi-trillion-dollar crypto space.
Tapscott says the damage might be done from a market confidence perspective, and that could have spillover effects into the rest of the crypto space.
“The psychological impact is significant because people are now questioning the viability of algorithmic stablecoins. They’re questioning whether or not these attempts at decentralized money will succeed. And any crisis in confidence in the asset class is going to be played out across other assets,” he says.
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 as low as US$0.95.
Bitcoin is among crypto assets that have had a poor 2022 so far, down more than 35 per cent year-to-date.
While Tapscott says that’s not the return most Bitcoin holders were hoping for, he’s encouraged to see that Bitcoin isn’t alone, and that high-growth tech stocks are bending to the same market forces as the popular cryptocurrency.
While he believes Bitcoin will always be its own store of value separate from other assets, it lends some comfort to see it’s not alone in the current downturn.
“It’s really no different from most of the other large-cap tech companies.”
What makes TerraUSD different from other cryptocurrencies?
Tether and USDC are examples of centralized stablecoins, which means they have reserves of U.S. dollars held in banks as collateral backing the value of the cryptocurrency.
Decentralized stablecoins don’t have real-world equivalents — they’re backed by digital assets held in smart contracts on the blockchain.
TerraUSD is a specialized version of this called an algorithmic stablecoin.
Here’s how it was meant to work.
TerraUSD maintained its peg to the U.S. dollar by attempting to balance supply and demand of coins on the market.
When the value of TerraUSD drops below US$1, holders are encouraged to “burn” the coin and take it out of circulation. In exchange, they’d get US$1 worth of Luna, another cryptocurrency.
Theoretically, the reduction in the overall supply of TerraUSD would then push its price back up towards the dollar peg.
It would work in reverse too: if TerraUSD goes above US$1, traders can burn a Luna coin to add another TerraUSD into circulation, raising supply and dropping the price.
If the traders remain active selling off and buying back UST and Luna in this dance, TerraUSD should maintain its value around US$1.
Do algorithmic stablecoins work?
This crypto model has come under fire in the past.
Ryan Clements, a professor at the University of Calgary who studies fintech, predicted eventualities like this in his 2021 paper titled, “Built to Fail: The Inherent Fragility of Algorithmic Stablecoins.”
He told Global News in an email this week that the algorithmic stablecoin’s premise is essentially a “confidence game” based on perceptions of supply and demand, rather than underlying assets with fundamental value like their centralized counterparts.
“Algorithmic stablecoins are based purely on confidence and trust in the economic incentives of the stablecoin issuer’s underlying ecosystem, as a result there is nothing stable about them,” he wrote.
“Once trust and investor demand evaporate, they quickly fail in a death spiral — and we saw this in real time over the last couple days with UST/Luna.”
Tapscott says while some decentralized stablecoins like DAI have shown stability through market downturns, attempts to build an algorithmic stablecoin that lives up to its name have not turned out.
“I’m not suggesting there’s anything inherently unworkable or bad about an algorithmic stablecoin, but these are experiments in monetary policy happening on the frontiers of digital finance. And so far, they’ve all failed.”
Are stablecoins regulated?
While regulators globally are trying to establish rules for the cryptocurrency market, some have highlighted stablecoins as a particular risk to financial stability — for example, if too many people tried to cash out their stablecoins at once.
In its stability report published Monday, the U.S. Federal Reserve 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.
U.S. Treasury Secretary Janet Yellen said Tuesday that the run on TerraUSD illustrates the need for to “act quickly” on a regulatory framework for the emerging financial tool.
Stablecoins are currently unregulated in Canada, but Clements said he hopes the current discussions about the fall of TerraUSD will prompt observers to put rules in place to protect the uninitiated against these sudden and dramatic falls.
“I’m sure there have been some tragic losses by unsuspecting retail investors in both coins that didn’t understand how fragile their so-called ‘stablecoin’ was to begin with,” he said in an email.
— with files from Reuters