A 2022 paper by the ECB stated that “stablecoins account for only a small part of the total crypto-asset market, but the largest ones have assumed a critical role within the crypto-asset ecosystem.”
In this article, we are going to explore this critical role and discuss some historic instances of what happens when stablecoins lose their value.
Table of Contents
What are Stablecoins?
A stablecoin is a cryptocurrency pegged to the price of another asset in order to reduce volatility — for example, USDC is pegged to the price of the US dollar.
The peg of a stablecoin, often the US dollar, gives a user the ability to interact with blockchain and crypto-ecosystems, with the confidence of a broadly stable asset.
For traders, stablecoins are vital on/off-ramp points, allowing them to enter or exit a position, locking in profits or escaping additional losses. In this way, stablecoins act as a sort of “connecting tissue” between fiat and crypto.
Stablecoins allow people and businesses to take advantage of the crypto space, enjoying faster cross-border payment and 24-hour service, while theoretically escaping crypto volatility.
This is perfect for a company that operates internationally, like the Nippon Yusen Kaisha shipping company, which now offers to pay their staff in stablecoins.
This useful function is why we’ve seen such an uptick in the stablecoin market cap from 30 billion in 2021 to its peak of 188 billion in April 2022.
How Do Stablecoins Work?
When demand for a stablecoin increases, more stablecoins are minted, and when it falls, stablecoins held in reserve are burned to decrease the supply. This keeps the price stable, and is typically handled by algorithms. When stablecoins are pegged to the value of an asset, like the US dollar, an equivalent value of this asset is held in collateral to maintain stability.
Terra Luna Case Study
One of the top five biggest crashes in crypto, the Terra/Luna obliterated about 60 billion dollars, sinking around 95% of its value in just under three days. Taking with it, people’s savings and a noteworthy share of the market.
But how did this stablecoin lose its stability?
Terra attempted to create a system that would stabilize the UST peg, by increasing the supply of UST if its value got too high, and burning UST tokens if its value got too low, thus theoretically maintaining value at peg.
This was done through a market cycle of arbitrage opportunities between UST and LUNA.
But the problem with this system was in its levels of arbitrage and management. Terra offered outrageous yield farming opportunities of 20% for staked LUNA, so its value skyrocketed by 135%.
Concerns over the sustainability of this opportunity began to take shape, fears worsened and some people began to exit their positions. Then when about 2 billion in staked UST was suddenly liquidated, a major crypto bank run took place.
On May 7th, UST slipped its peg to the dollar. Now the algorithm tasked to stabilize its value was minting and burning tokens below peg, worsening its conditions automatically in what is supposed to be a system of regulated ups and downs This is what is called an “algorithmic death spiral.”
The Tether Scare
Hilary Allen, a finance expert at American University once stated “Tether is really the lifeblood of the crypto ecosystem, if it imploded then the entire facade falls down.”
Around May 10th of 2022 Tether’s circulating market supply dropped from 83 billion to about 76 billion, causing it to briefly slip its peg by about 5 cents. This is most likely due to the Terra/Luna debacle. Tether recovered, but later when FTX collapsed, it once again slipped its peg, somewhere in the region of 93-97 cents.
What can be observed here is that crypto market conditions are closely interlinked with each other, highly dubious exchange management or dangerous algorithms can create “knock-on” conditions across crypto, which if they were to seriously damage Tether, could impact a vital connecting tissue within the market.
In February 2021, Tether agreed to pay $18.5 million to end a long-running probe into whether they covered up around 1 billion in losses from its customers and sketchy reserve practices with its sister company Bitfinex.
What this New York probe also unearthed was a more thorough breakdown of Tether’s collateral reserves, finding that a portion of its capital was tied up in highly volatile commercial papers.
Confidence is a key element of what makes a stablecoin stable, so Tether has been fast to respond, pledging to decrease its holding in commercial pacers to around 8.4 billion by 2022.
The concern here is not that Tether might momentarily slip its peg, because as has been observed throughout Terra/Luna and FTX, Tether has been very good at righting itself in bad conditions.
It’s difficult to say exactly what the future will bring for Tether specifically, perhaps these trial-by-fire market conditions over the last few years have tempered this stablecoin, and Tether will continue to be one of the strongest examples of this relatively new kind of centralized cryptocurrency.
Or the cracks might be more foundational, and the market may be in for a big upset when they eventually give way.
But what will remain true, is that the role of stablecoins is foundational to the market itself. So where one crypto might fall due to greed, mismanagement or structural flaws, others will take their place, and either by regulation or experience, be better suited to their role.
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